My comments on this are also in wide circulation elsewhere this week, so I'll just leave links:

1) The Daily Beast, on the latest plan: 

http://www.thedailybeast.com/blogs-and-stories/2009-03-24/the-geithner-plan-wont-work/

2) The Washington Monthly, on the broader issues:

http://www.washingtonmonthly.com/features/2009/0903.galbraith.html

3) Some recent TV commentary:

http://finance.yahoo.com/tech-ticker/article/216311/Part-I-Geithner's-Plan-%22Extremely-Dangerous%22-Economist-Galbraith-Says?tickers=%5Egspc,%5Edji,c,bac,jpm,WFC

The Yahoo headline, incidentally, though widely quoted, is a bit stronger than my actual remark. I said the plan had some "extremely dangerous features" -- not that the whole thing was "extremely dangerous"  per se.

JG

 

Despite the initial positive reaction of the market, and despite heroic efforts by Secretary Geithner to be creative in the drafting of a plan, the plan will probably not work. The plan hopes to partner with the private sector to purchase distressed assets that are currently trading at far below their recovery values. These underpriced toxic assets have been depressing bank stock prices, and making banks unable to lend or raise new capital. The key problem with the plan is that it will not have much of an effect on subprime-related asset prices, and therefore, will not help the banks' stock prices recover, which is necessary for them to raise capital, and grow their lending. And, of course, that stock price recovery process is being further undermined by Congressional bonus tax threats that are creating new risks for banks daily. Profitable bank traders will be flocking to hedge funds to avoid bonus taxes. Prospective new equity investors have little incentive to invest in banks, given the lack of a real plan, and the mounting Congressional threats.

The problem is a political one. Any attempt to offer a real plan to stop the crisis would have to actually help the banks, which would be an invitation to an attack from the other side of the aisle. That is why neither Secretary Paulson nor Secretary Geithner has been able to get support for launching a real fix. The public and Congress are hell-bent on punishing banks, and the President (seeking to avoid the public's wrath) has encouraged the populist demagogues.

A plan that might actually work to stimulate lending in the financial sector would boost bank stock prices by removing substantial downside risk from banks, and not try to profit from doing so by taking the upside of asset appreciation away from the banks (the UK has gone farthest in this direction). Removing risk associated with meltdown scenarios would raise bank asset values, and stock prices, and begin the process of bank recapitalization and lending.

Buying bank assets at rock bottom prices, as under the Geithnew plan, may sound like a good deal for taxpayers, but it is not: taxpayers also have jobs, houses, and retirement savings, and would benefit much more from a plan that would restart the flow of credit. The only ones who will really gain from this plan are the money managers (Soros, Pimco, etc.). Unfortunately, they do not make consumer and business loans, only campaign contributions.

The next phase of the financial crisis is already brewing in Europe -- European countries are struggling with the same populist revulsion to helping banks that is gripping the US, but it is magnified in Europe by their inability to coordinate loss sharing across borders. The European financial implosion that seems to be coming will not only add to the global liquidity crisis, it will also test political and economic institutions throughout continental Europe. The United States is wasting precious time inventing mechanisms (can anyone even keep track of the acronyms anymore?) pretending to fix the financial mess.

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The Treasury’s Financial Stability Plan: Solution or Stopgap?
by Adam S. Posen | March 23rd, 2009 | 05:55 pm

I hope it works. The financial stability plan presented on March 23 by Treasury Secretary Timothy Geithner could be a part of the solution because it would remove some of the bad assets from the banks’ balance sheets and put some capital into the banks.  The Treasury’s is clearly trying clever tactics to avoid going to Congress for more upfront on-budget expenditures to fix the banks.

Even in the best case, though, I worry that the avoidance of upfont costs makes it penny-wise, pound-foolish, for the US taxpayer.  The private sector investors get a subsidy from the government in terms of both leverage and insurance against asset declines, and the current bank shareholders get higher prices for their assets via these subsidies. It may well thus cost the taxpayer more on net, between these subsidies and the lost upside gains, than if the government had stepped in more aggressively to take full ownership and pay low prices for these assets, even if it costs less upfront.

More worrisome, this partial fix might only be temporary.  The banks will still have left the worst toxic assets on their books, their incentives will not have changed, and they will be playing with a fresh stack of public money with insufficient conditions and probably insufficient capital.  Then, 18 months or so down the road, the US government would still have to put capital into the banks, because lending will have broken down again and many banks will again be under water.  But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out.

The explicit premise of this plan is that the real issue here is a market panic. Treasury is assuming that the private money managers on the sidelines are just sitting there because they are scared, and that the risks they fear (about the economy in general) are very unlikely to be realized, and that the banks’ investors need assurances to encourage them to buy. 

