Thursday, February 12, 2009

Is Geithner's Plan Really a Disaster?

A lot of black pixels have been splashed across our computer screens bemoaning the inadequacy of Geithner's bank bailout plan as he presented two days ago. I think the problem is mostly one of public relations, not substance.

First, what Wall Street was actually looking for was a plan that allowed major players to unburden themselves of all their toxic exposures at taxpayer expense. Luckily, they didn't get this from the Obama administration. Geithner's plan is a subtle evolution of TARP rather than a radical revision. I suspect the market would've reacted badly no matter what, and as the White House Press Secretary Robert Gibbs explained, "yesterday's speech and framework were not designed for a one-day market reaction." Can you imagine the markets reaction had Geithner invoked the N-word? In my mind, a good plan should really disappoint almost everyone: "Mission Accomplished".

Let's look at where Geithner is going. At its simplest, a bank basically has three legs: capital, liquidity and assets. The Treasury Capital Purchase Program is strengthening the capital base of individual institutions when neccessary and liquidity is ensured by the expansion of deposit insurance and the alphabet soup of debt guarantees and Fed lending programs. The problem that Paulson's original Tarp proposal foundered on how to deal with toxic assets and this remains the most difficult to address. Geithner's approach is somewhat more nuanced and while only subtly different is much more promising.

There's a chicken-or-egg problem here which prevents the start of any resolution of bad assets. Banks are holding hard-to-value assets at prices above what they would fetch on the market. The lack of investors is something of a myth - there are vulchers willing to buy these securities at the right price and these securities do trade. The reality is that there are no investors willing to pay the prices banks must sell them for to stay in business. Accounting rules mean that selling any portion of these assets mean similar assets should be carried at the sale price. With any sale, banks would have to declare all their losses at once, shred their capital base and put themselves out of business, so they are unable to sell. Their only option is to unload assets at a carrying price only loosely associated with reality. With no private investors is willing to buy at the carrying price the banks can only hope the government will take them off their hands. By temporarily softening mark-to-market and allowing banks to pay for losses out of earnings over time, Geithner's plan could potentially start getting some of the bad assets out of banks without destroying their entire capital cushion with mark-to-market losses.

Ideally the purchase of toxic assets would best be left to private participants willing to take on a high level of risk. However the scale and urgency of the problem necessitates government intervention. For such a plan to be fair to the taxpayer and politically viable, government must not overpay for such assets and thereby preserve the potential for upside. Creating a hybrid public-private vehicle to make these purchases mean the government will not pay more for toxic assets than its private partners are willing. A clear line in the sand may jump-start asset sales when banks realize they are waiting in vain for the government to pay inflated prices. Pushing a ward of the state like Citi to sell to the vehicle while simultaneously easing mark-to-market accounting rules will encourage price discovery without making it poisonous.

The primary problem with suspending mark-to-market is that you have to trust banks to eventually value all such assets correctly, rather than paying out bonuses and dividends as if the problem didn't exist. This is clearly the reasoning behind restrictions on executive pay and dividends for institutions receiving extraordinary assistance. Such restrictions ensure that it is primarily shareholders and management who pay for the losses over time. This is also the reason behind the "stress test". The "stress test" has been universally panned as just another bank exam but the true intention is to create an inventory of bad assets, assess the true scale of potential losses and maintain a "real" balance sheet in parallel to the public balance sheet.

This plan is really one where we see if the banks can bail themselves out given a little time and minimal support. The fed ensures access to low cost liquidity through ZIRP and allows banks to earn larger spreads. Those $100B institutions which require 2 years or more of earnings to cover potential losses will probably be nationalized. Obama is right that magnitude is a problem. It's important not to forget we're talking about $6 trillion assets in the 4 largest BHCs now. Unless you'd like the financial system to collapse and start from scratch, nationalization means taking both these assets and $5.7 worth of liabilities. This is what the FDIC does when resolving a smaller bank failure. That's a lot of risk on the nation's balance sheet, and if you think the system is insolvent - ie. liabilities > assets - nationalization charges losses in excess of capital right to the taxpayer.

Anticipating an outcry about addressing the foreclosure crisis and stabilizing house prices, I will point to a legislative solution moving through Congress: Mortgage Cram-downs. The issue has been thoroughly addressed over at and the solution has a lot going for it including it imposes a fairly severe cost on consumers, reducing moral hazard. The Conyers bill is imperfect but it affords homeowners with severely underwater mortgages a chance to force lenders to share in the loss of collateral value and remain in their homes. The bill also preserves some upside for lenders should property values revert to their recent aberration from historical trends.

No comments: