Springtime for Banks

Less than a week after pulling off the media coup of publishing his universal credit insurance proposal in both the FT and the WSJ on the same day, Ricardo Caballero has a new proposal for solving the banking crisis, this one in tomorrow’s Washington Post.

He should go back to the last one.

Here’s the new proposal: “The government pledges to buy up to twice the number of bank shares currently available, at twice some recent average price, in five years.” According to Caballero, this will have the following effects:

  1. Because bank stocks immediately become more valuable, it has a wealth effect that pushes up the value of all assets.
  2. Banks will be able to raise private capital, because they can issue additional shares equal to all of their outstanding shares, and these shares will have a price floor.
  3. Because this will have a stimulative effect and will solve the bank capital problem, the economy and the banking sector will go back to normal, and five years from now the government won’t actually have to buy any shares, because they will be trading above the government-guaranteed price floor.

Let’s start with the most important issue: fixing the banking sector. Caballero’s credit insurance plan would solve this goal, because it involves cheap government insurance for all bank assets. This proposal, by contrast, is a private sector recapitalization plan. Essentially, each bank would be able to raise new capital (by selling shares) equal in value to twice its current market capitalization, because those shares are guaranteed. For Citigroup, that would be about $20 billion. Does anyone think that would be enough to lift the clouds hanging over Citi? JPMorgan, by contrast, could raise about $150 billion. But there’s nothing saying that they have to, and bank managers who think that twice their current share price is still undervalued will have no new incentive to raise capital.

This is especially true because of the perverse incentives this plan creates, which make it especially hard to understand. This plan creates a government guarantee on the stock price. In other words, it says, “No matter how stupid you are, what ridiculous risks you take, and how bad your bank is, we will buy your stock at an artificially inflated level.”  Is this really the way to create a healthy banking system? I understand why people are afraid of government control over banks, but this seems at least as bad to me, since it creates an obvious incentive to take excessive risks. In addition, this takes away the usual incentive for raising capital: the need to maintain capital adequacy levels. Now that the government has guaranteed that shareholders will not lose their capital, no matter what, why raise more and split the upside with new investors?

What about the stimulative effect on the economy? Basically bank stocks would double in value overnight. Now, the S&P 500 Financial Sector Index is down about 80% from the summer of 2007; banking stocks are probably down a little more, say 85%, and insurance stocks down a little less. So the day after this plan is announced, your bank stocks – by now a small part of most portfolios – are down only 70% instead of 85%. While this might have some wealth effect, I think it would be relatively small; among other reasons, stock holdings and retirement accounts have a relatively small impact on consumption, compared to wages, dividend and interest income, or even home values (because they can be used for home equity lines). And I don’t see how it could turn around the economy.

Besides, if the idea is to stimulate the economy by making people feel wealthier, the simplest and fairest way to do this is through a tax cut. But the problem with tax cuts right now is that most of the tax cuts will simply be saved. This should be even more true of the Caballero plan, which just makes your banking stocks double in value. And if we are looking for creative ways to make people feel wealthier, what about a government guarantee to buy your house, in five years, for whatever you paid for it? (That was a rhetorical question.)

But, Caballero says, the great thing about his plan is that it is free. Because the plan will turn around the economy and return the banks to normal, the government will never actually have to buy the shares. This is wishful thinking in its most pure form. Yes, it is possible that if we fix the banking system, the economy will turn around, and most of these troubled assets will return to something like their current book values. But in that case, every proposal anyone has offered will turn out to be free. Caballero’s credit insurance plan will cost nothing, because the government will never have to cover any losses. Paulson’s plan to buy toxic assets will cost nothing, because those assets can then be sold for more than the government paid. The nationalize-reprivatize plan will cost nothing, again because the the government can sell the bad assets at a profit. Buiter’s and Romer’s “good bank” plan will cost nothing, because the good banks will be worth more than the capital it takes to set them up. A government recapitalization plan – say, for example, the government buys, at twice the current price, a number of shares equal to the current shares outstanding, will cost nothing, because the government’s new shares will be worth more than it paid for them. (This is similar to Caballero’s plan, except we know that the banks will actually raise capital, and the taxpayer gets the upside as well as the downside.)

