Leaving aside the question of subsidies, which has gotten piles of attention on the Internet, Simon and I are skeptical that the Geithner Plan will achieve its basic objective: getting enough toxic assets off of bank balance sheets to restore the financial system to normal functioning. We discuss this in today’s Los Angeles Times op-ed, although our regular readers could probably fill in the blanks by themselves.
Update: At 2:30 PM Eastern today, I’ll be on a live chat at Seeking Alpha with Felix Salmon and possibly Brad DeLong and Mark Thoma discussing the Geithner plan. Salmon is strongly against, Delong is moderately (strongly?) for, Thoma is moderately for.
Update 2: At The New Republic, Simon discusses one plausible scenario under which the Geithner Plan is the first step in a comprehensive bank rescue strategy. But he’s skeptical that we will see the other necessary steps.
Update 3: Chat is done; replay is here.
By James Kwak
The Baseline Scenario 
I thought the basic plan was to establish a price for the assets and to kick start the secondary market back into life — no?
Instead of rescuing the big banks to get capital flowing, would it be possible to buy up some of the loans from mid-sized banks to give them capital to lend?
When the curtain is pulled back at the “auction” of these black-box assets, and we get to see what’s inside, who gets to bid the price, the US (85%) or the subsidized investors (15%)? And if the bid price is too low, what would force the Bank that now owns it to sell? Pardon my naive questions.
Will It Work?
How can it? It doesn’t confront the problems. We have toxic bankers; we are subsidizing them. We think that will ‘restore confidence’.
I don’t know if the plan is to get all of the assets off their books. If the plan gets some of the assets off of the banks books, and then “prices” the remaining assets below a price the banks are willing to accept we can proceed with nationalization. The benefit of this is two fold. 1) It buys the regulators time to get through the stress tests. That’s desperately needed for a successful nationwide nationalization process. 2) It removes the socialist aspect of nationalization. It wasn’t the government who said these banks were insolvent, it was the market.
As Mr. Krugman said, these are not toxic or even bad assets, just misunderstood assets. A little wayward, and with a little guidance and nurturing, they will get back on the path of the straight and narrow…. he, he, he….. Misunderstood? Just like Citi and Bank of America and AIG are misunderstood. I wonder what a dead cat looks like when it bounces. Where did that phrase come from?
I think the whole discussion about whether this plan will work or not is a bit misguided.
Of course the plan will work, as the government will guarantee that it will work. No hedge fund interested in buying in? Don’t worry, they’ll form a new hedge fund with Goldman, Sachs and buy between themselves.
The real issue that matters, though, is to whose benefit will the plan work?
Even if the plan works 100%, it will have absolutely no benefits to 99.9% of the population who doesn’t work at big banks or hedge funds. The money will never trickle down to the rest of the economy.
Moreover, if the plan does work and some money trickles down (unlikely, but possible I guess), the money won’t come soon enough to halt what will be a staggering economic decline.
Probably not. Rarely, if ever, do government actions lead to a net positive outcome.
Depending on how these “assets” (I would claim they are truly liabilities) are priced everyone holding US dollars will be left holding the bag while the these large institutions are made almost completely whole. Why did I not say “US taxpayer”? Clearly taxes will never be raised to a level sufficient to pay down the national debt or to pay for evermore bailouts…this will all be paid for through inflation, just ask Ben.
These large banks should be allowed to fail. The administration claims it wants to revive lending to the “average American”. This can be done locally by smaller to mid-size banks that will benefit tremendously from the failures of Citi, BoA, Wells, etc. Of course this free market solution couldn’t be allowed to work given the extremely powerful lobbyists and insiders the banking system has in Washington.
“It’s unlikely he will raise his bid from 38 cents to anything near 97 cents.”
This seems to ignore the demand-side impact of non-recourse leverage that will be available to the private investors. That is, because investors are able to lever their positions, they’ll receive a higher IRR on a given cash stream than if they purchased using simply 100% of their own capital, or even less than 100% of their own capital with recourse lending. So private buyers should be willing to pay more for the asset to achieve the same IRR. How much more, I agree, is still up in the air. The loan details (e.g., terms, interest rates) have not been settled, but seems like any amount of non-recourse leverage would bring a much greater demand for the assets than if investors were only buying on a 50/50 basis with Treasury. Hence a greater demand and higher prices for the assets.
