"The opinions expressed in this article are the views of individual PRMIA members and do not in any way represent an official position or commentary from PRMIA - The Professional Risk Managers International Association "

ALTERNATIVE BANK ASSISTANCE PROPOSAL DRAFTED BY INDIVIDUAL MEMBERS OF PROFESSIONAL RISK MANAGERS INTERNATIONAL ASSOCIATION

Sunday, September 28, 2008

This is an outline of an alternative structure for the market bailout plan that applies to all troubled assets held by US financial institutions. We believe that it has certain characteristics that will make it much more palatable financially and politically than the existing proposals. In particular it solves several problems that exist in most proposals, including proving a capital backstop for financial institutions. While the present crisis may have begun due to concerns about liquidity, the dysfunction in the financial markets is being driven by concerns regarding capital and solvency.

* The government only puts up cash for losses incurred. As such the total debt issuance is much smaller than the existing plan and happens over a longer time period.

* The banks get time to work out loans. No bank has to take a write-down on an asset to participate in the program

* Banks get a capital backstop.

* Economc interests between the public and the bank shareholders are aligned

* Bureaucracy is limited. The size of the agency that has to be set up to administer the program is kept to a minimum.

* The government earns a profit on its bailout of any given institution before the shareholders. This makes it more likely that over its lifetime, the program will not lose money for the taxpayers.

* Banks can stay independent and can earn their way back to health rather than having a large portion of the banking system government owned.

* The government doesn't end up with massive equity holdings or a controlling interest in surviving institutions.

The plan works as follows:

* For a given set of mortgage characteristics - MSA, FICO, LTV, etc. - the government sets a backstop level. Now, say that we have a pool of loans and the backstop level for this pool is 90. It doesn't matter where the bank has the asset valued. All banks get the same level.

* Banks bid for the backstop by offering callable preferred equity with the following characteristics

* The coupon is fixed at a rate higher than treasuries so that the government earns positive carry

* The call price is set to give the government a fixed positive internal rate of return (IRR) over the life of the transaction.

* Common equity cannot receive dividends before preferred gets paid and over time (after say 5 or 10 years), common equity dividends and/or earnings must be diverted to reduce principal

* The value that is used to determine the auction price is the IRR. Banks bid for backstop and the one that agrees to pay the highest IRR gets the backstop. The total IRR is capped as it makes no sense to allow somebody to guarantee rates of return that are completely unrealistic. If the auction reaches the cap, then bidding switches to lowering the backstop level.

* The bank issues no preferred equity on day one. Equity is only issued as losses are realized beyond the level of the backstop. Thus, if we have a 100 dollar pool with a 90 dollar backstop, the government doesn't pay out any cash until the losses exceed 10. At this point the bank issues the equity in exchange for cash. Since it is preferred, it counts as regulatory capital, but it solves the problems of making sure the government gets paid before common equity holders

* The government gets positive return unless the bank fails, but that is a case in which it would have to take over the bank anyway.

* The number of financial institutions that has to be placed under government supervision is minimized

* The Treasury only issues debt to fund losses as they are taken. It doesn't fund whole loan pools. This makes the total debt issuance lower and stretches it out over time.

* A backstop price is set for the cost of bank capital. This makes it cheaper for banks to raise capital in the open market and less likely that the backstop will be drawn. Remember that if a bank raises capital that is cheaper than the backstop it has the incentive not to use the backstop.

One still needs to worry about workout. In order to avoid moral hazard there are two choices

* All loans in the pool stay on banks balance sheet but are managed by a central agency.

* Banks continue to work out loans directly. In order to keep them from taking too much risk we may need to have the banks take a quota share of the residual. That is, for a given pool of loans, the bank takes 100% of the risk on 10% of the pool and only the first 10% of the loss on the other 90% of the pool. The government takes the loss on the last 90% of the 90% piece of the pool. This is a reinsurance concept called a tower or quota share.

Drafted by several senior members of PRMIA (www.prmia.org) and posted with thanks by Christopher Whalen, Regional Director, Washington, DC Chapter, and James Tunkey, Regional Director, New York Chapter. The opinions expressed in this article are the views of individual PRMIA members and do not in any way represent an official position or commentary from PRMIA - The Professional Risk Managers International Association.