Next week, Tim Geithner will have an opportunity to explain his plans for the financial system (Cash Room of the Treasury, Monday, 12:30pm), and defend these plans in front of the Senate Banking Committee (Tuesday, starting at 10am) and Senate Budget Committee (Wednesday, also from 10am).
Here are the questions (in bold) we would ask him. And, just in case any of you are involved in preparing the Secretary’s briefing book, we also suggest some answers.
1. Do you agree that, to restore trust in the financial system, it is essential that the Treasury (working with other relevant US authorities) take rapid steps to “once and for all” completely recapitalize the banking system?
2. Would you also agree it is critical that you and your colleagues tell the unvarnished and unequivocal truth regarding the needs of the financial system and your plans to recapitalize banks, so that clarity regarding the policy framework can be restored and uncertainty diminished?
3. Do you agree that a one-off, transparent assessment – with the methodology and results fully divulged in public – of the solvency and financial condition of all banks is required within three months so that we can precisely define and address the problem?
– The only answer that should give any credibility to questions 1 and 2 is: yes.
4. Many banks value securities, mortgages, and other loans close to the face value of the obligation on their books, while market prices for similar assets are far below book value. Which value should be used when assessing these assets to determine if banks are solvent or not?
– The only fair answer for taxpayers, and the only way to ensure adequate capital comes into the banks subsequently from private investors, is: we will value all assets at market values. If market values are not available, then a highly conservative approach should be taken, i.e., assign a very low value. This will lead to major asset write downs at all banks and a larger need for capital, but it will ensure that this is the last time (in the foreseeable future) the Treasury needs to recapitalize banks.
5. Some sources report the Treasury is considering purchasing assets from banks which have been marked to market, while insuring assets which have not been marked to market. This would enable banks to avoid marking down assets, i.e., so that they don’t need to recognize further losses. Why should taxpayers insure any asset at a price significantly different from the market price?
– The concept of “insuring” assets that have been priced above market value is a non-starter. It would be a means to provide taxpayer money to banks by stealth, and is not credible since it will become transparent (and face a major political backlash) as soon as the details face serious scrutiny.
– The Treasury needs to state clearly that most banks need large recapitalizations based on current asset prices, and it would not be fair to taxpayers if we provide cheap insurance (e.g., as if the assets are really AAA) for bad assets that are marked too high on banks’ balance sheets.
– If the banks are forced to mark assets to their true prices, there is no need to provide insurance. You may as well recapitalize the banks fully to reflect those losses and then let them also manage all the remaining risk on their balance sheets.
6. How much money is Treasury expecting will be needed in the recapitalization of banks, i.e., what will be the net new injection of capital?
– If the answer is not at least $1trn, in line with the estimates of the IMF, then it’s not enough. (Note: the headline number may need to be larger, depending on the approach; focus on the recapitalization/increase in capital of the banking system as the bottom line).
– We can rely on private capital also to inject funds, but only if the principles the authorities use for valuation of banks are very conservative so that there is adequate upside to new investors.
– If the headline amounts are less than $1 trillion, this is surely not enough.
– If the headline amounts are vague or we hear statements such as “it’s too early to know,” then the entire approach is not credible and we will need to reconvene when the Treasury is properly prepared and ready for a serious discussion.
7. Where will Treasury get this amount of money at short notice?
– The best answer would be a mix of private and public funding, but initially at least $1trn of public funding for recapitalization needs to be available.
– If the answer for public funding is: “the remaining TARP funds plus backstop loans from the Federal Reserve”, this is unlikely to be enough.
– Treasury needs to request further funding from Congress in the next month or so, in particular several hundred billion dollars in additional debt limit authorization; this can then be combined with Federal Reserve financing to get to scale quickly.
– There is no substitute for an early and completely frank conversation with Congress regarding why this new funding is needed, how exactly it will be used, and what the impact will be on various stakeholders (including insiders at the large banks, new investors, and the taxpayer).
– If the Treasury requires banks to write down assets to market prices, it will provide the clarity needed for private investors to re-enter the market. The stock prices of the worst banks will fall because it becomes clear the government is not prepared to provide further cheap taxpayer money as a subsidy, but this will finally put the banks at valuations that attract new private owners willing to make substantial investments. The government will then be providing funds alongside the private sector and less government funding will ultimately be needed.
8. How many of the largest 5 banks will likely end up with government as majority owner?
– Any honest market-based valuation of bank assets will show a majority of large banks are presently insolvent but can be righted with substantial new capital.