But as Martin Wolf put it in a post I’ve recommended before and recommend again, “the heart of the matter . . . is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best.” That question answers itself.

19 responses to “Springtime for Banks

  1. If the government pledged to buy ever share of C at, say, $5, there’s no question that the share price of C would instantly go up to $5 or near it. But at the same time, unless C actually becomes worth _more_ than $5 on its own merits, the stock price will never sell for more than $5, and the government will never be able to sell any of those shares back to anybody, save at a loss (can you imagine that? “Buy C from us at $4.80, and we’ll buy it back from you at $5!”). There’s a fundamental problem with owning large amounts of stock that has no real worth other than your personal guarantee to buy it at a particular price, while it gives the asset value to other people, it inflates the worthlessness of the asset to you. Also, if everyone that has shares in C can sell it to the government for $5 and it has little likelihood of being worth more than that in the next 5 years, why would anyone keep it?

    Then there’s also the fact that a low share price won’t have much impact. If C needed $30 billion cash infusion, then they would need to issue 6 billion shares at $5, which is more than the number of shares they currently have outstanding (further devaluing any ‘actual value’ the shares have, which basically means the government has then gone from double a recent price of $2.50 to quadrupling it). A high share price, however, would greatly reduce the chance that the government will ever see any return on those shares whatsoever.

    I seem to recall from Galbraith’s book on the Great Crash a number of stories of very wealthy people desperately propping up share prices with purchasing guarantees. I think pretty much all of them ended with them trading in unimaginable amounts of their personal or corporate wealth for stock that was worthless save for their personal guarantee to buy it. Just because the government has a source of funds to draw from that is beyond unimaginable doesn’t mean that it makes it a better idea.

    With the Buffett/Paulson-style stock infusion plan, at least the government can force a 6% dividend, giving the stock an inherent worth for as long as the company is viable, regardless of what the rest of the market thinks of the common stock price.

  2. The government should spot areas of the economy that have businesses that have become too big to fall, and directly finance the rise of competition/innovation. This would prevent us from facing situations such as the ones we are facing with financial institutions and the auto industry.

    The solutions are always simple, but it takes foresight and long-term commitment. Sadly, due to politics everything is short-term. Among big corporations, the golden parachutes have the same effect of inciting short-term thinking over long-term.

  3. Karl Denniger has the best proposal for the “banking problem.”

    Full article can be found here:
    http://market-ticker.denninger.net/archives/812-CAUTION-October-87-Re-Run-On-Deck.html

    The 11 step Rx, once he appointed to replace Geithner:

    1. The memo goes out in the AM to every bank in America: No more lies. If you lie, even once, your bank gets seized and you will be criminally charged personally. Period. I am particularly interested in Mr. Lewis’ claims on national television (CNBC) that Bank America had a “great” January. That sounds an awful lot like Dick Fuld who said he was going to “burn the shorts” and was “well-capitalized”. Oh by the way, I’d refer Mr. Fuld’s statements over to Justice immediately, along with everyone else who said something similar (Bear Stearns anyone?)

    2. I would then amend OTS and OCC rules: All bank examinations are public data. All examinations must either have every asset marked to the market or the full model and data inputs must be disclosed, without exception.

    3. Next, I would take the stage and give every bank in America 72 hours to disclose their current Tier Capital numbers under those rules. They have ’em in the possession of their Risk Manager. Let’s have it. In public. You publish it, we print it. Everyone who is under-capitalized and has been hiding it – your shares are suspended. We’ll get to you.

    4. For those who are under-capitalized: If you have sufficient capital in your debt to be crammed down, that’s what happens. Your common equity is gone. Preferred is crammed down, if that’s insufficient it is gone. Next we do subordinateds, and repeat until sufficient capital is restored. End of discussion.

    5. For those who cannot be crammed down we seize you. Your deposits and good assets are auctioned off to sound institutions, spread among the physical locations of those assets and deposits so no concentration of more than 5% in one bank occurs. The rest of the assets go the FDIC and are run down or auctioned off as they deem appropriate.

    6. Any bank with more than 5% of the deposit base has 12 months to reduce it to under 5%. This affects fewer than 20 institutions.

