Graham’s Investing Blog

An Alternative to Paulson’s Big Busted Bond Buying Binge

I have an alternative plan that doesn’t involve any buyout of anyone who can’t balance his or her checkbook. It’s based on the recognition that the fundamental problem is not insolvency, but lack of credit. Paulson’s plan deals with the lack of credit through the alleviation of the insolvency of large financial institutions. My plan attacks the credit issue directly, and prevents the kind of abuses that have occurred to date by putting into place an incentive system that will reduce unsafe lending practices.

The plan is for the Federal Reserve and Treasury to offer loans through banks and other deposit-taking intuitions (like credit unions). The lending bank would have to participate in each and every loan by contributing some amount to the loan (say 10 or 20%). Moreover, there will be no securitization or selling of loans. The issuer will have to hold the loan to term. This creates an incentive for the bank to ensure that the loan is a reasonable risk given the interest rate charged.

The bank is free to set the interest rate. The bank will receive all the interest on the portion of the principal (the 10 or 20%) it contributes. In addition, the bank will receive 0.5 or 1 percentage points from the interest on the whole loan as a processing fee. To ensure the proper incentive structure, it is important that the bank not receive this fee up front, but off the interest as the loan is repaid.

This arrangement will ensure that credit is available for those who deserve it, at a rate they deserve, without bailing out anyone who engaged in fiscal shenanigans.

To reduce corporate shenanigans, banks that participate in this program will have to abide by certain conditions regarding executive compensation. The conditions are designed to align the financial interests of the executives with the long term interests of the shareholders. Much of the problems with mismanagement that have occurred to date has resulted from executive compensation based on short term stock performance (with golden parachutes when performance is terrible). This has encouraged executives to take on too much risk, and to engage in fiscal shenanigans.

The measures regarding executive compensations to align their interests with those of the shareholders are:

1- Employees of the institution are not allowed to hold options on the stock of that institution.

2- Executives must contribute 20% of their salaries to bolster the bank’s capital reserve until a Treasury defined standard is met.

3- Executives must use 5% of their salaries to purchase stock in the bank at market values, every year. The stock must be held for at least 5 years.

4- Bonuses are to be based on fiscal performance, with charges for poor performance.

5- Severance pay will be a function of the bank’s cash flow during the executive’s tenure. Other than this, there will be no severance pay or compensation.

If the executives do not accept these measures, their institution cannot participate in the program. It’s up to them; they are free to choose.

This program will be insufficient for some banks to remain solvent. Too bad for them. Other banks, that have been better managed, will take them over.