Streetwise Professor

February 10, 2009

As Bad As You’ve Heard It Is–Take It From Me, It’s Worse

Filed under: Economics,Politics — The Professor @ 8:35 pm

The financial world watched Timothy Geithner’s speech and collectively said: “That’s it?  I mean really, there’s nothing else?”  And then they went out and sold stocks, oil, the Euro, the pound, the Loonie, and the Australian dollar, and bought Treasuries and yen.  In short, the market’s reaction to Geithner’s non-announcement announcement was that observed every time concerns about the financial crisis have ratcheted up–a flight from risk; a flight to perceived quality and safety.  

My reaction is not that much different from the market’s, and the vast majority of economists and finance people who have expressed their opinion.  I do have several specific comments, however.

First, the “Bad Bank” idea is here.  I think.  Hard to say, because it is now dressed up as a “Public-Private Investment Fund,” the motto of which appears to be “If we build it, they [i.e., private investors] will come.”  The Treasury recognizes the difficulties of pricing bad loans, but somehow private investors will magically solve this problem: “[the Investment Fund] allows private sector buyers to determine the price for current troubled and previously illiquid assets.”  Uhm, like, isn’t that possible now?  But, like, nobody’s doing it?  Isn’t the reason that “[m]any proposals designed to [cleanse toxic waste from balance sheets] are complicated by their . . . sole reliance on public purchasing” that no private purchasers are willing to buy them from banks?  So how is slapping a new name on this going to make any difference?  

The discussion of the Bad-Bank-Whose-Name-Shall-Not-Be-Spoken also reveals the political wordsmithing, not to say dishonesty, that pervades the Treasury document.  It says the the Investment Fund will help banks “cleanse their balance sheets of what are often referred to as ‘legacy’ assets.”  Except they’re almost never referred to as “legacy” assets.  The proper name is “toxic assets.”  This Victorian primness is just plain weird.  

The details are maddeningly missing here.  Who decides what assets go into  Bad-Bank-Whose-Name-Shall-Not-Be-Spoken?  Who decides on whether to accept bids (if any are forthcoming)?  Will BBWNSNBS package assets and auction them?  Sell them one off?  The document says–and I quote, because otherwise neither you nor I would believe it–“the new program. . . COULD involve . . . .”  Good grief, it COULD?  What else COULD it involve?  The Treasury has spent how many weeks/months designing this and came up with one COULD?  I mean, the original TARP plan, hurriedly slapped together over a weekend, was a masterpiece of detail compared to this.  This is devolutionary, not evolutionary, let alone revolutionary.

Bad bank precedents (e.g., Resolution Trust, the Swedes) basically seized banks whole, stripped out the bad assets, and put them in a bad bank.  My Humpty Dumpty approach doesn’t go that far because it doesn’t involve the seizure (nationalization) of entire banks.  Instead, it involves the admittedly compulsory exchange of toxic assets for equity in a company that holds these assets.  It’s not really a bad bank, because I don’t envision it being highly leveraged.  It’s more like a Bad Hedge Fund or Bad Private Equity Fund.  It could be funded by revenues from the assets it holds, and perhaps through sale of some equity to the public or the issuance of (limited amounts) of debt.  

But the point is that pussy-footing around with getting the bad assets off the bank balance sheets ain’t gonna work.  It’s long past time for that.  The government can wait for Citi or some others to go into FDIC receivership, and then strip out the bad assets to seed the Bad Whatever, or it can find the will and the way to force these assets into the Bad Whatever without nationalization.  

Second, the plan puts the government in the CDO/asset backed security business.  The “Consumer & Business Lending Initiative” will “support the purchase of loans by providing the financing to private investors.”  But don’t worry, it will “Protect Taxpayer Resources by Limiting Purchases to Newly Packaged AAA Loans.”  That makes me feel so much better!  The government will only purchase the senior tranches! We all know how safe those are!   And how reliable those AAA ratings are!  

Memo to Treasury: a lot of senior tranche, AAA rated paper will–or at least should–end up in the bad bank.  That is, dubious–to put it as kindly as possible–credit ratings provided the cover by which banks loaded the boat on risk, and then saw the boat sink.  Given this history, the bold-faced, italicized hype about “protecting taxpayers” by relying on AAA ratings reminds me of Samuel Johnson’s quip about second marriages being a triumph of hope over experience.  

I mean really.  Did anybody actually read this?  Anybody who’s been conscious since August, I mean.  

Third, guarantees make it, I think, but again in a dishonest, stealthy, cross-dressing kind of way, so I’m not quite sure.  Banks that have undergone a comprehensive “stress test”  will “have access to a Treasury provided ‘capital buffer’ to help absorb losses and serve as a bridge to receiving private capital.”  

The introduction to this section mentions “uncertainty about the real value of distressed assets and the ability of borrowers to repay loans.”  Therefore, it is reasonable to conclude that the losses to be absorbed would include mark-to-market losses on existing toxic assets on bank balance sheets, i.e., it would provide a guarantee on these assets to facilitate the ability of banks to attract private capital.  Reasonable, but it’s not certain that that’s the right interpretation.  Would have it been so hard to make it clear, one way or another?  Why play twenty questions?  And then not answer them.  

Fourth, the document makes it clear that banks that receive government assistance will be required to expand lending.  Although it sets the benchmark for comparison as “what would have been possible without government capital assistance,” this is a nebulous standard.  We can’t run parallel universes, controlled experiments, that permit a precise comparison of what would have been possible in this but-for, no capital assistance world.  Note that the burden of proof is squarely on the lender: the standards “require recipients . . . to show how every dollar of capital” is preserving or generating lending.  Thus, faced with the burden of proof to demonstrate that it is meeting an objectively unproveable standard, it is inevitable that banks will be under tremendous political pressure to expand lending, or to engage in extensive loan forebearance.  This will compromise, and could overturn altogether, the primary objective of returning banks to financial health and stability.  

Fifth, but don’t worry, “Political Interference in Investment Decisions” is “Prohibited”!  Boy, I feel so much better knowing that the Treasury “has announced measures to ensure that lobbyists do not influence applications for, or disbursements of, Financial Stability Plan funds, and will certify that each investment decision is based only on investment criteria and the facts of the case.”  No mention of Congressmen, Senators, political appointees in Treasury, the White House (e.g., David Axlerod), etc.  Put differently, the “lend or else” dictate makes financial institutions acutely vulnerable to political pressure from elected officials and their political appointees.  The decisions made in this environment will almost certainly mean that a large fraction of the loans that banks make under this sword of Damocles will be bad, further deepening the hole that this plan was supposedly intended to get us out of.  

My final judgment, after reading and re-reading the plan (multiple re-reads being required because I couldn’t believe it the first several times through)?  The market was very forgiving in its judgment.  This is a step backwards, not a step forward.  No, it is many steps backwards.  It addresses NONE of the crucial issues in a serious, conclusive way.   To be quite honest, I think that even the REALLY REALLY Bad option I discussed over the weekend–nationalization–would be better than this.  

I should also note that in addition to the errors of commission, by failing to set a clear path forward, this thing (I shouldn’t dignify it with the name “plan”) ramps up the policy uncertainty and political risks in the market to an unacceptable degree.  It also seriously undermines market confidence in the competence of the Treasury–and Obama.  The indecisiveness is incredibly damaging.  Deciding on something–even something I would consider inferior–is better than floating this term paper that decides nothing.  

In a nutshell: a first class FUBAR.

Snarky postscript: I may be dating myself, but when I see Geithner’s picture I think of “Eraserhead” (a 1970s David Lynch cult film.)


Treasury Secretary Timothy Geithner addresses a news conference ...

He just needs a bit more of an up-do and he’s got it.

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  2. Nouriel Roubini’s thoughts on nationalizing the banks:

    There are three basic approaches to a clean-up of the banking system: recapitalization together with purchase by a bad bank of toxic assets; recapitalization together with guarantees – after a first loss – of the bad assets; outright government takeover (call it nationalization) of insolvent banks to be cleaned after takeover and then resold to the private sector.

    Of the three options the first two have serious flaws: in the bad bank model the government may overpay for the bad assets as the true value of them is uncertain; even in the guarantee model there can be such implicit over-payment (or over-guarantee that is not properly priced).

    In the bad bank model the government has the additional problem of having to manage all the bad assets it purchased.

    Thus, paradoxically nationalization may be a more market friendly solution: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and – possibly – even the unsecured creditors in case the bank insolvency is too large; it provides a fair upside to the tax-payer; it can resolve the problem of government managing the bad assets by reselling most of the assets and liabilities of the bank to new private shareholders after a clean-up of the bank.

    This “nationalization” approach was the one successfully taken by Sweden while the current US and UK approach may end up looking like the zombie banks of Japan that were never properly restructured and ended up perpetuating the credit crunch and credit freeze.

    And a NYT’s article about the Swedish bank rescue:

    Comment by penny — February 11, 2009 @ 11:16 am

  3. I think you’ve hit the nail on the head. Great analysis. Can’t help but chuckle about the pricing of “currently troubled” and “previously illiquid” assets. Previously illiquid? Like you said, I think the market *has* priced these assets, and I’m not really sure how anybody in good faith could consider them “currently liquid”. Where’s the market? If there *is* a market, then pricing them should be fairly easy – mdi-point between the bid and ask. ;^)

    Now if we could just find that bid…

    Comment by Mack — February 12, 2009 @ 11:43 am

  4. Err.. that was supposed to be “mid-point between the bid and ask”. Can you fix that?

    Comment by Mack — February 12, 2009 @ 11:44 am

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