    7. No bank may transact in any instrument that is (1) not a whole loan or (2) is not traded on an exchange. Period. Any such “assets” currently held must be disposed of within six months. No exceptions. I recognize that this makes banks a “utility” – entities that take deposits and make loans. So what? Its a good and profitable business, has been for hundreds of years, and forces proper underwriting since you must retain the risk.

    8. Any bank that finds (7) onerous (and most will) is free to split itself into two firms, one a bank and the second a non-bank affiliate held by the parent. The affiliate may not utilize depositor capital or otherwise be cross-contaminated with bank assets and support, but is of course free to raise money via debt offerings in the marketplace such as it is. Said non-bank firm may trade in whatever it would like, however, it will not receive any government support of any kind. Cross-contamination of any sort between a regulated bank and a non-bank sub will be treated and prosecuted as bank fraud. Any existing “affiliate” bank credit lines must be extinguished within 90 days and “23A letters” are explicitly disallowed.

    9. Reserve ratios are set at 8% with no exceptions.

    10. Bernanke will do as the above directs without complaint or I will exercise my lawful and Constitutional authority to issue United States Notes, bypassing The Fed entirely. Ben and The Fed work under my direction, not the other way around. End of discussion.

    11. Any bank that does not want TARP money may repay it immediately. If you keep it, no employee may receive total compensation exceeding that of the President of The United States, without exception and in all forms, including stock, options as valued under Black-Scholes, deferred compensation, benefits and cash. Period. You are working for us, therefore we set your salaries.

  4. An ally of Nouriel Roubini makes this observation here: http://www.debtdeflation.com/blogs/

    “Now we are being held in a permanent financial crisis by governments attempting to revive the system while continuing to honour debts that should never have been issued in the first place.”

    That is the crux of the issue – the govts have become dependent on banks (through cap/asset ratios and the reserve ratio) to keep the money supply increasing and the economy growing, rather than doing this themselves. In essence, banks have had the power of seignorage (printing and spending money), which has been a tremendous source of wealth. Hence the massive transfer of wealth (and the growth of) the finance sector, which has accompanied its dramatic increase in political power.

    Any plan that has govt. assuming these debts – privatization or guarantees or whatever – assumes mountains of debt that should never have been issued onto the shoulders of a rapidly dwindling income stream (US tax revenue in the face of a crumbling GDP).

    Why would we ever do this?

    Because the alternative of letting the big institutions fail is unthinkable – so we are told. Lehman was only a taste of that.

    So let us accept that we are held hostage, and we must pay (and even if we nationalize, we will STILL pay, we just get the pleasure of kicking out the executives who started this mess).

    The only reasonable outcome – and Warren Buffett stated this clearly in October – is inflation. It is the only way out, save for US default, because it represents a tax on currency-denominated assets (e.g., US T-Bills) which are the only asset class (other than gold) to have risen since september, while other asset classes plummeted. It cuts the value of debt without resorting to mass default.

    Without inflation, you can bet that the US will ultimately default.

    Critics may note that the US paid off earlier debts (WWII). Very true, and we did it through inflation (during the war) and crushing taxation on the very highest income brackets during a growing economy in which there was virtually no global trade competition (the competition was military – USSR and China).

    So choose – inflation now (which has a good shot at fixing the downturn and growing GDP), or US default 10 years down the road after a massive decade-long recession/depression.

    Until the smart guys in the room get this ridiculously simple concept, we will continue to let that little creature of the banks (Geithner) hose our children and grandchildren.

    BTW, do not suppose inflation will be pretty – it MUST come with permanent cuts in US entitlement programs to restore long term fiscal balance. And the printed money must not be squandred – it needs to be spent on long term energy resources (to cut the oil-driven trade imbalance) and a rationalized health care and education system. These are the hard problems.

  5. I have posted responses or questions on all his previous posts, including on Vox, which never prints my comments. Today, when I saw the WaPo post, I gave up. He’s constantly altering the conditions of his plan in order to avoid some kind of nationalization scheme. It would be better if he came out with a clearer explication of his objections to nationalization.