– If the answer isn’t “at least two,” then either the Treasury does not plan to properly value assets, or someone is not yet prepared to tell the full truth.
9. How does Treasury plan to use its shares when it has a controlling stake?
– If the answer is, “as a passive shareholder,” then we are really in for a rough ride (as seems to be the approach of Gordon Brown in the UK).
– The Treasury needs to have a plan to get shares back to the private sector quickly. We need new, strong private owners. This is the only way to really restructure the banks and force the necessary changes in management personnel and systems.
10. Does Treasury anticipate changes in management at these banks as a consequence of these actions?
– There is a critical need for new management in banks, but this should generally come alongside the infusion of new private capital. New private owners should restructure the banks and greatly improve how they are run.
– It is important that strong anti-trust provisions be attached when the government sells its stakes to new investors. This will ensure they have an incentive to break the largest banks into smaller, more manageable entities, all of which could productively be placed under new management.
– Any bank that is “too big to fail” is also “too big to exist”. This should be a fundamental principle applied by both regulators and anti-trust authorities overseeing all dimensions of the financial system.
This Q&A was drafted by Peter Boone and Simon Johnson.
The Baseline Scenario 
What, no mention of bondholders taking a haircut?
Have we completely given up on the idea that those who voluntarily took on risk in search of profit should pay anything? Are we simply going to make all creditors whole at taxpayer expense, no questions asked?
Is the debt of every major bank now de facto backed by the full faith and credit of the United States?
Hi Simon,
Do you think we could ask Mr Geitner to quantify what exposure the US taxpayer currently has to the nation’s banks (both direct and indirect) and how much this will rise to?
Geithner should be pressed on why any federal money is necessary to recapitalize the banks.
One simple approach is to admit the obvious – capital requirements for banks that are “too big to fail” need to be increased. So double the capital requirements. The government can sweeten the deal by exempting banks from corporate income taxes for five years. Banks that have a positive economic net worth should have no difficulty raising this money through a rights offering to existing shareholders. Banks that cannot are seized and recapitalized by converting the unsecured debt in their capital structure to equity. The Fed can facilitate the recapitalization by purchasing T-bills on the open market while investors are buying into banks.
We are missing a golden opportunity here to actually pay for some of this by hiking gasoline taxes to pay for road, bridge and mass transit construction. Yes, it would be a tax increase and I see the argument of not increasing taxes in a recession, but this one would hardly be a noticeable tax increase because gasoline prices have declined so much so recently. I don’t see how this tax increase would suppress economic activity. A 10-cent, or 20-cent increase in federal gasoline taxes would hardly be noticed, and would relieve some of the pressures this plan is going to put on the government’s balance sheets.
Great post, except for the bit about Fed financing to get up to scale. There should really be a “Question 11”:
“How much will you rely on the Fed’s balance sheet for injecting capital or buying or insuring bad assets; and does the Fed have a CREDIBLE plan for selling these assets or without generating inflation?”
Questions 1-10 can be answered to your satisfaction by overestimating losses and leaving the Fed on the hook for them. No legislation, appropriation or debate would be required. No increase in deficits or the national debt. No “cost” to taxpayers. Brilliant! Its the equivalent to sweeping the cost of the bail out under a rug, with the hopes that the resulting mound isn’t noticeable to the currency markets.
I just read your post on Buiter. I think your response to my comment above would be:
“Dear David, the Fed should absorb any losses and finance any liabilities of the banking system until some sort of tipping point is in sight, at which time they should simply stop.”
Please let me know when we approach that tipping point, so I can be sure to place my wealth in non-dollar assets. Would you be so kind as to let me know before the market has re-priced those assets, but after you reach a high degree of certainty? What? The market may re-price the assets before there is certainty? Well, this is known as increasing velocity in emerging markets — or capital flight, if you will. It doesn’t occur in one discrete “jump”, but gradually, and as you well know, once the psychology sets in its extremely hard to reverse without the type of austerity measures that the IMF has championed time again. “Tipping points” are the near-vertical part of exponential functions, and they are set in motion way down in the shallow part of the curve.
I think Buiter has it right, and with all due respect, that you haven’t thought through his argument before debunking it.
How’s this for question 11 — or maybe 3.1? “Will you require troubled asset holders seeking preferential federal treatment to disclose the facts about their assets using an industry standard computer language so that taxpayers and the market can more accurately estimate the potential value of the assets?” See http://paulwilkinson.com. Structured disclosure in the form of U.S. GAAP was the solution to inadequate public company disclosure in the 30s. Now that ABS comprise a material part of many public company balance sheets and data tags exist for more than 15,000 U.S. GAAP concepts, why shouldn’t the few hundred concepts related to ABS be similarly disclosed, particularly before taxpayers are compelled to purchase them?
