Geithner Plan Not So Dumb
Geithner Plan Not So Dumb
Another bailout, another outcry from the ‘let them rot in hell’ brigade. For mine, Tim Geithner’s latest rescue plan for the US banking system is the best we’ve seen so far.
The US Treasury is going to start its own hedge fund in partnership with private investors, specifically designed to buy toxic assets from the banking sector.
The government will provide debt funding, up to six times the amount of equity, and also contribute half the equity. Private sector investors will provide the other half of equity and make the decisions about how much to pay for the assets.
To use an example, let’s say a pool of sour mortgage loans with a face value of $1,000 is put up for auction. Several pre-approved private investors bid for the assets, with the highest bid being $700. The winning bidder will contribute $50 of their own equity. Treasury will also contribute $50 in the form of equity and $600 as a non-recourse loan.
If the government had simply bought the assets itself, it's likely it would substantially overpay or, at the very least, that would be the public perception.
Under the latest plan, the government will be using the private sector to set appropriate prices, forcing those private investors to contribute some of their own capital so that they have an incentive to get their bid price right. There’s also a good chance of the government sharing in the private sector’s profits.
Still, the leverage looks too high. As Paul Krugman noted in a recent New York Times piece, that creates a return asymmetry. Equity investors are incentivised to overpay for assets because they get all of the upside and only have to wear a little of the downside.
But if the loan is priced correctly, there are also plenty of scenarios where the government does much better than the private investor. If we assume the asset in the example given above turns out to be worth only $650, the government would get $625 of its $650 back, and some interest, while the private investor would only get $25 of its $50 back.
Thus far, there have been three or four plans to address the US banking sector crisis. Of the ones that we've seen, this is the best. And something had to be done: it remains extremely difficult for even sound, creditworthy businesses to access credit - a disaster for the US economy and, by extension, the world.
But why Geithner chose not to simply start a new, government-backed bank to meet demand from genuinely creditworthy borrowers is beyond me. Surely it would be a highly profitable venture given the current pricing of loans? But in the absence of a brand new balance sheet, this looks like a sensible proposal for cleaning up the old ones.
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Your frank comment let them rot in hell and start with a brand new balance sheet is a sensible proposal and the only one that's going to work.
Paulson try a similar idea had to pull the plug losses were to great one trillion dollars is a drop in the bucket to the amount of bad loans off the balance sheet.
High leveraged what got us into this mess and no way in hell it's going to get us out of this situation.
Just because something is the best of a very bad bunch doesn't mean it's "good" Steve. This plan is just the latest abomination the series that have spewed forth from US Treasury since last September or so.
Ultimately this plan may "work" in the sense that the banks will shovel out their toxics into the PPIP (whilst participating in it as a funder at the same time - what a joke!) but the truth of the matter is that the US taxpayer is about to get a massive fleecing at the hands of Treasury and President Obama - far higher in fact than if they simply bought out bank equity at current market prices and transferred the toxic portfolio to a special-purpose vehicle which the could run-offf themselves (basically "Maiden Lane" model used in the aftermath of Bear Stearns).
Why the US government won't cross the ideological rubicon of "nationalization" and simply seize the mantle is just beyond me. When the FDIC takes over a troubled bank (e.g. IndyMac), this is a de facto Nationalization. TARP money should have been poured into the FDIC and used to take over troubled banks like Citi and BAC. Now we have moral hazard aplenty, reward for failure (90% tax not withstanding) everywhere, and no doubt Blackstone and PIM(P)CO standing to make filthy lucre from the PPIP junk bond program. Let's party like it's 1979. Drexel redux.
Oh - and if you think this plan is going to get banks "lending again" you're on crack. Mark my words.
Hi Steve,
It is interesting the polarization of opinion that can be caused on issues that from a distance and limited knowledge of the depth of the problem, seem to create clarity of resolution.
I think Dave has missed the point, that the administration is trying to save the financial institutions by any means possible regardless of the moral implications. To buy toxic assets at "market value" would defeat the purpose of one of the goals the Fed/Government is trying to achieve.
