What the Treasury Plan Needs: Price Discovery, Writedowns and More

Includes: BAC, BK, C, GS, JPM, MS, WFC
by: Jeffrey Frankel

Some observations on the plan announced by Treasury Secretary Tim Geithner yesterday…

Clearly we need to hear more details. I sympathize with Geithner, who has only been in office a couple of weeks. He has had to take over in the middle of a massive and unprecedented crisis in motion, at the same time that he must personally fill out the reams of forms that it takes to get confirmed by the Senate –as all new appointees to such positions – and to fill lots of positions with good people throughout the upper levels of the Treasury. But the American public will demand further elaboration on his plan soon.

For now, one must guess what is going to be the precise shape of the new Private Public Investment Fund (PPIF). I would bet that the plan will do a better job of preventing taxpayers from being fleeced by bankers than did the preceding incarnations of TARP or than would some of the alternate proposals that are out there. In this regard, the caps on executive pay for those banks taking advantage of government money will draw the most attention. But even more important is that, whereas the original TARP paid the banks more for their damaged assets than the market was willing to pay, I hope and expect that the PPIF will have mechanisms to guard against paying more than these assets are worth.

The valuation will come from other private investors who put their own money on the line to buy these assets at discount, in the open, not from some Treasury official making some impossibly wild guess as to the assets’ value. But we still don’t know, for example, whether the form of Treasury assistance will be a commitment to help cover any future losses if these assets were to decline further in value relative to what the investors pay for them (”insurance guarantees”) or some other form of joint participation with private investors (”coinvestment)”. Something is needed to get private equity and distressed-debt specialists to get in the game now.

Much is made of the sharp negative reaction of the stock market, as on Inauguration Day. Clearly markets were disappointed in what Geithner had to say. But I haven’t seen anyone point out an implication of the fact that the losses have been heavily concentrated among prices of banks and other finance stocks: This need not necessarily be an entirely negative signal on the Administration’s plan. What is in the interest of bank shareholders is definitely not the same as what is in the interest of the rest of us. Bank shareholders are still hoping that, with government budgetary outlays, they will recoup much of the value of their shares. But the rest of us are, loosely speaking, hoping for the opposite – at least in the case of banks where the big losses can be attributed to bad mistakes on their part. To my way of thinking, it is actually a good sign if what is making shareholders unhappy is the Geithner plan’s measures to prevent banks that ask for government money from then paying dividends or acquiring other banks (unless asked to do so), until they have repaid the government.

The goal of any Treasury plan should be, and I believe is currently, to recognize (write down) the losses of the banks and near-banks, putting these losses in the past so that the banks can resume lending, and to do it without incurring further huge costs for taxpayers beyond what is absolutely necessary to get the economy going again (taxpayer protection). Knowing how to price unpriceable bank assets (price discovery) has been the big stumbling block. We don’t want to repeat the original Paulson plan of paying more for these assets than they were worth.

Increasingly, observers like Nouriel Roubini are saying that the best way to accomplish these goals is simply to nationalize the banks, wiping out the shareholders’ equity, and then re-privatizing them in the near future. This is the famous Swedish model. But Secretary Geithner points out that government officials are not good at running banks. Furthermore, given the huge national debt that was (needlessly) run up by the previous team and the huge additional budget deficit that we will run this year due to the recession, the Treasury is constrained in how much money it can lay out in its financial repair plan. Finally, everyone recognizes that most Americans are allergic to the idea of nationalization. (At a minimum, a euphemism is needed. I suggest the simple label “bankruptcy” to make clear to the public that the bank shareholders and managers are not being bailed out.)

Coinvestment then. Or insurance guarantees. In any case let’s hope Geithner and team come up with their more complete answer soon.