The whole idea of using taxpayer money at the Treasury to stabilize the economy and arrest the collateral economic damage which Wall Street has wrought on Main Street is either naïve or sinister. Naïve if Paulson and Congress really thought this was the most efficient and effective way to restore liquidity and viability to the banking system and thus circumvent unnecessary business failures. But sinister if Wall Street intentionally conned Congress into buying an economic Armageddon (by the time the Asian markets opened if we didn’t do this) scenario so they could effectively rob the Treasury.
Although they would never admit it publicly, you have to believe that these bank CEOs were smart enough to understand that they had screwed up the risk management and leverage to a point where they were in no position to use the lion’s share of the cash they received from Treasury to make loans. Surely they knew that this capital would be used to plug holes in severely over levered balance sheets and make good on some counterparty claims rather than make new loans in a stimulative fashion or renew revolving credit to creditworthy and current borrowers reliant on bank lines to run their businesses effectively.
Most of the $80B that AIG took went to counterparties like Goldman Sachs (GS), UBS and Merrill Lynch and statutory capital requirements that should have been met all along. And most of the rest of the TARP money has effectively gone to bail out bond investors which made bad investments in over levered financials. Recall that in most of these instances, even though equity holders can get slammed (and rightfully so), bondholders got taxpayer financed guarantees. Where are the anti-socialist free marketeers when you need them?
The reason banks haven’t loaned the TARP monies as expected is simple as I understand it: when you are way over levered and under provisioned and credit losses are surging, as your revenues are collapsing, you have to shrink your balance sheet asap or risk having the little tangible equity capital disappear as a result of additional charge offs. The problem with that is that shrinking your balance sheet is inconsistent with extending incremental credit. The math is in some ways simple and in other ways complicated. Simple because a bank levered 30 to 1 has little room for error before their capital is wiped out to an extent where solvency becomes an issue. But complicated due to a lack of transparency where assets had to be marked incorrectly, which distorted book values dramatically. Either way, the balance sheet got way too big, the assets way too risky and the transparency way too murky.
So the net of it is that most of our largest banks are in no position to lend more or take more risk, and the economic ramifications of what’s happened now make virtually all lending more risky. This should be clear as despite huge capital injections, banks struggle to meet regulatory capital requirements. And if meeting regulatory capital requirements are a priority, then how do you expect that capital to get translated into credit or investment that might mitigate the economic meltdown underway. So what to do now? More of the same? I don’t think so. We must do much better.
I understand that if the banks could shed some of the garbage assets they have on their books at above market prices then they would be in better shape to lend and I understand that given the lack of transparency and a most uncertain and dire economic outlook, that serious bids from the private sector are largely absent. So I understand the temptation to rationalize taxpayer financed welfare for the banking dregs amongst us, especially when you consider the audacity of these bank managements in the first place. This is not the best way to underwrite the costs of fixing our credit market problems, and it's not the best way to get liquidity to the many solvent companies that need it to maintain employment and consumption (by both consumers and businesses). We truly need more novel approaches, so I thought I’d mention a few that I’ve thought of.
Now I’m not as smart as Paulson, Bernanke and Geithner so forgive me if this sounds a bit crazy or technically unfeasible. Although I’m not an expert here, I do have a cursory understanding of how the business and the economy works so here goes. You can always do conservatorship coupled with direct lending (which as far as the goal of increased lending is concerned seems to be a better option than TARP as it's been administered to date). But I think present circumstances call for a more creative approach and probably more than one.
Why not have government employed securitization experts repackage some of the less than most toxic assets and couple them with a European style put option (written by the Treasury) which exercises a couple of years out. Or I guess it could be American style by application if necessary. Encouraging a longer term holder here would seem preferable so I think it makes sense to structure and incentivize accordingly. A sort of structured product priced to offer a chance to make a better than average return for a nominal but quantifiable risk and only make this available to banks that were responsible enough not to over leverage themselves in the first place. You could also incentivize and subsidize banks that put assets into such vehicles such that making new loans with their refunding was an attractive economic option.
Why not have the Treasury and/or Fed also subsidize restructuring and refinancing of mortgages such that the Treasury and the creditor share a principal reduction while the terms are extended a number of years AND a newly formed government agency funded by TARP money also subsidizes the mortgage rate for homeowners with cash flow sufficient to finance their primary residence if only the terms were better. Make it a needs based program with stiff penalties for fraud to prevent abuse. This would not only help lenders with more cash flow and less credit losses but also stabilize home values and residential mortgage backed securities valuations – which would buy extension lift the value of assets on bank balance sheet and their book values and thus not only lift capital ratios (which ultimately improve a bank’s lending capacity) but also make it easier and cheaper to raise additional capital from the private sector.
I thought this might be necessary a year ago and I’m shocked that it hasn’t been seriously considered. The reason it hasn’t is due to political ideology related to contract law. What’s crazy is you could have made this voluntary – some smart banks would do it and others would follow if/when it proved successful. The charges wouldn’t be as great because the Treasury or Fed would take half the hit so the bank’s book value, capital ratios etc. would be impacted substantially less, and the bank's liquidity position would be better than otherwise the case. Loan to value ratios would also improve so credit worth would improve. And the incentive to not walk away would thus also be strengthened. The irony is that by not doing something like this, the damage to creditors has been magnitudes worse as cash flow has disappeared and collateral values pummeled. It’s also ironic that the only way a bank would be otherwise worse off is if borrowers became healthier quickly and/or home values surged – both high class problems in comparison.
Another option I thought of was allowing substantial holders of U.S. Treasuries to swap Treasuries at bubble like valuations for bank asset pools with puts attached that would again limit losses in return for a chance of a reasonable return commensurate with the risk that would be realized if the buyer would have to exercise their put option. This too should not be structured in a risk free way but some risk would be necessary AND this risk could also be collared in a way that the Treasury would realize upside beyond some predetermined level in the event that the structured product performed exceptionally well. This would free up capital that banks could lend and transfer some re-priced risks to foreign central banks with stronger balance sheets.
All of these things can be done with more direct government lending. The direct government lending should be underwritten sensibly (such that the taxpayer cost is minimized yet borrower capacity to remain current maximized. And any such direct government lending could be done in a way that minimizes potential competitive damage to private sector lending by allowing banks to either participate in syndication or by subsidizing the loans to some degree so that the private sector can take down such loans at say a percentage point above where the government would do it, and that extra percent would be paid by the government. This would incentivize the private sector to lend more because they would get better than market terms. In instances that no private sector offers came to the market, the government would do the lending. Thus more lending would occur and it would get done on better terms with or without private sector participation.
Subsidies should not be permanent - they should remain in effect only for such time as necessary to restore the banking system. Congress could set up an agency to administer this for say a 2 year period and it could be renewed if necessary. And discretion should be paramount – although with increased lending the last thing we need is more “unintended consequences”. Underwriters should be compensated and incentivzed accordingly – with back end bonuses to the extent that they increase lending and the loans perform such that cost to taxpayers is minimized. One way or another we need to try to stabilize home values, support solvent businesses with credit and create jobs. Drastic times call for drastic measures; but the more creative the measures then less drastic they might be. We must do better than we’ve done thus far or we’ll face a depressed, lost decade.
Stock position: None.