There are three interconnected but different questions about the Obama/Geithner banking plan: (1) will it work? (2) is it the most politically feasible plan? And (3) is it fair?
Initially I have taken a strong position against this plan. Having considered it at more length, and read commentary from a number of vanatage points, I would like to offer a more balanced analysis of the three diefferent issues. In essence, I will argue that (1) it has a reasonable chance of working, (2) it is the most politically feasible plan that Obama can offer for the least sacrifice of political capital, and (3) absolutely not.
Finally, at the end of this diary, I will consider the unthinkable.
Yesterday in the course of commenting on several diaries, I was asked if the Obama/Geithner plan would work, or if it would just inflate another bubble. I responded that I wanted to consider the plan in more detail with more reflection before giving a lengthy response.
The diaries yesterday were "instant analysis", knee jerk reactions one way or the other. Now, upon further consideration, I think a fair answer to the three interconnected questions above are possible.
1. Will it work?
I won't rehash the causes or manifestations of the banking crisis. By now you have a good idea. So let's begin with the outlines of types of crises and rescues. Prof. Brad Delong wrote a great synopsis the three basic types of crises:
- Liquidity crises
- Solvency crises that are easily cured by easier monetary policy that boosts asset values
- Solvency crises that aren't easily cured by easier monetary policy
that he then describes in fuller detail:
The first -- and "easiest" -- mode is when investors refuse to buy at normal prices not because they know that economic fundamentals are suspect, but because they fear that others will panic, forcing everybody to sell at fire-sale prices. The cure for this mode -- a liquidity crisis caused by declining confidence in the financial system -- is to ensure that banks and other financial institutions with cash liabilities can raise what they need by borrowing from others or from central banks.
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In the second mode, asset prices fall because investors recognize that they should never have been as high as they were, or that future productivity growth is likely to be lower and interest rates higher. Either way, current asset prices are no longer warranted.
This kind of crisis ... [is] because the problem is that banks aren't solvent at prevailing interest rates. Banks are highly leveraged institutions with relatively small capital bases, so even a relatively small decline in the prices of assets that they or their borrowers hold can leave them unable to pay off depositors, no matter how long the liquidation process.
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The problem is not illiquidity but insolvency at prevailing interest rates. But if the central bank reduces interest rates and credibly commits to keeping them low in the future, asset prices will rise. Thus, low interest rates make the problem go away....
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The third mode is like the second: A bursting bubble or bad news about future productivity or interest rates drives the fall in asset prices. But the fall is larger. Easing monetary policy won't solve this kind of crisis, because even moderately lower interest rates cannot boost asset prices enough to restore the financial system to solvency.
By now we know that this is neither a pure liquidity crisis nor a type two limited insolvency crisis (liquidity injections didn't work, nor did lowering interest rates to zero). It is a full-fledged type three insolvency crisis.
The thinking behind both the initial Bush/Paulson plan last September and the Obama/Geithner is the same, however: even though the banks are insolvent, the crisis might yet be salvaged by liquidity injections.
Consider the following example: On my balance sheet I have $300,000 in assets but $400,000 in liabilities. I am insolvent. If the reason for my problem is that the value of my assets is depressed due to a temporary emergency, an injection of $120,000 gives me a net worth of +$20,000. I am solvent. Now suppose that the value of my assets is only depressed $50,000 due to an emergency. I am still insolvent based on the normal, actual underlying value of my assets. But it I receive $120,000 from my rich uncle, I am solvent anyway! The reason for the valuation of my assets and liabilities is irrelevant. Whether I receive a temporary loan (liquidity injection) or a permanent infusion (a subsidy), my problem is solved.
Of course, it cannot be said with any certainty that the liquidity/subsidy of the Obama/Geithner plan will be sufficient to carry the big banks over the threshold to solvency. But the enormous $1 Trillion price tag means it is within the range of reasonable possibility.
2. Is the plan politically feasible?
The Bush/Paulson plan last September immediately created a firestorm of such intensity that Congress initially balked. That plan, however, was sufficiently simple enough to understand that it was immediately dissected by just about every economist and pundit as straightforwardly requiring the taxpayer to overpay for badly-behaved banks' toxic assets, with virtually no upside to the taxpayer. The Obama/Geithner plan, by contrast, is "feindishly complicated". Here's an interesting take by financial blog Clusterstock:
When the government got around to figuring out what it would cost to overpay enough for the troubled assets that banks would come clean, the number was almost certainly beyond anything they had contemplated.
How big could that bill be? Senator Charles Schumer has said that the bad bank could cost $3 trillion to $4 trillion. We’ve heard estimates even higher. One banker we spoke to said the bad bank would have to be prepared to spend as much as $8 trillion.
