Friday, September 19, 2008

Resolution Trust Corporation

The US proposal to create an RTC has helped stabilise markets today- or so it seems for now. The RTC would buy bad assets from banks at an appropriate price.It would auction those assets later once markets have stabilised. What does this achieve? It helps stabilise the value of assets of financial firms and prevents the collapse of highly leveraged institutions. Hopefully, the RTC will make a profit later; if not, the government incurs a cost equivalent to the losses on sale of assets the RTC has bought.

Writing in the FT, Raghuram Rajan argues that this is not the right proposal because it ends up rewarding institutions that have taken wrong decisions at a cost to the tax payer. He says it won't address the basic problem which is lack of capital at financial institutions. He suggests intead that these institutions be asked to withhold dividend payments; and stronger firms be asked to make rights issues.

It's doubtful this will work. Shareholders of existing firms lack the incentive to subscribe to rights issues until then are sure that asset prices have stabilised. Secondly, capital will be ready to flow into today's distressed institutions once investors are reasonably sure that the firms' asset values will not decline further.

So, the RTC is indeed the way out. Yes, there is moral hazard. But the world is falling apart, that's not the time to think of moral hazard.

10 comments:

2jaipm said...
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2jaipm said...
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stevie84 said...

hello sir as i think
Troubled assets don't become more valuable over time; they become less valuable

Sharan said...

Dear Sir
The timing of the Fed seems all wrong to me. The argument for moral hazard was present even when Bear Stearns was bailed out. But Bear Stearns was bailed out.

With this in mind, it’s difficult to cite Moral Hazard as the reason for allowing Lehman Brothers to go over.

It’s also been argued that using the tax payer's money to bail out banks is fundamentally incorrect. I find such an argument ironic. The origin of the liquidity crisis comes from lending to sub prime borrowers, people who may either not fall under the tax net, or may not have a strong record of paying tax. However, the people who find them selves without jobs are some of the highest tax payers in the country, whose’ spending habits keeps alive many industries (aviation, tourism etc.).

The implications for the present turmoil are bound to have long lasting effects. So, does making an example of institutions like Lehman, and Merrill really make sense?

Syam said...
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Syam said...

am in agreement that the time to cite moral hazards has past. Action is necessary as this mess has become one of global proporations, and shakes the very foundation of the world as we know it.

For the record, I do not like the use of taxpayer money for bailing out this financial mess created by lax regulations and financial institutions driven by profits and greed...but at this point there really is no choice.

I am a taxpayer in the US, and I hate to see my hard earned tax money diverted to bailout those "greedy professionals and profit driven institutions" who should have known better!

After all, the finance industry and its well educated professionals should have appropriately understood risk to reward ratios...and since they did not care to do so, well, we are witnessing first hand what happens.

I would also like to clarify that sub-prime borrowers, who represent a large part of this puzzle are really a minor part of the lending picture in the US. They should not have qualified for such sized loans based on gross annual earnings...since loans here in the US are based on gross earnings (less outstanding debts).

One could argue they are living for the moment, and that is true...their spending habits are beyond their means.

Should they be blamed for their spending habits? I argue no, since it always has been a given those types of profiled borrowers have a habit of not earning enough to support their debts.

However, on the other hand, institutions that created (or took part in) a myriad of products based on CDO's and other derivatives are in trouble today, because of not properly evaluating the fundamentals of the underlying asset prices.

I own a home in the US, work hard, earn a good salary...and pay a sizable income tax, and I am not a sub-prime borrower. However, the current state of affairs threaten even well qualified borrowers...due to the domino effect of failing financial institutions.

So moral hazards aside, action is necessary. Those of us who honestly work and pay taxes are not happy, but the system threatens to affect all of us if not stabilized soon.


I also want to highlight that even though the US Gov't let Lehman Brothers go to bankruptcy, it seems the US Fed is helping their good assets through the "back door". JP Morgan Chase advanced them $138 Billion...and precisely where does JP Morgan Chase have that kind of money in this day and age?

Besides, Lehman's senior management knew this was coming, and waited too long to find a suitor.

As for Merrill Lynch, they struck a merger deal "very quickly" so as to avoid the same fate as Lehman Brothers.

Making an example of these types of institutions is appropriate since these "investment banks" are the major piece of the puzzle to our current debacle.

When you take into account the bonuses that senior managment will take with them despite failing their organizations multi-billions of dollars...while the average workers get to see their tax money used to bail these failure, I do have my issues.

However, for the good of the many, we hope to see stabilization occur sooner than latter...and the inevitable use of taxpayer money to do so.

The segregation of troubled assets may not become more valuable overtime, however, the mere act of segregating them creates a stability...as opposed to unwinding them in a rapid fashion.

So yes, an RTC style bailout is appropriate given the size and scope of the current debacle.

I apologize for the length of this post, however, I keep combing through the internet to see what other professionals are thinking and your post caught my attention. I want to thank professionals like you and the other posters in this blog for helping all of us to better understand the current state of affairs of this massive debacle.


Kind Regards

Adorable Bad Guy said...

I understand that RTC will buy illiquid assets from Banks probably at a deep discount and thus inject new capital into banks which they can then use to generate business.

To me $700 billion is an investment which may even have an upside. I really do not understand why ppl are opposing it. Whats your take on this? Do you think its all bad news for the tax payers?

A bank would have to take huge write-down in its P&L the moment it takes this lifeline due to the deep discount associated with it. Therefore this may be their last resort to raise new capital.

We still have to wait for the details to come out, but to me it appears a sane approach.

Dota said...

Thnx, interesting information!

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