troubles come, they come not single spies, but in battalions.� --Shakespeare
�The liberty of a democracy is not safe if the people tolerate the growth of
private power to the point where it becomes stronger than the democratic state
itself. That in its essence is fascism -- ownership of government by an
individual, by a group or any controlling private power.� --Franklin D. Roosevelt (1882-1945), 32nd US
�Our economy is facing a moment
of great challenge. . . . We�re in the midst of a serious financial crisis.� --George
W. Bush, September 24, 2008
gridlock about finding a solution to the subprime
financial crisis in the United States is turning into a tragedy, seemingly
because of a fundamental lack of understanding and communication about the
causes of this financial crisis and the most efficient way to solve it. The
nature of the crisis, the economic consequences if it is not solved, and how it
could be solved without costing the government and U.S. taxpayers a single
penny has not been properly explained to Congress and to the U.S. population.
Indeed, in this election period, there is a clear danger
that the financial crisis is not going to be solved properly by the U.S. government
and by Congress, and that there will be dire economic consequences in the
months and years ahead, not only for the United States but also for the world
economy. A similar subprime crisis has been solved in Canada, without costing
the government and Canadian taxpayers a single cent. Although such a solution,
i.e. transforming most of the subprime mortgage-back securities into medium
term debentures, would have to be adapted to the peculiar American situation,
this can be done.
The Canadian solution
In August 2007, it was discovered that Canada, just as the
U.S., had a subprime mortgage-backed securities problem. Since the Canadian
economy is more than 10 times smaller than the American economy, the magnitude
of the problem was also smaller, but it was nevertheless acute.
Indeed, Canada�s subprime mortgage market was a smaller
proportion of the total mortgage market than in the U.S. and mortgage defaults
have not been as prevalent in Canada as in the United States. For instance,
there has not been a housing bubble burst in Canada. Overall, risky
mortgage-backed paper constituted, about 5 percent of the total mortgage
market, while in the U.S., subprime mortgage paper constitutes about 20 percent
of the total mortgage market, and mortgage defaults have been rising
Nevertheless, there was some $32 billion (CAN) of non-bank
asset-backed commercial paper in Canada. When this market became illiquid after
August 2007, as a consequence of the global credit crisis that originated in
the U.S., a restructuring committee was assembled in Canada by large pension
plans, Crown corporations, banks and other businesses holding the bulk of $32
billion in non-bank asset-backed commercial paper (ABCP) in order to find a
solution to the liquidity problem. (Large Canadian banks covered the
asset-backed commercial paper that were on their books or in their money market
funds). This was the Pan-Canadian Investors Committee for Third-Party
Structured ABCP, chaired by a Toronto lawyer, Mr. Purdy Crawford, and created
after a proposal that originated from the large Quebec pension fund, the Caisse
de d�p�t. This was the Montreal proposal.
The committee ended up proposing to restructure the frozen and
illiquid securities into longer-term securities. It proposed that ABCP notes,
initially intended as low-risk and short-term debt, be exchanged for new
replacement notes or debentures that would not mature for years (seven or nine
years) while earning interest originating from the underlying primary
mortgages. The plan was approved by a Canadian court last June and is scheduled
to close by September 30, after Canada�s Supreme Court refused to hear an
appeal against the plan.
The plan was designed to prevent a forced a fire sale of the
asset-backed paper and to restore confidence in the Canadian financial system,
especially in the money market funds. And it did all that without the
government risking a penny of taxpayers� money.
Of course, those entities that had invested in what they
believed to be liquid and relatively high-yield 30- to 90-day debt instruments
had to accept new notes maturing within nine years, but most of them thought
that this was better than the alternative of outright liquidation. Those
investors can hold the newly issued notes to maturity or they can try to trade
them in the secondary market. A market for asset-backed securities was thus
indirectly created where none existed before.
What lesson can be drawn for the current U.S. predicament?
The U.S. problem:
Real danger of a cascading debt-deflation spiral
The financial crisis is much more severe and much more
widespread in the U.S. than in Canada. Therefore, a large-scale Canada-like
solution would have been, most likely, unrealistic. Could hundreds of American
banks and pension funds get together to restructure the illiquid
mortgage-backed paper? This is doubtful.
However, the principles behind the Canadian solution can be
retained and the mortgage-backed securities could be restructured into
longer-term securities carrying interest. But because of the size and
complexity of the American financial system, this would have to involve the
U.S. government as an intermediary.
