As lawmakers appeared to reach a tentative deal on a Treasury rescue proposal for troubled assets, Steve Quinn, associate professor of economics at Texas Christian University in guest post for Real Time Economics, looks back at Britain’s experience in the 18th century to offer an alternative plan.

The current financial crisis began with the idea that pooling diverse obligations could create a less volatile, more liquid security. Debasement of standards by loan originators and repackaging by bankers, however, has left these securities unmarketable and the financial system in a credit crisis. Now, the Treasury, the Fed and Congress seek ways to bring liquidity to assets originally created to be liquid.

This proposal takes a page from history and suggests creating liquidity through an enormous debt-for-equity swap. Creditors, such as banks and hedge funds, would swap assets for an equity share of the pool created by the amalgamated assets. All the stock would be identical, so the operation would create large amounts of a new, homogeneous asset. In execution, the Treasury could set swap prices by auction to reflect risk, but a simpler approach would offer a 1:1 swap of shares for book value. Obviously, the most toxic obligations will join, and a large amount of homogeneous stock will be created. A secondary market and price will quickly emerge.

I suggest the idea because I have been studying how Britain restructured its national debt in the early 1700s. While not an identical situation, one salient problem pertained, how to restructure assets into a liquid form without requiring lots of cash? In 1697, 1711, 1719 and 1720, the British government conducted debt-for-equity swaps that moved parts of the national debt from individuals into two corporations: the Bank of England and the South Sea Company. The corporations were a type of government sponsored enterprise akin to Fannie Mae and Freddie Mac. The historical point is that the operations worked. Many creditors voluntarily swapped debt for stock, and the stock became liquid. Today Fannie Mae or Freddie Mac could be used, or a shell company, called special purpose vehicle, could be created.

The bailout takes the form of the Treasury guaranteeing a portion of the pool?s assets. Such underwriting spares the government massive immediate payouts, for the Treasury does not contribute until, and to the degree, performance falls below the threshold level. The Treasury?s commitment creates a price floor for the new stock, and creditors holding healthier assets will balance the advantages of liquefaction against the cost of joining the weaker assets in the pool.

A bank that sat out the operation would also benefit, for markets would now have a worst-case valuation for the bank?s assets, yet the bank need not adopt that valuation for accounting purposes. Indeed, holding out would let a bank signal that its assets as superior to the pool.

In summary, a debt-for-equity swap partially bails out the weakest assets and creates a huge pool of homogeneous stock for those needing liquidity. The Treasury only injects cash when the pool underperforms. Creditors only swap healthier assets if they need the liquidity.

Tags: Creditor, Liquidity, Freddie Mac, Financial Crisis, Editors, Securitization, Assets, Banks

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