Warrants Alone Will Not Solve Financial Crisis

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This is a response to “A Rescue Plan which Puts America First” by Jim Neal.

Consider the proposal to only buy warrants from banks and insurance companies licensed by the United Stated federal government or one of the U.S. state governments.

Suppose Investment Bank A has a lot of mortgage-backed securities.  Bank A buys credit default swaps (CDS) from Insurance Company I to insure the value of those mortgage-backed securities.  Due to non-performing mortgages, the mortgage-backed securities decline in value.  That puts stress on Bank A’s balance sheet.  Bank A does two things:  It asks Insurance Company I to put up more collateral on the credit default swaps, and it petitions the U.S. Treasury to buy Bank A warrants.  Insurance Company I also has a distressed balance sheet.  It also petitions the U.S. Treasury to buy Company I warrants. 

What should the U.S. Treasury do?   Buy warrants from A or I, or both?  The two applications were both triggered by the same event, but it is not apparent to the U.S. Treasury, because Bank A has many mortgage-backed securities, and Company I has sold many CDS’s. 

Suppose the U.S. Treasury buys warrants from Bank A, enough to improve its balance sheet.  The U.S. Treasury also buys warrants from Insurance Company I, which uses the money as collateral on the CDS’s.  The price of houses continues to decline, the value of the mortgage-backed securities goes down again, and again Bank A asks Insurance Company I to put up more collateral for the CDS’s.  I goes back to the U.S. Treasury to sell more warrants.

Then it comes to light that Bank B had bought CDS’s from Hedge Fund H on the mortgage-backed securities owned by Bank A.  U.S. Treasury declines to buy warrants on Hedge Fund H.  Hedge Fund H declines to put up more collateral on the CDS it sold to Bank B.  Outside auditors demand that Bank B write down the value of the CDS it bought from H, causing Bank B to need more capital.  Both Banks A and B ask U.S. Treasury to buy warrants.  Hedge Fund H runs low on capital, and starts to sell its good equities in the stock market to raise capital.  The stock market declines.

How long will this mess go on? 

If this example seems to be dense, I assure you that it greatly oversimplifies the situation.

The warrants-only proposal would leave the toxic assets on the books of many financial institutions for years.  We do not want our banking mess to drag on for a decade, as did the Japanese Banking Crisis.

Conclusion:  It is OK to ask the U.S. Treasury to buy options in the companies from which it buys troubled assets, but to buy only warrants would prolong the financial crisis.  The government needs to reduce the amount of toxic assets clogging the books of financial institutions.

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One Response to “Warrants Alone Will Not Solve Financial Crisis”

  1. Jim Neal Says:

    I didn’t suggest “warrants alone.” I suggested buying convertible preferred stock. Preferred preferred stock equals the sum of (i) preferred stock which is senior to common stock, plus (ii) an option (not a warrant…warrants are securities which trade trade independently) to buy common stock of a bank by exchanging the convertible pfd. stock for common stock (at a time when the value of the common is greater than the value of the conversion value of the preferred.) This is a rough sense of what a convertible pfd. security is and isn’t. Alternatively, the Treasure could issue senior debt and receive warrants to acquire common– which would put it in even a more secure position as it could exercise the warrants and still hold senior debt which is superior to all classes of stock.

    Having clarified that, let’s address your scenario. Firstly, it’s not clear that Treasury could buy CDXs. Secondly, if a bank has received an infusion of capital it can sell the toxic assets and not trigger an obligation on Insurance Co. I to increase its collateral– the insurance doesn’t attach to the debt if it’s sold. And BTW….the last thing I want is for the Treasury to become mired in trying to mitigate the CDX market: that’s a $60 trillion market used to insure soup-to-nuts assets and often sold against a debt obligation that the insurance receiving on the other end doesn’t even own?!

    Your premise is that if the Government doesn’t buy the toxic mortgage debt the US economy is going to mimick the Japanese experience. That’s a premise which is pure speculation on your part. What we do know is that bailouts have seldom worked– the results have been negative for many governments save for Sweden (which, by the way, acquired equity stakes in the firms it bought and retained control over their business.)

    We simply disagree here. You advocate a straight-up bailout of the private sector by the public; I do not.

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