While markets do get things wrong, I think the panic is a misdiagnosis of the situation. 

Part of the problem is that some of these assets are genuinely toxic because they are part of larger securitized packages and there is an inability to see what is behind them.  Under this plan, those toxic assets are not restructured, because doing that would require government supermajority ownership, which will not happen.  So some will fail to find a market.  In that case the FDIC will end up having to pay out on the insurance for overpriced assets.   

Another part of the problem is that the banks’ current management and shareholders have been unwilling to sell some of the assets for which there is a market at the prevailing low prices because they have been hoping for a government bailout.  Bailout is what this plan may give them, with all the subsidies.  Given the apparent deep motivation of the Treasury to minimize both on-budget costs and even temporary public ownership of anything, the Obama team is apparently willing to risk overpaying current owners of these assets rather than forcing sales.

The Treasury plan is also supposed to lead to ‘price discovery’ through the use of auctions and then resales.  This sounds very nice, but since there is no new information for the private investors, except the government guarantee and leverage terms, what price will be discovered besides the worth of that subsidy?  Nothing here transforms the worth of those assets.  Who will be the eventual market for these assets unless that insurance and subsidy is transferred?  If that is the real asset being sold, then why not have these investment firms sell derivative contracts stripping out and offering that insurance, based on the public guarantees?  I am skeptical about the amount of price discovery that will occur in such a scenario.

I and others have been arguing for a more direct government approach [pdf] not only to get the taxpayer the least cost in the end, though government should indeed be concerned with the long-term instead of temporary budget illusions.  The main reason I argue for a more aggressively interventionist strategy—with clean lines between public and private ownership and more stringent pricing of bad assets—is that bolder intervention is the one proven way to resolve such a situation lastingly.  

Japan in 1998 had a reformer, Hakuo Yanagisawa, come in as Financial Services Minister, and he got a bank recapitalization underway—but he did so without putting on enough conditions on the capital, and three years later the Japanese banking system failed again.  Only when Heizo Takenaka became the responsible Minister, and forced the banks to truly write down the value of the distressed assets before injecting capital, was the Japanese banking crisis resolved.  Various Japanese government efforts to play with bad asset purchases before that only resulted in overpayments and the eventual accumulation of more bad assets.

I hope that the current Treasury plan contributes to stabilizing the US banking system in a lasting way, even if it comes at excessive cost to the taxpayer and offers too much benefit to the private participants. But I also worry that in the end Treasury will have to just do this again with more public money for the same banks amidst renewed financial disruption a little later.

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On NPR's On Point, with other guests, Monday.

Here is the link:

http://www.onpointradio.org/shows/2009/03/banks-bailouts-team-obama/

 

 

 

 

Geithner's plan isn't money in the bank

  There are reasons to be concerned about the Treasury secretary's proposal to clean up the financial system's toxic assets. By Simon Johnson and James Kwak
March 24, 2009
Monday's proposal by Treasury Secretary Timothy F. Geithner is the government's latest shot -- and perhaps its last clean shot -- at extricating up to a trillion dollars' worth of toxic assets from the financial system and making an economic recovery possible.

But will it work? We believe the best mechanism for solving the banking-sector crisis is government-supervised bankruptcy, also known as receivership. However, the Obama administration has made it abundantly clear that it will not consider this option, except perhaps as a last resort.

Without receivership, financial institutions can't be forced to sell toxic assets unless they choose to, nor can they be forced to lower prices that are unreasonably high. The problem in the market today is that the prices demanded by the banks are much higher than the prices that private buyers (hedge funds, private equity firms, sovereign wealth funds) are willing to pay.

The government has no way to bring down the banks' minimum sale prices, especially without the threat of receivership. So the only option is to induce buyers to pay more than they think the assets are worth in today's generally risky climate, and the only way to do this is through subsidies.
The Geithner plan offers private investors incentives to participate. Those who put up funds will be eligible for government-guaranteed loans to purchase larger shares of the toxic assets. Because these loans do not have to be paid back, investors cannot lose more than the money they invested, even if the value of the assets plummets. At the same time, there is no limit on the amount they can make if things turn out well.

There are three reasons for concern.

First, the subsidy may not be sweet enough to close the deal. According to one analysis, a specific mortgage-backed security was held on a bank's books at 97 cents, while its market price was about 38 cents. Even if you limit the buyer's potential loss to the capital he put in, it's unlikely he will raise his bid from 38 cents to anything near 97 cents.

Second, there is a "lemons" problem, also known as adverse selection. Even with a reasonable degree of disclosure, the selling banks will still know more about their assets than the buyers. The banks will be trying to dump their most toxic assets (their lemons); the buyers, fearing exactly this behavior, will reduce all their bids accordingly. This will make it harder for buyers and sellers to meet.