As a concrete (and timely) example, consider the effects of increased non-recourse leverage on U.S. housing prices. Historically, borrowers were required to put 20% of the house price down (i.e., a 5x leverage ratio). However, after 2002 (roughly) borrowers were allowed greater leverage, which arguably led to increased demand and greater prices. An additional example is the increase in takeover purchase multiples in the LBO world during 2003-2006.
“lemons” problem. I think the “lemons” problem is particularly acute when there’s informational asymmetries, (e.g., in the insurance market). However, with respect to the MBS/CDO/CMBS assets, I’m having a hard time imagining any private information that would remain undisclosed from private investors.
The three concerns identified are each important, but I suspect that the third concern will be most significant in the end. If the Geithner plan fails, then from a technical standpoint there are still options on the table. However, the public may not have the stomach for it.
Treasury is attempting (and failing) to convince the public that the Geithner plan is attempting to maximize the impact of the remaining TARP funds.
From Treasury’s press release:
“Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power”
Treasury tries to downplay the extent to which purchasing power is generated by the non-recourse government loan. From the press release it sounds like private investors are contributing significantly to the increase in purchasing power. However, the public is increasingly aware that we are just paying institutions to manage these investments.
If the plan fails it will be viewed as a failure of ideas rather than a failure of execution. Treasury will have a hard time receiving support from congress if they are viewed in this light.
Whenever I hear the term “dead cat bounce” I’m reunited with a memory of an experience I had while working for a telephone company. I was driving slowly through a neighborhood on a summer night. As I looked for an address my peripheral vision spotted a small animal dart under my truck. As I felt the bump of my tires run over it I looked in my side mirrors to see a cat flipping fitfully into the air. Turning the truck around and returning to the scene I found a crowd of little children standing over the now still cat. When I leaned out the window to take a better look all the neighborhood children pointed their little fingers at me and cried, “He’s the one that did it! He’s the one that did it!”
The memory now makes me wonder, when the cat stops bouncing and the Banksters return to the scene, will the neighborhood still recognize the culprit?
Steve F. above hit the nail on the head. What institutional bank knows so much more about the value of these assets than hedge/private equity funds? What everyone seems to lose sight of is that the risk and value of these assets are tied directly to the housing defaults. Once a buyer of the assets is able to “peek” into a pool of the CDO’s and get a feel for the risk ratio of the underlying homeowners, they will be able to ascertain a price. Furthermore, with only limited risk to their own equity and plenty of free government money I think that price and value will be determined and transactions will occur. Absolutely. Is it a good thing? Should we all be happy? No, this is a collosal disaster but this is the only foresseable way out. We all must distinguish between what is “just” and “good” versus what will work.
Regarding the New Republic article point no 3, what is wrong with letting the banks sit on the toxic assets for years? Clearly, I don’t understand the problem. If they can do that, it means no bailout money is required for them. As others have suggested, use the $1T for more productive uses, e.g., SBA, FHA, and smaller well run banks. I get the impression that there is no political will to water the garden, but there is to put out a fire.
Mark, I think part of the problem is that no one is being very clear on what they mean by “insolvent”. Are the banks producing positive operating cash flow such that they can pay their debt on an ongoing basis? As long as the spread between return on assets and outgoing to service the debt is greater than zero, given sufficient time, an insolvent bank will surely recapitalise itself.
How will the price of the troubled assets purchased through the Public-Private Investment Program be set/determined? Is it that the PPIP is creating a market where there is now none … or are they pulling together capital in order to get the “assets” off the balance sheets of banks? What if there are more than $500 billion in assets to purchase to get balance sheets on stable ground? What if the prices set for the assets aren’t high enough to keep banks from going insolvent anyway?