    It sounds to me like he has a version of what I take the position of William Gross to be, which is that wiping the bankers and shareholders out in this case is worse for our “capitalist system” than pinning the losses on the taxpayers. The bankers and shareholders are simply more important than the taxpayers. If that’s the position, then he should say so.

    William Gross also gives a rosy scenario, that makes it sound like this fiasco is a once in a lifetime value investing opportunity for the government. I don’t agree.

    Since people like credentials, please read this post on the current public/private ideas:

    http://www.ocnus.net/artman2/publish/Business_1/Geithner_s_AIG_Strategy.shtml

    Geithner’s AIG Strategy
    By Pietro Veronesi, Luigi Zingales, City Journal 19/2/09
    Feb 19, 2009 – 9:21:59 AM

  6. I’m sure that campaign contributions from financial institutions play no role whatsoever in Washington Nationalization discussions.

  7. To the site administrator:

    Be clear, I resent your editing my comments without my permission. You do so arrogantly and presumptuously. Either publish them as submitted or not at all.

  8. This is easily the most ridiculous plan I have read.

  9. I continue to be totally torn between the conflicting balance between the policy choices of improving savings/investment versus income/consumption. Somehow society has to downsize an economy that has become too large by some percentage of debt financed consumption. The problem is that a fast transition to a savings model risks more dramatic consumption declines.

    The banking industry is at the center of this mess, in my view, because most changed their role from institutions that acted as a conduit converting the savings of some to the investments (or consumption) of others. They became leveraged “investors” by multiplying a deposit base into large trading books. Capital market business made more money, achieved higher stock market multiples and allowed for significant incentive compensation to no-doubt talented people. But now the conduit business is semi-dead while the trading books wait for better prices. It seems nobody told Congress about this change….they seem to have forgotten their repeal of Glass-Steigel. Nevertheless, society now wants (and needs) the conduit but not the leveraged portfolios.

    The new Caballero plan which provides more equity capital to banks would have the effect of allowing them to continue holding those trading book assets which are transacting at levels materially lower than carrying values. To be sure. more would pass the as yet to be defined “stress test”. But, they would remain leveraged investors. It is not clear that added capital would be enough to regenerate the good banks we want. The same holds true for wrapping guaranties around segments of their capital market portfolios (the large number of good trades that have become bad investments). The only way to break clear of the banking logjam is to get the banks OUT of the capital markets and investing business. Guarantees on bad assets will not work and creating more capital will not work. It is time for those who have the deposit insurance benefit to get back into the banking business.

    So, perhaps deposit insurance itself could be turned into “the stick” we need. Deposit insurance exists (I think) so that banks could borrow short and lend long….holding “loans” that were made to borrowing customers, and providing some public protection when the loan books were stressed or had some losses. Could deposit insurance possibly exist to protect purchases of DCO’s, MBS, RMBS, public stocks, etc. in the capital markets divisions?

    So, the idea would be that some definition of traditional banking functions could take insured deposits and make loans. The remaining parts of any “bank” would have to be structured in separately capitalized entities. Oh, sorry…is this good bank/bad bank? Possibly! But, it would (or could) keep the government out of managing banks and let the private sector decide which of the banking institutions with capital market functions actually deserve capital.

    BTW: If we had such “good banks”, who would (or should) qualify for loans? Corporations and individuals are mostly in the mode of deleveraging and have tenuous asset values as collateral. It could be that all this angst is for nought.

    respectfully,

    db

  10. the dialogue i’ve seen on this sight has been insightful….please guys,,,,keep it up….a little story about MIT that i would like to share….as i was growing up,,,,my mother was a hostess of a plantation in southwest georgia named magnolia…the owner was a guy named charles allen thomas and had some experience with the manhattan project,,,ceo of monsanto chemical and phd from mit…..quite frankly,,, the smartest human i’ve ever known…..one duck shoot while i was nine,,,,i killed pretty much 20 out of 23 ducks that i shot at….i don’t hunt anymore but he took me under his wing after that….didn’t know why at the time but in later years figured out that he might have been intrigued at the hand -eye coordination of a nine year old…..he told me at that young age that the hardest thing that he had to ever learn was COMMUNICATION…..please keep the opionions flowing……MIT holds,,,in my opinion,,,our finest minds

