Article Dow Jones News Service

A Different Approach To Fixing The Financial System

The stakes couldn't be higher. It is fair to say that the financial sector is at significant risk and, if the credit markets continue in their frozen state, the world economy could enter a severe recession.

Clearly, this puts Main Street at risk, and it can be argued that our financial institutions need government help to begin working properly again.

After more than a year of severe strain on the financial system and our economy, Congress, acting on pleas from the Federal Reserve and the Treasury Department, attempted to act to open up the credit markets. But, due to partisanship, real differences of opinion on the best policy to protect our fragile financial system, and the upcoming elections, the Troubled Assets Relief Program (TARP) failed.

Now, the government is at it again, trying to pull a bill together that can pass. (Editor's note: The U.S. Senate passed a version of the bill Wednesday night, subsequent to the writing of this commentary.)

The stated purpose of TARP is to get financial institutions to lend again - to unfreeze the credit markets. Our credit markets are frozen because financial institutions are in an unending tailspin.

Financial institutions - banks, investment banks and insurance companies - are over-leveraged. As their assets decrease in value, they are forced to raise funds. This de-leveraging process is painful and will continue until the assets are written down once and for all.

As a result, TARP, among other things, was intended to buy up to $700 billion of troubled assets. With these assets off of the financial institutions' books, they can write them down and raise required funds.

Supporters of the plan hope this will lead to financial institutions extending credit again. At the end of the day, the government hopes that the troubled assets will, eventually, increase in value and the taxpayer will be protected.

To pass a bill that works, the proposal needs to be considered in perspective. To simplify, there are four observations worth considering.

First, as TARP suggests, the government is concerned with troubled assets on the balance sheets of financial institutions. Restructuring professionals and distressed investors describe these types of assets as distressed assets. Thus, the government is seeking to make a "distressed investment" and, as such, it would make sense to analyze the problem through a restructuring lens. In other words, how would restructuring professionals and distressed investors attack this problem?

Second, Main Street has major concerns about TARP. Some of these concerns exist because the government has done a poor job of explaining the true nature of the problem. Main Street also wants to make sure that Wall Street does not benefit at the taxpayer's expense.

Third, politicians, whether Republicans or Democrats, hold strong ideological views on the economy and do not want to explain to their constituents why they did a 180-degree turn on their principles. Right-wing Republicans believe in the benefits of free markets, smaller government and lower taxes. Bailouts are anathema to them. How can they go back to their constituents and say "I was against bailouts before I was for them"? How can left-wing Democrats tell their constituents that they sided with George W. Bush?

Fourth, the program needs to be simple. TARP is complex. The government will buy troubled assets from financial institutions. How would the troubled assets be priced? If mortgages were purchased, who would negotiate new terms with homeowners?

TARP should be based on concepts already ingrained in our financial system. It should be politically neutral, simple and it should protect Main Street.

Rather than purchasing the troubled assets, taking investment risk and establishing new regulations on golden parachutes and bonuses, a simpler and more palatable bill should be passed that would employ current private distressed-investment and restructuring techniques.

As a distressed investor, the government should only invest capital if it believes it can realize a return on its investment. In a distressed situation, this investment should be in the form of debt so the government will be protected in the event that the financial institutions struggle or fail.

Specifically, the government should provide financial institutions with a senior, secured revolving credit facility. This will enable financial institutions to accomplish two goals simultaneously: writing down the distressed assets and raising sufficient capital to begin lending again.

At the same time, the government would not be buying the distressed assets and taking the investment risk. Rather, it would be making a secured loan to the financial institution. If the financial institution fails, the government would own the financial institution and be able to sell it at a later date.

The loans could include all sorts of typical covenants so the government is continuously kept apprised of the financial condition of the institutions. In addition, the conditions could set limits on payments by, and activities of, the financial institutions, such as golden parachutes, bonuses and the purchase or origination of risky securities.

This plan also would be palatable to politicians on both sides of the aisle. It is not a bailout of Wall Street. It is the government becoming the lender of last resort. It is not a risky investment. The government will be paid back before anyone else in the capital structure. It is not new regulation. It is the extension of credit with affirmative and negative covenants in a credit agreement that puts parameters around the activities of financial institutions. It is relatively simple. Main Street and Wall Street will understand it and be able to act accordingly.

Overall, it may accomplish the critical goal of starting to get our financial system on firm ground.

Reprinted with permission from Dow Jones & Company, Inc.