The more I think about this whole toxic assets situation, and the Geithner plan(s) the more confused I get. Here are some of the things I am wondering about:
– Who on earth is going to buy these mortgage-based assets at anywhere near face value (even with a taxpayer subsidy) as long as housing prices are continuing to decline? Wouldn’t the rational thing be to wait at least until housing prices stabilize before buying any mortgage based assets?
– If the goal is to get lending moving again, why not just cut to the chase and use this money to finance the creation of fresh new banks that will have zero toxic assets and let the existing banks fend for themselves? The new banks can provide the financing the economy needs and the old banks can suffer the consequences of their poor choices.
– I have lost track of how exactly paying banks top dollar on toxic waste will get them to do more new lending. Here is my thinking: If a prospective borrower is a good risk then isn’t giving her a loan the rational thing for the bank to do whether or not the bank has toxic assets on their balance sheet? If a borrower looks risky, isn’t it a bad idea to make a loan even if the balance sheet is purged of toxic assets? What am I missing? Aren’t the banks going to take the subsidized money for the toxic assets, say thank you very much, and then make the exact same loans they would have anyways?
No one is trying to pay top dollar. That’s why private money is involved and why it takes the first hit: so they doesn’t pay top dollar. The point is to not overpay, but to find some kind of a market price at which banks can sell and stay in business, and at which investors can feasibly earn some kind of return. Because these investors are only putting in 3% for a much greater potential upside, the extreme risk in the credits markets might just be bearable. Then, the markets/I mean heavens open and we enter the credit thaw and perpetual Great Moderaspring. Or something. Anyway, I think it’s a pretty smart idea.
Brad DeLong has the best take on it though: “[T]he Geithner Plan is a reasonable way for the Treasury to spend $100B of TARP money…”
When he puts it like that, who can argue?
Why would the banks keep the toxic assets and not sell them just because the price is not right ? What purpose would that serve other than to continue the
status quo when other banks are turning around ?
With all the bailout money, taking less but getting rid of the no market assets seems to be the way to go.
James.
I am Steven from the discussion today. Here was my question as printed:
“[Comment From Steven]
Still wondering why there has been no administration discussion of bank bondholders versus taxpayers in absorbing bank losses? At a minimum we are owed an explanation, don’t you think?”
I wanted to thank you for your thoughtful response. I still believe that we need to hear a public explanation from Geithner and Summers and even Obama on this issue.
GM bondholders are being asked to take a substantial hit yet bank debt holders get to ride the A-train so to speak.
It’s because of political influence in my opinion and tht is very troublesome.
To be honest and not to impugn Brad Delong, but he sounded like a shill for the administration. I was a little upset by some of his comments. Especially when he asked Felix not to use the word ‘dishonest’ but instead ‘creative.’
Dishonest was the correct word. My rebuke of Delong is in the following article:
http://dailybail.com/home/the-great-unclog-of-2009-industrial-strength-drano-anyone.html
“The Great Unclog of 2009: Industrial Strength Drano, Anyone? ”
Thanks again James for your thoughtful responses and for always standing up for taxpayers.
We need all the help we can get with Geithner and Summers in charge.
Steve
Publisher The Daily Bail
Quick answer: NO ONE KNOWS…
I don’t understand how the financial markets can make up “products” out of thin air. MBS are understandable: Basically they are different types of debt instruments packaged neatly and offered for sale.. CDS are understandable: Basically insurance of the MBS.
Now, let me ask you, if I said that I came up with a new way of harnessing the wind using tethered, floating (using helium) windmills, what do you think the Government would say?
1. It will need to be tested using the best engineering principles (basically on paper).
2. A protype must be built and then it will need to be tested, in a place that will not impact humans
3. It must meet all safety regulations
4. We need to add new regulations to safeguard the public
5. It will need a permit and can’t be higher than X number of feet
6. You must have a study completed to determine the impact on wildlife, people, watersupply, future generations, etc.
7. You will need to have a way to tie it into the current grid
8. Etc, etc.
Second example, what about a new medication? Same result right? It will need to be tested, it must show efficacy, long term studies must be done, it can’t be duplicative, etc.