Nemo is right on the mark. Bond holders must take some losses.
[7.]” – Treasury needs to request further funding from Congress in the next month or so, in particular several hundred billion dollars…”
This would be the thorny point at which real problems are going to arise in people’s minds about the way things are going. So I suppose the whole insurance scheme is a way Treasury hopes to end run further public disclosures of the need for stupendous funding.
It doesn’t seem likely that Geithner can be forthcoming and honest before the public. He just won’t have enough confidence that any of their schemes can work. Will Buiter’s anxiety about a lack of political will prove well-founded?
It’s hard to see how we can safely escape danger without real sincerity.
Chris Whalen was in fine form at AEI recently (my transcription):
“Going back to the historical American model, not the Swedish model, why did the Founders put bankruptcy in our Constitution? Because they knew that finality was good for society.
“The longer we dally with the big banks, the less growth we will have. It’s a very simple trade-off.
“Shoot the banks fast. Let Sheila take care of all of them this summer. Break them up and sell them.
“There will be a crowd of people standing on the other side of that receivership, OK? (Many of them are my clients! They all have shelf registrations with the OCC and FDIC right now.)
“You wanna fix this? Feed The Beast. Let them buy the assets.”
John Paulson: “Even in opaque areas of the markets such as in bank debt, mortgage backed securities and other distressed securities, we see hundreds of millions of dollars trading every day.”
Fantasy Geithner: “We nationalized the 35 largest banks this morning in order to begin an honest restructuring of our capital markets… The President has abandoned the stimulus package. For now, fiscal policy will consist of support for state and local governments, and a cut in the payroll tax… This morning we submitted our plan to abolish the SEC and eliminate the Fed’s role in banking oversight, and create a new entity charged with overseeing our financial markets….”
Real Geithner: Hey folks, we’re just gonna blunder about for a while longer. Get used to it.
I would like to hear more about how Geithner plans to use the TALF program (Term Asset-Backed Securities Loan Facility). This program looks like a “help our buddies in hedge funds make some easy dough while the taxpayer takes on the risk” kind of deal. Wow, what a surprise coming from Mr. Geithner!
A link to today’s article titled “U.S. Weighs Fed Program to Loosen Lending” in the WSJ:
http://online.wsj.com/article/SB123396660738259033.html#articleTabs%3Darticle
What kind of methodology will he use to evaluate the stimulus package’s impact? Can he monitor the impact monthly? Can he communicate the evaluation results to the press and public so that most would understand what adjustment need to be made? What are his step by step milestones that will get us to the place where we want to be? Finally, how will he obtain feedback from others that that are receiving the funds or are seeking improvements?
These are pretty basic items, but I have not heard if the Treasury Dept. has any plans for doing an evaluation.
Bob Spencer
Why is it that the public did not share in the record profits the banks made from 2000-2006, yet, now we are being forced to share in their record losses? Perhaps Mr. Geithner should also bailout each and every taxpayer who lost a home, his job, his investments and his retirement plan. Unfortunately, the govt’s actions speak loud and clear to those who can still hear and see straight: “the corporations have more rights and are more important than the individual”! God Bless the Corporations!
Regarding the question of bondholders’ claims, I believe Simon/Peter would advocate them taking a “haircut” in the event that market pricing determined that the banks in question were insolvent (see above commentary on 2/5 of the largest banks being insolvent).
In that event, I’d expect Treasury to help organize the bondholders to do debt-for-equity swaps. This would effectively kill two birds with one stone. Get the liabilities down to a reasonable level and you’ll attract additional private capital.
Re: the status of the largest 5 banks, it is possible that all 5 of them will have qualified opinions from their external auditors, questioning whether they are a “going concern”? If they all need major help from the US Treasury, and given all the talk about lack of liquidity in the system, doesn’t it follow that their 12.31.08 financial statements should have some large red flags raised as to whether they have the ability to survive 12 months? Not a good time to be an accountant with a large banking practice.
i think the decision has been made…..
god speed
I am having a hard time understanding why our government doesn’t buy controlling interest in the banks in trouble, fire the responsible parties,(with no parachute) and then recapitalize them. This may be a stupid idea but makes more sense to me than most of the suggestions I’ve read. Yes, “I’m mad as hell”.