Third, there are political pressures, which have multiplied recently. For this plan to succeed, it has to offer private investors both upfront subsidies (cheap loans) and the long-term prospect of high returns. Both of these will be broadly unpopular with the public, especially given general attitudes toward hedge funds and private equity firms. Any attempt to limit the upside for the private sector has, apparently, been vetoed by potential investors. And that will make it look and feel like a taxpayer shakedown.

Public outcry against the American International Group bonuses (and the funneling of bailout money to AIG's counter-parties) was justly deserved. But it has changed the political landscape. The administration had already tied one of its hands by ruling out bankruptcy, even as a potential threat. Its other hand has since been tied by the blunders over AIG, which have ruled out in advance any plan that is too obviously a subsidy to banks or to private investors and have reduced the chances of getting new money from Congress.

Those two constraints dictated the anemic plan Geithner proposed: enough of a subsidy to raise public suspicion but not enough to guarantee that private investors will buy in or that the market for toxic assets will function smoothly. And while we're waiting to see whether banks actually get rid of their toxic assets, the economy will continue to deteriorate.

The plan could work -- but only if the banks agree to sell at reasonable prices. If it doesn't work, we'll need to come up with another approach, either one that is even friendlier to banks or one that confronts them head-on. Banks in this country have become too big economically and too powerful politically. Going forward, we have to fix this. We simply cannot afford to have another problem of this magnitude.

Simon Johnson is a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics. James Kwak is a student at Yale Law School. They are co-founders of baselinescenario.com, which tracks the global economic crisis.

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New Plan, Old Fears

By Peter J. Wallison Tuesday, March 24, 2009

Filed under: Economic Policy

  The Geithner plan is particularly vulnerable to the kind of criticism that might chase away private investors.

In response to public outrage about bonuses paid out by American International Group, Congress is now working feverishly on legislation that would penalize the workers at banks and other companies that have received funds from the Troubled Asset Relief Program (TARP). This must be one of the most disheartening episodes ever witnessed in Congress, not because the bonuses deserve support but because our representatives are structuring legislation that would punish almost everyone—the guilty and the innocent, the competent and the incompetent, those necessary to run the businesses that receive TARP funds, and those who may be superfluous—in a headlong rush to pander.

This spectacle could have important consequences for virtually all current and future economic recovery plans. Congress has shown itself to be an unreliable partner, panicking at the first major public backlash and retroactively changing the rules that others have relied on. Its action raises questions whether it will be safe for private-sector companies to participate in any of the government’s current or future financial rescue efforts.

This must be one of the most disheartening episodes ever witnessed in Congress; our representatives are drafting legislation that would punish almost everyone.

Potential private-sector participants must now be wondering just how far Congress’s punitive actions and clawback principles go. Might they apply to “unconscionable” bonuses or profits for companies that are building the shovel-ready projects in the stimulus package? Will they cover the profits that participants in the Term Asset-Backed Securities Loan Facility (TALF) might earn by purchasing assets with government loans? Or the similar assets to be purchased from banks under the long-awaited plan of Treasury Secretary Timothy Geithner? Is every project, every reputation, and every dollar of profit only good until the first “60 Minutes” report? At the very least, Congress’s action probably administers the coup de grace to companies taking equity investments from the government. If there was ever a demonstration of the dangers of nationalization or even a temporary receivership, this is it.

Still, responsible people in Congress should want to press forward with TARP implementation. The original plan, to buy troubled assets off the balance sheets of the banks, remains sensible. There is no way to get the economy back on track without restoring the largest banks to health. As it happens, however, the Geithner plan is particularly vulnerable to the kind of congressional criticism that might chase away private investors. The central problem that has bedeviled the TARP since its adoption has been how to price assets that the banks believe have significant value because of their continuing strong cash flows, but which have market prices well below these values.

Market prices are low to nonexistent today primarily because potential buyers have no confidence that they will be able to resell the assets without the development of a normal trading market, and the risk of losing financing for a portfolio of assets that cannot be resold is too great for most private-sector buyers to bear. A normal market, in which mortgage-backed securities and other asset-back instruments could be readily sold, has not existed for well over a year.

The Geithner plan goes halfway toward a solution for this problem. It provides several ways for buyers to finance their purchases. Assuming that the government financing made available under the plan will not be limited in time (so that the buyers will not be required to go out and find new private-sector financing), the plan will enable private-sector buyers to acquire and hold the assets, earning profits from the difference between the costs of financing and the assets’ cash flows—in other words, exactly what the banks are doing now. In effect, the banks are being asked to give up significant cash flows at a price that is low enough to attract investors who are not usually in the business of holding assets for their cash returns.

