Tim’s Got a Plan

Original Link: http://alhambrainvestments.com/blog/2009/03/23/tims-got-a-plan/

Posted by Joseph Y. Calhoun, III

Treasury Secretary Tim Geithner today unveiled his long awaited plan for relieving banks of their responsibility to own up to their past lending mistakes. He even wrote a nice Op-Ed for the WSJ to explain his plan. My comments appear in red below:

The American economy and much of the world now face extraordinary challenges, and confronting these challenges will continue to require extraordinary actions.

No crisis like this has a simple or single cause, but as a nation we borrowed too much and let our financial system take on irresponsible levels of risk. Those decisions have caused enormous suffering, and much of the damage has fallen on ordinary Americans and small-business owners who were careful and responsible. This is fundamentally unfair, and Americans are justifiably angry and frustrated.

The depth of public anger and the gravity of this crisis require that every policy we take be held to the most serious test: whether it gets our financial system back to the business of providing credit to working families and viable businesses, and helps prevent future crises.

The extraordinary actions taken to date have done nothing but make the problem worse. More extraordinary actions will have similar results. It is true that we borrowed and spent too much and some of our financial institutions took on too much risk. Is it too much to ask why that happened before we go trying to craft a solution? We borrowed and spent too much because the Fed and the Treasury didn’t do their job and protect the value of the dollar. The Fed, particularly under Alan Greenspan, saw every hiccup in demand as an excuse to lower interest rates and encourage more borrowing. The Treasury spent the last 5 years ignoring the value of the dollar. With artificially low interest rates and a falling currency value, is it any wonder that Americans took on more debt and banks provided the credit? And it is fundamentally unfair to ask the prudent to bail out the imprudent. So the question I have is why are you still asking? Why not let the imprudent take the hit?

Geithner spends the next few paragraphs extolling the wonders of the myriad programs put in place to keep the Ponzi scheme going. Finally, we get to the plan:

However, the financial system as a whole is still working against recovery. Many banks, still burdened by bad lending decisions, are holding back on providing credit. Market prices for many assets held by financial institutions — so-called legacy assets — are either uncertain or depressed. With these pressures at work on bank balance sheets, credit remains a scarce commodity, and credit that is available carries a high cost for borrowers.

Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity. Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The financial system is not working against recovery; it is trying to preserve what capital it has left by finally allocating credit more prudently. And those legacy assets are depressed for good reason - they aren’t worth much. Credit is scarce for people and companies for which it should be scarce. As a whole we haven’t seen much contraction in credit provided by banks. We’ve seen a contraction in non bank credit. You don’t need to set up a market for the legacy assets, it already exists. The banks that have the bad assets just don’t like the price being offered.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The partnerships will be funded by more borrowing by FDIC, funds from TARP and financing by the Fed. Too much borrowing got us in this mess, but apparently the answer is to borrow more. And by the way, if FDIC is providing the bulk of the funding, why don’t we just use those funds to have FDIC take over the bad banks and get rid of the current management? Isn’t that what the FDIC is for? As for sharing risks, well as usual the taxpayer gets the shaft on this one. Taxpayer funds will provide 97% of the capital and get 50% of the profits. And the funding is non recourse. Huh? Would anyone in their right mind agree to that deal without a gun to their head? Furthermore, it would seem that with so little capital on the line, the bidders might just not be as prudent with their bidding, but assuming they act rationally and don’t overpay, will the banks be willing to sell? Not if the price is less than their current carrying mark.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

So we’re buying up $1 trillion in assets at inflated prices from institutions that failed to operate prudently so private investors can get a chance to buy in at low prices? And then we expect these banks to get back to lending out more money in an economy that already has a debt/GDP ratio of 350%? Is there a plan to ever reduce the debt or do we plan to just keep borrowing more and more? And one more thing: will the banks selling the assets also be allowed to participate in the partnerships to buy them? If so, this “plan” is nothing more than a scheme to dump their losses on taxpayers. A bank could put up 3% of the capital in one of these partnerships and then bid a high price for their own assets, effectively shifting most of the risk to taxpayers while avoiding a writedown. Is that the real plan?

That’s the meat of the plan. Taxpayers put up most of the capital and private investors get an outsized portion of the reward. I sure wouldn’t want Geithner negotiating a joint venture for my company.

The Geithner plan is premised on the same assumption as every other plan that has been floated - that somehow we can induce someone to overpay for these bad assets. Geithner has constructed a plan with so much taxpayer provided leverage that it just may work. Of course that depends on your definition of “work”. If your definition is having taxpayers bail out the stock and bond holders of every bad bank, then this just might get the job done. If we had let the banks fail, stock and bondholders - the owners of these badly run institutions - would have taken the losses. While that would be unfortunate for them, I fail to see how it justifies pawning off the losses on the public.

The whole idea behind these bailouts is that the public benefits by maintaining the status quo in the financial sector. Considering that it is the financial sector that got us in this mess - with a lot of help from politicians and the Federal Reserve - one has to wonder why that is considered a public policy goal.