The Pros and Cons of a Taxpayer Bank

May 20, 2009
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On the Nature & Philosophy of Financial Instability and Application to the Current Financial Crisis Part III

The Pros and Cons of a Taxpayer Bank

By Julian Sanchez, PhD

Read: Circuit Systems & our Financial Crisis – Part I
Read: Functions of Taxpayer Bank and the Market – Part II

The most attractive time for the taxpayer bank to purchase loans is when there is a significant drop in the price of the bank stock. In the case of National City Corp., (whose purchase by PNC Financial Services in late 2008 for about $5.2 billion in stock was supported by U.S. Treasury funds), the returns were as high as 1650% for the capital injected by the taxpayer bank. In a certain sense the taxpayer bank acts as a counterweight since the investment becomes more attractive the greater the fear in the market as the stock price of the bank becomes more depressed. This will place a floor on the stock price of the troubled bank when it needs it the most. Hence, the taxpayer bank will stabilize the financial system in much the same way as a counterweight causing a building to stabilize in a high wind. That is, the taxpayer bank incentive increases as the market spirals further downward (depressing the stock price). The increased likelihood of the taxpayer bank to invest in a downward spiral will cause investors not to panic and force the shorts (attempts to profit from an expected decline in price) to be more cautious, therefore stabilizing the market.

One main argument against forming a taxpayer bank is the implications concerning morale hazard. In essence, the concern is that a government bank acting as a backstop would encourage reckless lending by the rescued bank in order to secure short-term profits at the expense of its shareholders and customers. In general, this is a true statement; however, one can engineer the system such that this risk is eliminated as will be discussed later in this paper.

The taxpayer bank should be organized into two main groups. One group, referred to as the Hard Asset Manager, will manage financial instruments that have physical assets tied to them. This includes but is not limited to residential and commercial real estate, autos, etc. The second group, called the Soft Asset Manager, will manage financial instruments such as Credit Card Debt, MBSs (Mortgage Backed Securities), CDOs (Investment securities backed by bonds, loans, and other asset pools), SIVs (Structured Investment Vehicles that borrow money by issuing short-term securities at low interest and lend money by means of long-term securities that pay higher interest), etc., which might not involve the disposition of assets. In the next installment, we will discuss the role and purpose of each of these asset managers.

Part IV



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