  11. Kevin Shambrook Ph.D.

    Bank Management Compensation

    If management of our companies felt like owners they would not take such risks – generally “partners” are much more focussed on preserving value. Approach: create a “management Stock” which is the same as common stock but is “restricted” for 10 years – it cannot be sold or hypothecated in that time. Above a certain salary, say $150,000 (to include middle managers) all increases have to be 50% “Management stock” – and this is ordinary income for tax purposes – tax is paid that year. After 10 years it becomes normal common stock with a new basis as of that date – hence there is no capital gains tax for 10 years. If the financial (or other corporation) does well, the manager is handsomely rewarded, but if not, he loses like the rest of his stockholders. No other bonuses or options are allowed.

    Aligning compensation with success of the corporation will do more than any regulation – the same applies to auto companies and all corporations. This would take the pressure off the Directors who seem incapable of curbing executive salaries.

  12. Whatever, before helping the banks, we foremost need our banks to become banks again.

    The banks leveraged because the financial regulators told them they could do so, for instance, in credits to AAA to AA- rated corporations they were AUTHORIZED to take on a leverage of 62.5 to 1.

    They reduced their credit analysis departments because the regulators in Basel told them that, from now on, the last word in credit analysis was that of the credit rating agencies.

    We do not really need the automated credit trading machines that the banks have become.

  13. Banks are a symptom, and not the problem.]

    The most effective policy would be one that goes around the banks to tackle the roots of the crises…

    Whereas most plans focus on increasing the stock value, that does very little… in residual effect… It is as if those making such proposals are simply trying to in order to raise the value of their bank stocks they still hold in order to sell them out at a higher price.

    The crises is in the lack of lending.. New proposals need to be implemented that tackle that problem… Once done, the stock values will again rise close to their previous level, making bank stocks one of the best short term investments short of a bubble….

  14. Lending is not the root of the problem, it is a result. If the economy was in good shape, there would be more lending. If we just force banks to lend more, we’ll get more bad loans and another crisis soon after (much sooner than it took to get where we are now).

    Trace deficit is the root cause.

  15. M.G. in Progress

    Caballero’s proposals tend to defend the status quo and the existing system by tweak in it. It’s some creative finance at his best. We all should be back to square one of narrow good and sound banking.

  16. He’s back on Vox: ( Comments Closed )

    http://www.voxeu.org/index.php?q=node%2F3112

    We understand the plan. We understand that it can work. I believe that it has the following drawbacks:
    1) Its the taxpayers money. In using it, we need to be conservative. This plan is too risky.
    2) It leaves the current system, a disaster, in place.
    3) It leaves the current management, dubious at best, in place.
    4) It will allow lobbying if things go sour for them.
    Just consider this:If we end up losing a ton of money going forward in order to keep some banks and their shareholders going, what might the social consequences of that be? I do not want to take that chance.

    As for this bank holding problem, it’s beyond belief. The whole point of the Swedish Plan for many of us was to work up a modus operandi of dealing with these big banks if we had to. Oddly, we didn’t think anyone with any sense would want to perpetuate the “Too big to fail” bank guarantee, which is what this is.

    Check out this Reuters story from January:

    http://www.reuters.com/article/mnaNewsIndustryMaterialsAndUtilities/idUSN1248357020090112?sp=true

    (For more Reuters DEALTALKs, click [DEALTALK/])

    By Paritosh Bansal

    NEW YORK, Jan 12 (Reuters) – Citigroup Inc (C.N) may explore further asset sales after divesting its Smith Barney retail brokerage unit to Morgan Stanley (MS.N), but the banking giant is likely to have a tough time finding buyers.( NB )

    Chief Executive Vikram Pandit is trying to shed hundreds of billions of dollars of assets and reduce risk after Citigroup suffered $20.3 billion of losses in the year ended Sept. 30. The bank is expected to post another loss for the 2008 fourth quarter when it reports results this month.

    Citigroup has considered selling its Banamex Mexican banking unit and Primerica Financial Services, people close to the matter have said. The Wall Street Journal reported on Monday that CitiFinancial, international retail-brokerage operations and the private-label credit-card businesses may also be put on the block. The bank declined to comment.