Insurance provides a much more politically palatable way of bailing out the banks. Politicians won’t have to spend a dime on day one. They’ll claim that much of the insurance will prove unnecessary because the asset values will recover. We're sure someone will say that taxpayers could even make money on the insurance, if the premiums charged to banks wound up being higher than the pay outs on the insurance. The budget makers will come up with a rose-tinted estimate of eventually payouts, and that estimate will be based on the idea that the troubled assets will recover their value. The Dislocation Ideology will become the official policy of the United States.
Yves Smith of Naked Capitalism agress that "the complexity is deliberate, to confuse the chump taxpayer."
The Obama/Geithner plan is a much more crafty and politically cunning version of the Bush/Paulson plan. The "senior Administration officials" flooding the airwaves are able to say that the private investors in the partnership have "skin in the game" and can "take a loss", and that contrarily taxpayers have tremendous upside, or can "make a fortune" as Professor DeLong has opined. The plan aims to mollify a substantial degree of populist rage at bailouts, while soothing Wall Street (as the DJIA certainly showed yesterday). It also preserves the option of nationalization further along down the road, if this plan does not work as intended. This seems like "vintage" Obama, offering a plan that may or may not fully address and issue, but preserves the most room for maneuver later on.
If early signals are correct, the plan stands a very good chance of passing Congress. Would a more radical, FDIC/RTC type receivership plan ("nationalization") also pass Congress? IF Obama got directly and enthusiastically behind such a plan, I believe it would -- there is simply too much popular rage in the country for Congress to jeopardize their seats by getting in the way of the tsunami. But that would require the spending of a huge amount of political capital by Obama, and he may also have ideological distaste for a "revolutonary" rather that "reform" plan. Politically speaking, Obama gets the most bang for his political buck from this plan.
3. Is it fair?
Does this plan reasonably approximate social justice? Not even close. Here, the Obama/Paulson critics are absolutely correct. Paul Krugman has pointed to an analysis by another blogger called Nemo which I am reproducing here:
The details of the "Geithner Put" have been released. It has two parts: One to deal specifically with bad loans, the other to deal with other legacy assets .... [T]he first part [is] dubbed the "Legacy Loans Program".
The Treasury helpfully provides an example, which I reproduce here:
Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.
Let’s flesh this out by repeating it 100 times. So say a bank has 100 of these $100 loan pools. And just by way of example, suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. (These numbers are made up but the principle is sound. Nobody knows what the assets are really worth because it depends on future events, like who actually defaults on their mortgages.)
Thus, on average the pools are worth $50 each and the true value of all 100 pools is $5000.
The FDIC provides 6:1 leverage to purchase each pool, and some investor (e.g., a private equity firm) takes them up on it, bidding $84 apiece. Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools but only puts in $600 of its own money.
Half of the pools wind up worthless, so the investor loses $300 total on those. But the other half wind up worth $100 each for a $16 profit. $16 times 50 pools equals $800 total profit which is split 1:1 with the Treasury. So the investor gains $400 on these winning pools. A $400 gain plus a $300 loss equals a $100 net gain, so the investor risked $600 to make $100, a tidy 16.7% return.
The bank unloaded assets worth $5000 for $8400. So the private investor gained $100, the Treasury gained $100, and the bank gained $3400. Somebody must therefore have lost $3600...
...and that would be the FDIC, who was so foolish as to offer 6:1 leverage to purchase assets with a 50% chance of being worthless. But no worries. As long as the FDIC has more expertise in valuing toxic assets than the entire private equity and banking worlds combined, there is no way they could be taken to the cleaners like this. What could possibly go wrong?
....[W]ith the auction process, the assets will get bid up to the point where private equity (and Treasury alongside them) do not make such massive profits. But in the process, the outcome becomes even sweeter for the bank and worse for the FDIC. This appears to be the entire point of the exercise.
Thus Part 1 could be read as a transfer of wealth from good banks to bad banks and private equity. Assuming Treasury actually demands repayment on the credit line and does not just write it off...
Part 2 of the Geithner Put is called the Legacy Securities Program. Here again, the Treasury provides an example:
Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.
Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.
Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.
This may sound similar to Part 1, with the Treasury providing the leverage instead of the FDIC... But it is actually completely different. The key concept is the non-recourse loan. If Treasury wants to hire a handful of money managers, ask them to raise private capital, match the capital raised, and then let them lever up 3:2 or 2:1, that is not a subsidy in the same way as Part 1. In this case, the loans are full recourse with respect to all of the assets run by that manager. So it is not trivial to construct an offensive example, and this structure by itself is not so bad.
No, the bad part is this bit which appears a few paragraphs earlier:
Expanding TALF to Legacy Securities to Bring Private Investors Back into the Market
.......