Congress’s action raises questions of whether it will be safe for private-sector companies to participate in any of the government’s current or future financial rescue efforts.

The plan contemplates that the private investors will bid for assets offered by the banks. In this case, the investors’ profits will depend on getting a price that is low enough to compensate for the risks they will be taking, which include the possibility of declines in the assets’ cash flows (coming, perhaps, from more mortgage defaults) and that they may be required to hold the assets for an extended period without the possibility of resale. The banks themselves are willing to do this—that is their business—but others are not set up to manage portfolios of mortgages over many years. The question, then, is whether the banks will be prepared to sell these assets at prices low enough to produce profit levels that will compensate private investor groups not only for their risks but also for alternative uses of their expensive equity capital over what could be several years.

Government financing arrangements can make the purchase of bank assets very attractive. Sufficient low-cost leverage makes small margins highly profitable. But that will mean that the division of the profits, if any, between the private groups and the government will have to heavily favor the private investors. The government will be taking the risk not only of a decline in the value of the assets’ cash flows, but also the interest-rate risk associated with making favorably priced loans to the private groups.

This is where the recent actions of Congress become troublesome. If the private groups earn very substantial profits, especially if the government suffers losses on its financing, will there be another backlash? Even if the government also profits, any report on the relative profits of the private investors and the taxpayers will likely show a top-heavy return to the private sector, and at a time of massive government deficits the possibility that Congress will go after these profits—as they are now going after the profits of private equity managers—cannot be dismissed. Only time will tell at this point whether Congress, through its populist pandering, has made private-sector involvement in the Geithner plan or any other economic recovery plan far less likely.

One other factor has to be considered. The process of negotiation between the banks and the private-sector investors who participate in the Geithner plan will be an extended one, even if the banks are willing to sell at the bid price. It will not provide the quick fix to the banking system that is necessary at this point. The Geithner plan relieves the government of the political problem of setting prices for assets that are likely to be well above market prices, but we have already wasted almost six months since the TARP plan was originally proposed, and the economy continues to languish without adequate financing. It is a legitimate question whether the taxpayers would be better served by a plan that works quickly and accomplishes the same result, rather than one that avoids political problems for the government but—if it works at all—will take many months to implement.

If the punitive congressional action on bonuses causes the private sector to shy away, there is still one plan that could work—the purchase of assets directly by the government, without private-sector involvement. Sheila Bair, chair of the Federal Deposit Insurance Corporation, noted in a recent interview that “we’re pretty familiar with the market right now. So we think that [it’s] absolutely true that assets are worth more than the current market conditions assign them.” This suggests that the government can complete the purchase of the banks’ troubled assets quickly, if it is willing to acknowledge that market prices should not determine their value.

The Geithner plan will not provide the quick fix to the banking system that is necessary at this point.

Using bank’s own cash flow valuations, the so-called “toxic assets” can be purchased at a price that is fair both to the taxpayers and the banks. The banks have priced the assets at their cash-flow values today, discounting for expected future losses. Although private-sector buyers have been unwilling to purchase these assets at the banks’ prices—because they could not be assured of long-term financing—this is not a problem for the government. Under these circumstances, even if the government were to purchase the assets at prices close to the banks’ prices, the taxpayers could profit immediately from the difference between current government borrowing costs and the cash flows the government will receive; and the government can wait indefinitely—until the market returns to normal—before selling the assets. A sale into a normal market, when the requisite private liquidity exists, could enable the government to recover all or most of what it spent to acquire the assets.

This is not to say that the government would not be taking risks. There are credit and interest rate risks involved—the same risks that the banks are taking today when they hold these assets—but we have to remember that the purpose of TARP was to help the economy recover, a result that would benefit the taxpayers as participants in this nation’s economy. Getting troubled assets off the balance sheets of the banks—and doing it quickly—is the policy that a responsible government should choose.

The administration is now clearly committed to the Geithner plan. We should all hope that it works. But if it founders on the shoals created by Congress’s actions on the American International Group bonuses, or because of its own complexity, there is a simpler and quicker plan available that will restore the banks to health without placing excessive burdens on the taxpayers.

If the administration ultimately turns to this approach, a remark often attributed to Winston Churchill will once again be proved accurate: “The Americans can always be trusted to do the right thing, once they have exhausted all other possibilities.”

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

FURTHER READING: See Peter Wallison’s essay on how the government should buy banks’ trouble assets at “net-realizable value,” a valuation based on current cash flows discounted by the expected credit losses. Alex J. Pollock suggests that entirely new banks are necessary. And Philip I. Levy argues that there is a new source of systemic risk: public outrage.

Image by Darren Wamboldt/The Bergman Group.

   

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