    But Citigroup may not find it easy to sell other assets, and like insurer American International Group Inc (AIG.N), it could run into problems disposing of units amid the financial crisis, investment bankers said. Few would-be buyers have enough cash, stocks are down, financing is not easily available, and the quality of financial assets is often suspect.

    “They may quietly explore what’s available. I just don’t think that they can do very many deals in the near-term,” said Marshall Sonenshine, chairman of New York-based investment bank Sonenshine Partners. “But over the next couple of years, they will sell a lot of those businesses, and so will AIG.”

    CONSUMER CREDIT

    Citigroup tried to sell life insurance unit Primerica over the summer, but its plans were set back as the financial crisis took over.

    Selling consumer lending businesses such as private label credit cards and CitiFinancial, which provides loans for home improvement, debt consolidation and tuition, is also likely to prove difficult in an economic downturn as consumers suffer.

    In September, General Electric Co (GE.N) shelved plans to sell its $30 billion U.S. private-label credit card business, saying it was a challenging time to find someone who wanted to take responsibility for more than $30 billion of assets.

    “Anything that has credit sensitivity to it, like a credit card business in this market — Citi will be crazy to try to sell something like that,” a financial services investment banker said.

    “There are no strategic buyers, no financial buyers. There’s no leverage,” the banker said. “You are going to sell an asset that has consumer credit risk to it? Good luck.”

    AT WHAT PRICE?

    Still, as it faces pressure to put its house in order, Citigroup may want to try, and some of its assets could lure potential buyers. But the bank will then have to deal with the problem of negotiating a good price.

    “Someone’s going to be interested in them at a certain price — maybe an unappealing price to Citi’s shareholders,” another financial services investment banker said. “They may not get the prices they want, but you can sell things.”

    In some cases, uncertainty about asset quality can be addressed by a deal’s structuring.

    The agreement for the sale of Chevy Chase Bank to Capital One Financial Corp (COF.N) has a clause that would have Capital One pay more if the acquired bank’s assets perform better than expected.

    So questions about the quality of Citigroup’s private-label credit card portfolio in a declining economy, for instance, could potentially be addressed by structuring a transaction where payments are made over time, with the amount depending on defaults, the banker said.

    “Whether Citigroup will be better off accepting prices today or deferring sales remains to be seen,” Sonenshine said. “In both cases, AIG and Citi, we are looking at the slow but inevitable disaggregation of overextended financial services companies that have demonstrated an inability to manage risk.”( NB ) (Additional reporting by Dan Wilchins; editing by John Wallace) (For more M&A news and our DealZone blog, go to http://www.reuters.com/deals) ”

    The point is that we are paying to keep them alive until they can sell these businesses, at our expense if they continue to prove incompetent. We know what a Holding Company is.The question is could we put people in place who would manage them better in the interests of the taxpayers. Listen to Liddy:

    http://www.pbs.org/nbr/site/onair/gharib/081110_gharib/

    “GHARIB: Mr. Liddy, make a case why American taxpayers should feel good about this latest rescue plan.

    LIDDY: The taxpayer in this case is being very well cared for. People use this term bailout and it’s got kind of a negative implication. But the reality is on the equity that we’re getting from the Federal government, we’re going to pay $4 billion a year to the taxpayer for that. The debt carries a full market rate of interest. Right now we’ll have about $20 billion outstanding, $21 billion. It carries interest at 5 or 6 percent. That’s a billion too. The government is going to have an interest in upside in the two asset entities that were two financing entities that we’re setting up. The taxpayer is being well cared for and well provided here.

    GHARIB: You have a lot of financial issues that you have to deal with over the next couple of months and years. How are you going to pay off these billions of dollars of government loans?

    LIDDY: We’re going do it by selling some our very best assets. This company has been built over about a 99 year period of time. We have some assets around the globe that are the envy of the world. They couldn’t be duplicated. They couldn’t be recreated today. The proceeds from those asset sales will pay down that $60 billion. And if we do really well maybe even give us enough money left over that we can call some of the preferred stock.

    GHARIB: How difficult is it to find buyers in this down economy?