Funding Purchase of Legacy Securities: Through this new program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency residential mortgage backed securities (RMBS) that were originally rated AAA and outstanding commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that are rated AAA.
Whoops, there are those "non-recourse loans" again. The TALF is the Fed’s new $1 trillion program to provide non-recourse loans against new asset-backed securities. Part 2 of the Geithner Put extends this program to existing securities. (Note the phrasing "originally rated AAA". We are definitely talking about toxic assets here.)
So the Treasury provides equity investment and loans for fund managers to purchase assets, and then the Fed provides the subsidy via non-recourse loans against those assets. The degree of leverage here is determined by the "haircut" applied to the assets; a 10% haircut corresponds to 9:1 leverage, for instance. Search for "collateral haircuts" in the TALF FAQ to get an idea of the numbers. Although bear in mind those are for the current TALF, and we will have to wait to see the haircuts for the Geithner Put extension.
Apparently, we are left with private equity firms and bankers being able to fleece the FDIC and the Fed via abusing the non-recourse loans, with the Treasury/taxpayer participating in the upside of the fleecing. Which is fine, I guess, if you believe the FDIC and Fed are themselves good for the losses; i.e., that the losses will not ultimately be placed on the taxpayer.
Unintentionally, Prof. DeLong's defense of the plan reveals this shortcoming. As I have alrady noted elsewhere, here's DeLong, in the next set of Q and A:
Q: Where does the trillion dollars come from?
A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.
Q: Why is the government making hedge and pension fund managers kick in $30 billion?
A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.
Q: Why then should hedge and pension fund managers agree to run this?
A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.
My question about DeLong's FAQ is the same question I have for all get-rich-quick schemes: if the return is so good, why don't we just cut out the middleman? Let's put up $970 Billion, cut out the hedge funds, and pocket all of the fortune to be made ourselves!
The obvious answer is, because the entire INTENT of the plan is to provide a windfall to those private investors. This is the Paulson plan, cunningly dressed up to appear to be populist-outrage-resistant. Willaim Seidman, on CNBC yesterday afternoon, bluntly agreed that the plan was intended to be a subsidy to private purchasers.
One interesting point that other bloggers haven't mentioined is how the "auction" system is actually going to work AGAINST the taxpayer. Let me give an example. Suppose I am an investor who wants to buy a work of art. I can show up at the auction personally or via phone and bid on it up to my limit of, say $1 million. Or I could deputize an agent to do that for me, and incentivize the agent to "bring change". The Obama/Geithner plan assumes that the market price will somehow be more "competitive" if I use not one, but five agents to bid against each other for the work of art! Is there anyone who thinks I am going to get a better deal with five agents bidding up the price against one another than by using one agent?
And as another blogger (sorry, forgot the link) pointed out, the various "agents" who will be hired by the Treasury are certainly not going to be at arms' length. There is every opportunity and, probably, desire, to collude with Treasury. So if Obama/Paulson want to "paint the tape" by getting good, pro-taxpayer prices on the initial round, thereby generating good will, before the anti-taxpayer bidding kickes in, they have every chance to do so.
And the system has the final virtue that it is payable over time in government bonds to be issued in mind-boggling proportions to fund the $trililon(s?) spent. The bill doesn't really come due until Obama, Summers, and Geithner are all retired.
On social justice/equity grounds, the taxpayer gets very limited upside and a generations'-long bill. All to subsidize the financial industry.
4. Which brings me to the unthinkable
All of what we are seeing is the desparate attempt to fend off "Great Depression 2". The cost of this effort, however, is becoming so great itself that it is worthwhile to consider the unthinkable: letting a depression happen. The Obama/Geithner plan, like the Bush/Paulson plan before it, pushes off to our children's and grandchildren's generation much of the paying of the bill, to avoid economic hard times to the generation now. Certainly if those future generations could vote, they would argue strenuously that the present generations should bear the brunt of their own collective folly. It is worth considering that such a point of view is correct.
Unlike the 1930's, we already have the example of FDR. We know about the New Deal's focus on "Relief, Recovery, and Reform." The first part, Relief, was to alleviate immediate suffering including privation and starvation that were becoming widespread. Provided we were generous with relief -- to ensure that citizens did not starve, nor freeze homeless on the stree -- and provided that we proceed with the infrastructure plan to provide as much employement as possible, just like the WPA and the CCC of the 1930s -- and finally provided that we Reform the system now to ensure as best we can that our children's and grandchildren's generation will not succumb to the same plutocratic fallacy that has become our undoing -- then in that event taking our bitter medicine and allowing a deeper economic calamity now, to avoid burdening succeeding generations with the obligation of tremendous debt, may be the most responsible thing we can do.