In the U.S., for example, the mortgage market (residential
and commercial) is about $14 trillion, that is a size equal to the annual gross
domestic product (GDP). Overall, the U.S.�s total interest-bearing debts are
now a staggering $51 trillion (consumer, corporate and government debt), that
is to say a level of total debt more than three and a half times the annual
GDP. In past decades, the ratio of debt to GDP was about 1.0. This shows the
extent of American current over-indebtedness.
In the short run, however, there are two urgent problems
faced by the U.S. economy that must be solved with as little economic
perturbation as possible.
First, there is the most urgent problem of solving the
overhang of illiquid mortgage-backed securities which were created as the
equivalent of liquid commercial paper. They must be urgently aligned more
closely with the more long-term mortgages downstream they are based on. Since
much of this illiquid mortgage-backed paper is found in the $4 trillion money market funds market, there was and there still is the
danger of a run on such funds in the coming days and weeks if investors fear
for the safety and liquidity of their balances. A collapse of the market in
money market funds would be equivalent to the banking collapse of the 1930s,
since this is where companies park most of their required cash flows in the
The second American financial problem is related to the
approximately $2.7 trillion in municipal securities outstanding, a large
proportion of which have been relying on a bond insurance system that is
teetering on the brink of collapse. The U.S. Treasury partly solved this
problem temporarily when it announced on Tuesday, September 16, that it had
loaned $85 billion (for two years) to the largest world insurance company, American International Group
(AIG), in exchange for a 79.9 percent stake in the company, thus avoiding a
formal bankruptcy filing for AIG. This was, of course, after announcing that
the U.S. Treasury promised to inject some $200 billion in the government-sponsored
Fannie Mae and Freddie Mac in preferred shares, in order to solidify their
mortgage lending operations and their $5.3 trillion joint debt.
The Bush administration�s proposal to create a fund of $700
billion to buy back illiquid mortgage-backed paper does not seem to have been
structured in a manner that would avoid an outright subsidy to the American
banking sector. If it were to be used to recapitalize private banks, this
amount would be too small. This need not be. In fact, much of the legitimate
fear that many Americans have that large amounts of public money are going to
be used to subsidize Wall Street firms can be avoided, and the amount required
to restructure the subprime-based securities market could be considerably
Indeed, there is a way for the U.S. Treasury to play an
intermediary role in restructuring most of the illiquid mortgage-backed paper
that creates so many problems today, not the least would be the possible
collapse of large segments of the U.S. financial system.
Since time is of the essence, Congress could approve the
creation of a U.S Government Banking Restructuring Trust, designed to exist for
a 12-year maximum period, that is, until 2020. Such a government trust could
buy back, at a fair market value (including a substantial discount to reflect
poor liquidity and poor marketability), illiquid but still solvent
mortgage-backed securities, held by banks or money market funds.
Simultaneously, the government trust would have the power to
reissue mortgage-backed debentures with a maturity of nine years or less and
carrying interest financed by the underlying mortgages thus acquired, and in an
amount large enough to cover at least the initial cost of acquisition. The Fed
and its 12 regional banks, plus Fannie Mae and Freddie Mac, could play an
important role in creating a liquid secondary market for such government-backed
securities. Because of this reissuance feature, the $700 billion guarantee
initially proposed by Sec. Henry Paulson could be reduced, possibly to a more
palatable level of $250 billion.
Such an operation would relieve the U.S. banking system from
short-term mortgage-backed securities that are presently de facto
frozen, because there is no market for them. It would also allow American
savers and investors to include in their IRAs or 401(k) plans safe and
profitable investments. Moreover, it would provide capital to the mortgage
market and help turn the housing slump around.
And, what�s more, such a debt restructuring operation need
not cost the government and American taxpayers a single penny, in the end. To
the contrary, the program can be structured in such a way as to generate a fair
return on the government�s initial investment.
Simultaneously, a regulatory ban on the issuance of any new
securitized mortgage-backed paper could be issued. The same could apply also to
the dangerous practice of elevating the credit rating of certain bonds or
debentures through reliance upon the credit-default (insurance) market. These
were the two main corrosive �innovations� which have resulted in the present
Moreover, such a restructuring plan could be kept simple and
In conclusion, this is something that the Bush
administration and the U.S. Congress might want to consider if they hope to get
out of the ideological and political deadlock they have talked themselves into.
Rodrigue Tremblay lives in Montreal and can be reached at firstname.lastname@example.org. He is the author of the book ��The New American Empire.� His new book,
�The Code for Global Ethics,� will be published in 2008. Visit his blog site at thenewamericanempire.com/blog.