    LIDDY: We probably have 75 to 100 companies that are seriously looking at various of our companies. These are very complicated businesses. In many cases they operate in multiple countries or in multiple positions around the United States. So getting everything just right is really important to us. I think we will be successful in this endeavor. ”

    Why you think that a government agency couldn’t do better than these idiots is beyond me. Talk about rewarding incompetence.In any case, you must believe that this is a good strategy to keep it going.The alternative is to take it over and run it ourselves. If we’d have starting thinking about this in Sept. as many of us wanted, we’d have a plan by now. At least then listen to the opinion of some people with some credentials. That’s all I ask:

    http://www.ocnus.net/artman2/publish/Business_1/Geithner_s_AIG_Strategy.shtml

    Geithner’s AIG Strategy
    By Pietro Veronesi, Luigi Zingales, City Journal 19/2/09
    Feb 19, 2009 – 9:21:59 AM

    “Judging by Geithner’s past behavior as chairman of the Federal Reserve Bank of New York—where he helped lead bailout deals for Bear Stearns, Citigroup, and others last year—it’s likely that the Treasury will try to attract investors by using government guarantees to cap their possible losses. On the face of it, this seems like a smart way for the government to stop the financial industry’s meltdown without incurring astronomical costs. By covering some potential losses, the thinking goes, the government can calm investors’ fears and lure them back into buying mortgage-related and similar securities from banks. If the government guarantee is large enough, investors can even pay for the securities at close to the value on the banks’ books—sparing banks the burden of recognizing additional losses, which could push many of them into official insolvency. Last but not least, the plan minimizes the amount of money that the government must request from Congress.

    To understand the problems lurking beneath this idea, though, let’s analyze a similar deal: the guarantee that the federal government provided to Citigroup in November 2008. For a $306 billion pool of Citigroup assets “consisting of loans and securities backed by residential real estate and commercial real estate,� the government committed to providing something like an insurance policy with a deductible. Citigroup would absorb the first $39.5 billion of losses on the loans and other securities, with the government picking up 90 percent of the additional losses and Citigroup just 10 percent. The government ingeniously divided its responsibility among the Treasury (the first $5 billion), the Federal Deposit Insurance Corporation (the next $10 billion), and the Federal Reserve (all the rest). In this way, the Treasury committed only $5 billion of the finite TARP bailout money to the deal.

    The real value of the guarantee (and thus its potential cost to taxpayers) should include not only the TARP funds but also these other commitments—and it is massive. We estimate that if the government were held to the same accounting standards as private companies, the expected liability it would have to report for the Citigroup guarantee would be $66 billion. Nobody knows the true value of the volatile loans and securities underlying the deal—meaning that nobody knows the true extent of potential losses. And even the $66 billion estimate assumes that the assets comprise an average pool of residential-backed securities. Since Citigroup has a strong incentive to put the worst, most overpriced assets in the pool, the government’s actual liability could easily be $78 billion or more.

    Geithner’s plan suggests that the government might be applying similar sleight of hand to the entire financial system. We estimate that to restore the solvency of the top 10 banks to their pre-crisis level, the banking system needs at least $4.5 trillion in purchases of its toxic securities. (That’s why former Treasury secretary Henry Paulson abandoned the Bush administration’s idea simply to buy up all the toxic assets—he knew that the government couldn’t afford it.) Based on the Citigroup example, we calculate that Geithner would have to commit $75 billion of TARP money to attract enough private capital for the plan. But just as with the Citigroup case, that initial commitment wouldn’t tell the whole story. Under proper accounting standards, and taking the entire government’s commitments into consideration, the strategy would actually impose a cost of around $1.2 trillion on taxpayers.”

    Check out this as well:

    http://faculty.chicagobooth.edu/luigi.zingales/research/papers/from_awful_to_merely_bad.pdf

  17. This is possibly THE worst idea I’ve heard in the last five years. “The government pledges to buy up to twice the number of bank shares currently available, at twice some recent average price, in five years”.

    I guess I’m just shocked that someone would even think this is a good idea. Everyone talks about confidence–but this wouldn’t give us confidence…I think this would make people more angry than they currently are. No good.

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