Monday, March 17, 2008

Financial Markets Crisis: A Potential Solution

In the late 1980's I had the opportunity to participate in the discussions of what to do with billions of dollars in commercial bank debt for countries in Latin America. In a nutshell, commercial banks had acquired a very large exposure to debt from Latin American countries, and in reality most of that debt was worthless although the interest rates were very high. The issue was similar than today's mortage backed subprime securities: the lending institution failed to follow fundamentally sound practices in their portfolios and their exposure came to the point of affecting the world finance markets. I remember the 2nd International Conference on Debt and Trade where the policy makers, financial instituions, and debt-ridden countries met. One of the solutions was to create markets for this exposure and hence the birth of the Bradley bonds. At the time, I was a proponent of a more drastic measure, to let the market forces decide the outcome of each financial instituion according to their exposure. Over the years I have come to the conclusion that the Bradley bond secondary market has substantially assisted in bringing order to the financial markets in a way that has not negatively affected Latin America countries.

My proposed solution to the current financial markets crisis is a three tier solution:
1. Allow a market for mortage backed securities in which central banks around the world could buy some of the exposures of large financial institutions. I would suggest up to 3% of the market capitalization of each large financial institution. This solution will allow the internalization of the financial markets by allowing central banks to have a direct ownership in private financial institutions. I know that this is a radical solution, but the liquidity problems in the financial markets are of such magnitutde that it requires the intervention of central banks around the world in a different way and at a different magnitude that past remedies. Special class of stocks can be created that will allow foreign central banks to participate that would restric voting rights, while simultaneously allows their input into investment practices.
2. Create a tax incentive for financial institutions in which they could lower by a total up to 3% the interest rate and/or the principal of the mortgage loan, for properties with the value of a mortage of up to $250,000. The total amount of the tax incentive could be cap at $2,500 per qualifying loan.
3. For properties with a mortgage value greater than $250,000 I would suggest to let the market forces dictate what will happen to these properties and the financial institutions that made those investments.

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