SO, FORREST, WHAT DO WE DO NOW?Ten Steps to Fix the Paulson Plan and Solve the US Debt CrisisJS Henry and Brent Blackwelder

The US Congress is busy working hard on US Treasury Secretary Henry M. Paulson Jr.'s $700 billion TARP bailout plan  -- at least everyone except Alabama's Rep. Spencer Bachus, the ranking Republican on the House Financial Services Committee, who has spent much of the day explaing why a senior official in his position has the time, much less the ethical license,  to be making scores of options trades during office hours.

While we have every confidence that Rep. Bachus and his peers will provide masterful oversight of the Secretary's proposal, it is understandable that with less than six weeks left to the November election, and Congress set to adjourn on Sept. 29, we appreciate that they may have more important things to worry about than the greatest US financial crisis since the Great Depression. 

So it is time to help them out. Given the widespread dissatisfaction -- indeed, revulsion -- at Paulson's initial request for a $700 billion blank check  -- on top of the other $500 - $700 billion that the Treasury/ FDIC and the Federal Reserve have already committed to Fannie/ Freddie, AIG, Bear Stearns, and other banks this year -- it is clear that revisions are needed. But time is short -- not just because of election imperatives, but because global financial markets are on pins and needles, waiting for a clear solution.

Any time there is this kind of sea-changing economic event, it tends to surface every interest group's Christmas wish list of long-delayed "essential reforms."

In this situation, indeed, the crisis has brought forth everything from proposals for "nationalizing the banks" and new regulatory agencies to "clawbacks" in executive severance plans and income tax reform.  There are also a substantial number of people who are concerned about the implications of the initial Paulson proposal for constitutional democracy -- some have called it as nothing less than an "economc coup d'etat" by "Commandate Paulson,"   because of all the unreviewable authority it would have vested in the Secretary and his minions. 

Given that Congress is moving at the speed of light, we need to "tier" these proposals according to their importance.  There are also a few more innovative ones that deserve immediate attention. Here's our own "Top Ten Improvements" wish list.

WISH LIST

1.  Equity  “Upside” and Voting Power.

In return for the undeniable new risks that US taxpayers are taking on, and the poor management track record of leading Wall Street institutions,  it is reasonable to insist that they receive an “upside” on the value of participating financial institutions (FIs) themselves as well as on the potential increased value of acquired mortgage-backed assets.  This proposal commands widespread support in this panel.

Technically, this could be accomplished by demanding preferred shares (with anti-dilution provisions) from any financial institutions (FIs) that receive assistance, as was routinely done by Bank of Japan in exchange for financial assistance during the Japanese bank restructuring of the 1990s, and by the Chilean government during the February 1983 bank nationalization.

Warrants might also be used, as was done in the case of the 1979 $1.2 billion Treasury loan guarantee to Chrysler. (According to Sen. Bradley, the Federal Government eventually made money on those warrants.) We believe that while warrants are easier to implement, it is vital to insist on actually equity (including voting power). This will provide the Treasury with much more direct influence over management behavior, will be easier to value, and will also be easier to explain to the public than warrants.

2. Clawback Provisions for Executive Severance Pay.

The basic  principle here is that for  senior FI executives, there should be accountability for some time period even after they leave office – at a minimum, any future compensation or severance that they receive should be subject to stiff taxes or repossession in bankruptcy court. Insisting on compliance with this standard should be a condition for participation in the bailout.

3. Share the Pain.
   
A.  Emergency Taxes. 

Since this very costly bailout package may severely limit the ability of the Federal Government to afford vital programs like health insurance reform and alternative energy, it is important that we deal now with the substantial “tax justice” implications of the bailout.

One way to do this would be to start treating this as the national emergency that it really is, and help ordinary taxpayers pay for it by: (1) eliminating the carried-interest benefits for hedge fund managers; (2) cracking down on offshore havens – no FIs should be permitted to establish subs or place SPVs  in them;   (3) imposing at least a temporary increased  income tax rate on all people with incomes above $1 million and on all estates above $10 million.

B. Compulsory Write-Down/ Debt Reduction of Residential Mortgages.

Given the failure of this summer’s relief packages for ordinary mortgage holders to have much impact, and the fact that foreclosures are still increasing (to a record 100,000+ per month, and that housing prices are still falling in a majority of key markets, this is an another essential measure. The debt restructuring should be implemented quickly, affect large numbers of people, and be inversely proportional to mortgage size. It might also be means –tested.

Such a measure would not only provide equitable relief to millions of would-be homeowners; it would also help to kick-start a US economy recovery.

4. Financial Products Safety Commission.

This would review and certify the quality of all financial products offered to the general public. Products like zero-down payment mortgages would require special labeling, and might not qualify for government incentives like interest deductibility, access to the government insurance window, and so forth.

5.  A New US Treasury-Created Market for MBS Insurance.

A novel idea suggested by our good friend Prof. Lawrence Kotlikoff of Boston University  is that the US Treasury might be able to use current authority to offer ABX-like insurance at a fixed price per tranche  to institutions that hold MBSs.  According to Professors Kotlikoff and Merlin, if such a government-backed insurance market were in place, backed by a significant reserve against losses, it might even obviate the need for the entire $700 billion, while creating a market-based workout alternative.

This could be combined with #1, if FIs were allowed to pay for the insurance with  equity or warrants.  This would also have the benefit of helping to recapitalize troubled FIs.

6.  New “Pecora Commission” (ala 1932): a congressional committee with subponae power to investigate the root causes of this crisis and recommend further steps.