My point in this example is that in non scientific pursuits, such as law, government, finance, etc. we as humans “wing it” all the time. If we injected the scientific method into this practice, we would all be better off in the long run. We should make it mandatory that any new “financial” instrument is completely vetted prior to allowing it to be unleashed. We have unleashed a plague due to our lack of forethought.
And we continue to play with fire. What evidence do we have the Tim’s plan will work? What are the second and third order effects of the Fed buying up debt? The answer is NO ONE KNOWS…
Believe it or not there are TEN, count em, TEN members of Congress with any scientific background (and that is counting Brian Baird, which for me, is a stretch). For all you scientists out there, that is 1.8% of Congress.
Here is a current list of Congressman who has degrees in the scientific area:
Vernon Ehlers received his undergraduate degree in physics and his Ph.D. in nuclear physics from the University of California at Berkeley in 1960. After six years teaching and research at Berkeley, he moved back to Grand Rapids to Calvin College in 1966 where he taught physics for 16 years and later served as chairman of the Physics Department. During his tenure at Calvin, Ehlers also served as a volunteer science advisor to then-Congressman Gerald R. Ford.
Russ Holt earned his B.A. in Physics from Carleton College in Minnesota and completed his Master’s and Ph.D. at NYU. He has held positions as a teacher, Congressional Science Fellow, and arms control expert at the U.S. State Department where he monitored the nuclear programs of countries such as Iraq, Iran, North Korea, and the former Soviet Union. From 1989 until he launched his 1998 congressional campaign, Holt was Assistant Director of the Princeton Plasma Physics Laboratory, the largest research facility of Princeton University and the largest center for research in alternative energy in New Jersey. He has conducted extensive research on alternative energy and has his own patent for a solar energy device. Holt was also a five-time winner of the game show “Jeopardy.”
Jerry McNerney has his PhD in mathematics, served several years at Sandia National Laboratories in New Mexico as a national security contractor. Then McNerney moved to California, accepting a senior engineering position with US Windpower, Kenetech, and in 1994 began working as an energy consultant for PG&E, FloWind, the Electric Power Research Institute, and other utility companies. Prior to his election to Congress, he served as the CEO of a start-up company that manufactures wind turbines.
John W. Olver was a chemistry professor at the University of Massachusetts at Amherst. Olver earned his B.A. from Rensselaer Polytechnic Institute, his M.A. from Tufts University, and his Ph.D. in chemistry from the Massachusetts Institute of Technology.
Brian Baird received his B.S. from the University of Utah, graduating Phi Beta Kappa in 1977. He continued on to the University of Wyoming, receiving his M.S. and PhD in clinical psychology.
Ron Paul graduated from Gettysburg College and the Duke University School of Medicine, before proudly serving as a flight surgeon in the U.S. Air Force during the 1960s
Dan Lipinski earned a Bachelor’s Degree in Mechanical Engineering from Northwestern University, a Master’s Degree in Engineering-Economic Systems from Stanford University, and a PhD in Political Science from Duke University.
Nancy Boyda graduated with honors from William Jewell College in Liberty, Missouri, where she received dual degrees in chemistry and education. She began her career in 1978 working as an analytical chemist and field inspector for the Environmental Protection Agency. Over the next two decades, she held management positions in several pharmaceutical companies, including Marion Laboratories.
Cliff Stearns graduated with a degree in electrical engineering [from George Washington University] and then started his four years of service in the Air Force. Serving during the Vietnam War, Stearns worked as an aerospace engineer in satellite reconnaissance. He left the service with the rank of Captain.
Joe L. Barton earned a four-year Gifford-Hill Opportunity Award scholarship to Texas A&M University, where he was the outstanding industrial engineering student for the Class of 1972. After earning a Master’s of Science degree in Industrial Administration from Purdue University, he joined Ennis Business Forms, where he rose to the position of Assistant to the Vice President. In 1981, he was selected for the prestigious White House Fellows Program, and served as an aide to then-Energy Secretary James B. Edwards. He returned to Texas in 1982 as a natural gas decontrol consultant for Atlantic Richfield Oil and Gas Company before being elected to Congress.