Monday, September 22, 2008

Duke: Treasury Action Should Work, But at High Cost to Taxpayers, Professor Says

The Treasury’s proposed action to use government money to purchase mortgage-backed securities held by financial institutions should work, but at an unnecessary cost to taxpayers, says Steven Schwarcz, the Stanley A. Star Professor of Law & Business at Duke University.

Schwarcz has studied systemic risk for more than a year and has suggested, in congressional testimony last October, that the government should consider acting as a market liquidity provider of last resort, but to do so at the outset of a financial market panic. His article, “Systemic Risk,” will be published next month in the Georgetown Law Journal.

“The focus from the outset should have been on treating loss of confidence in the financial markets, which is the underlying cause of problems in the financial system,” Schwarcz says. “While it may have been necessary under the circumstances for the Fed to act to prop up AIG and Bear Stearns, among others, preventing financial institution failure amounts to treating symptoms of the disease, not its underlying cause. By delaying, the government missed a vital opportunity to nip the problem in the bud at a much lower cost to the American taxpayer.”

The Treasury’s proposed bailout plan is a semi-strong version of Schwarcz’s proposal, which he said would work most effectively if used at the outset of a market panic. The current panic has become so entrenched, however, that financial institutions now distrust the creditworthiness of other financial institutions; they do not know how much in mortgage-backed securities those institutions hold or the value of those securities.

The Treasury, therefore, needs to address both this counterparty risk perception and the market collapse. It is proposing that government money be used to purchase, at a deep discount, mortgage-backed securities held by financial institutions, which would stabilize market prices and reduce counterparty risk.

'This should work," says Schwarcz, "but it will be much more expensive than if the government had stabilized the market at an earlier point."

Georgia Front Page
Fayette Front Page

No comments: