Streetwise Professor

November 12, 2008

Died of a Theory

Filed under: Derivatives,Economics,Politics — The Professor @ 7:39 pm

Hate to say I told you so, but . . .

Today Treasury Secretary Henry Paulson confirmed what pretty much everybody had figured out: The Treasury will not buy troubled assets under the TARP program. TARP monies have gone primarily to buying equity stakes in banks.

Paulson said “[o]ur assessment at this time that [the purchase of troubled assets] is not the most effective way to use TARP funds, but we will continue to examine whether targeted forms of asset purchase can play a useful role, relative to other uses of TARP resources, in helping to strengthen our financial system and support lending.” In other words, don’ t hold your breath.

Back in September I expressed extreme skepticism at the theory underlying the TARP program, and questioned many of the proposed implementation schemes. I was not alone. Paulson just validated these judgments.

With TARP funds running low, Paulson is now resorting to investment banker-speak to plead for private capital infusions to complement TARP investments in banks: “We are carefully evaluating programs which would further leverage the impact of TARP investments by attracting private capital through matching investments.” “Leverage the impact.” Yuck. English, please.

This communicates an air of desperation. It’s no surprise that the market was down about 5 percent today in the aftermath of Paulson’s remarks.

This whole fiasco reveals that government recapitalization of banks is a necessary, but not a sufficient condition, to restore stability to the financial system. It is also imperative to clean up banks’ balance sheets by addressing the toxic asset problem. Laurence Kotlikoff, Perry Merhling, and Alistair Milne made a similar point on an FT blog last month but I do not believe that their plan for the government to insure the “AAA” rated CDO tranches on banks’ books goes nearly far enough. This will restore the value of some collateral, but not all of it. Moreover, it will not kickstart the price discovery and revaluation process that is necessary throughout the entire system. It also represents a substantial additional taxpayer funding commitment.

So. . . I keep coming back to Humpty Dumpty. Go ahead. Call me obsessive. I can handle it. I know it’s radical, but nothing else on offer gets to the heart of the matter. That dark heart is the complex optionality in all of the stuff churned out by Frankensteinian financial engineers. If that complexity is not undone, these assets will continue to contaminate balance sheets from sea to shining sea–and beyond.

I ran the idea by someone in a position to do something about it. I was forthright about the pitfalls of the idea–the difficulties in valuation and the extraordinary powers involved. He basically patted me on the head, and told me to go back to the ivory tower, saying that these problems made the plan a non-starter. Fair enough. I understand that response.

But that was October 18th. Four weeks have past. TARP is in a shambles. The Treasury has committed billions, and is running out of ammunition. The AIG bailout has been bailed out. The line of mendicants asking for handouts is stretching as far as the eye can see. Although certain indications from the inter-bank market suggest that the extreme panic has subsided, the renewed swoon in the stock market, led by crashing bank stocks, makes it painfully clear that the situation is still fraught with danger, and that the direct government injections of cash has not solved the crisis. Something more is needed, and soon.

Humpty has numerous virtues which, in my view, more than outweigh its defects. To repeat:

  • It does not require a commitment of taxpayer funds, and does not subject the taxpayers to adverse selection.
  • It will facilitate the restructuring of mortgages.
  • It will improve the liquidity of troubled assets by destroying the complex optionality that saps liquidity. This will increase asset prices, and thereby increase bank capital.
  • It will improve the transparency of bank balance sheets by replacing heterogeneous, impossible to value securities with a homogeneous claim that will almost certainly trade much more easily and efficiently than the existing troubled assets. This improved transparency will reduce the difficulties that private lenders and investors face in valuing banks, which will in turn reduce frictions in the inter-bank market and facilitate the re-capitalization of banks. It will also help the government identify which banks are in greatest trouble, and respond accordingly.

If Paulson wants to attract private capital to banks to complement government investments, it is imperative that potential investors know what they are investing in. This requires a quantum improvement in the accuracy of the valuations of the assets on bank balance sheets. He has just admitted that TARP as originally conceived won’t do that. Humpty has the best shot to do so. Without aggressive action to attack the troubled asset problem, Paulson’s call for additional private capital will be a pitiful plea that falls on deaf ears.

Yes, Humpty Dumpty poses serious challenges. But in my view it is, to paraphrase Churchill, the worst way to deal with troubled assets, except for all others that have been tried or proposed from time to time.

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