Part of the reason the financial institutions are in a financial crisis is due to their 'assets' no longer being of the value they mistakenly placed on them. If the government paid market value the institutions would crumble in value if not go under anyway. This reduced equity and further erosion of confidence would compound an extraordinarily difficult and complex problem, not to mention the repercussions to the rest of the financial system and possibly turning a recession into a depression but a few years longer.
bern
The way Bill Gross explained it, the current situation is that potential buyers are bidding roughly 30 cents in the dollar for these assets, while banks refuse to let them go for anything less that 70 or 80 cents (presumably because a lower price would force a mark to market adjustment of their loan book, making them technically insolvent). Gross said that the Government's cheap loans to the buyers will allow them to increase their bid price yet achieve a similar risk/return situation as bidding today at 30 cents. And if banks are willing/able to lower their offer price a bit, it might allow buyers and sellers to meet where currently there is stalemate. I won't comment on the Government funding that difference, lest my cortisol levels rise. But I'll make the comment that smart bidders are going to make a lot of money here, in all likelihood. Keep an eye out for bids from the likes of Berkshire Hathaway, Baupost and Yale Endowment Fund.
Steve
I broadly agree with your comment, the Geithner plan being as it is a compromise. But I also agree with, Stephen, Dave, Bern and Gareth. These banks should be allowed to fail, but if that happened we would not be out of depression under a decade. Pimco and the like will make a fortune, but the moral hazzard is colossal. I am afraid that even if this does work it will only get the V8 US banking system firing on one cyllinder. The last word I acknowledge to Dave - the US needs to nationalise the banking system. Alas that is not acceptable at the moment, but I suspect it will be before this is over. In the words of Marc Faber, (paraphrased), What a bloody mess!
Russ Hawking
The Geithner plan takes risk off the balance sheet of banks and puts it into the laps of US taxpayers. That is not the way it is supposed to work. Banks that make bad loans should be forced to work off those loans or fail. It is infuriating to ask taxpayers to indemnify the financial elite.
The obvious solution to this problem is to create a bad bank inside of the good bank, and to relax the requirements to use up reserves against assets in those bad banks. Give financial instititutions a decade to payoff losses in those bad banks. By doing this you allow capital injections into the good bank to be used to write new business, instead of being held to reserve losses on toxic assets.
The reason no one in Treasury goes for the obvious solution is that apparently the US government has become a captured regulator, simply caving to the interests of the financial class. Geithner's environment at the Fed was filled with Wall Street bankers. Geithner's solutions all look like they are written by Wall Street banks primarily as vehicles to preserve those bank managements intact and indemnify all their losses.
Finally, anyone who thinks this plan is going to make banks lend again is crazy. Banks are not lending because banks during recessions always wait for the cycle to turn before they start to lend. They want to protect their money after all. This recession is doubly bad because the banks must use capital injections to cover reserves on bad assets.
The system had too much lending. The whole scheme of securization of mortgage assets was broken top to bottom, and failed to make the lenders accountable for loan quality. We don't need more of what was broken.
Set the bad assets aside so they don't eat reserves, then let banks settle down to a lower level of lending, based on sane lending standards and real economic growth.
Dave & Will, I think you miss the fundamental points of why this program is being initiated by the US Treasury...
Yes, the 'risk' is being transfered to the US taxpayer (I am one), but so is the reward. 'Private Investors' ARE the US taxpayer in all different forms- and they stand to increase their wealth dramatically if they participate in this program.
Lets not forget that 95% of Americans are still paying their debts... so these 'toxic assets' are not so toxic, they just dont have a market to be traded in, and thats what the Treasury is creating....
It seems there has been too much listening to the press with talks of bailing out the financial elite etc- Although easy to assume from a distance, Its just not the case.
Angus, this is ridiculous: the 95% of the American taxpayers who are not billionaires and who are not going to have any opportunity to gouge the US Government under this program are being asked to absorb losses for the financial elite who will participate.
In fact you are not creating a market. You are subsidizing the purchase price in order to distort the market to create an illusion that will support banks' balance sheets.
Get assets out of good banks into bad banks, relax the reserve requirements, and then the government can start a marketplace to trade those assets. But there is no reason to subsidize the price at the cost of the American taxpayer, and no reason to absorb the losses of the buyers.
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