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

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.

Comments

[charles hopfl:]

The American public would be more understanding to all these bail out plans if they were given something. Changing capital loss treatment to ordinary loss in 2009 would allow the average investor to offset his income against these losses in 2009. His cash flow would be improved. The investor had no say in the lack of oversight, the lack of transparency in hedge fund and private capital dealings especially with the use of leverage, the scams and fraudulent practices of many executives to enrich themselves through bonuses and fees, etc. and is now asked to pay for many years through additional taxes for these misdeeds. Its great to worry about saving the bankrupt, saving the defaulted homeowner, etc. What about the average person?

Feb 11 02:11 PM

[Dirk McCoy:]

Watching the bank CEOs today, it seems unanimous amongst them that:

A. They're going to repay the TARP funds, with 5% interest;
B. They're going to come out healthy with profitable operations;
C. They expect the world to continue to revolve.

The problem I have with some plans is they stop the world. OK, the world will keep spinning, but nationalizing THE BANKS says to everyone who would ever invest in a bank again that YOU'RE AN IDIOT. Because the Fed can jack up interest rates whenever they want, create an economic downdraft, throw you into insolvency, and you lose- everything. OK, investors maybe keep investing, but interest rates will be about what you get from the payday loan outfits or Guido and Johnny. And if you think we're going to put gigawatts of solar or millions of electric cars or expand much of anything with 20% interest rates, you're dreaming.

Instead of bankrupting the banks and cramming down principle for the sole purpose of proving Roubini and Brown and Schiff and Marx were all smarter than the vast majority of humankind who thought there was no problem with expanding credit, the internet, and new houses, why not do the obvious? Inflate. Home prices go up, China goods and oil go up, and confidence is resumed while Americans are forced to go to work again. It's clear that retirements will be postponed. Is it any worse for that retirement to be postponed a bit because a steak costs $10 instead of $5 than for it to be postponed for decades because people have lost 50-100% of their wealth (except for those parked in gold and cash who may not have done a single productive thing in twenty years except whine about risk)?

I won't claim to have a Black-Scholes-like model that tells me how much of which assets the Fed needs to buy to create inflation, but inflation they must create.

Feb 11 04:11 PM

[dlaw:]

"Price Discovery"???

How about we figure out what the heck these jokers are even trying to sell us first?

Feb 11 05:13 PM

[D. McHattie:]

Why do so many authors refer to nationalizing the banks as an all or nothing proposition?

Why can't we just 'take over' (not 'nationalize') those banks that do not meet a certain solvency threshold?

Yes, the government is not good at running banks. This is why we would melt the taken-over banks down and sell them for scrap.

If we had taken over the insolvent banks a year ago we would probably already be half-way through selling off their assets, thus achieving 'price discovery, writedowns and more'... without encumbering several generations of taxpayers with trillions in obligations.

Feb 11 08:03 PM

[who:]

Some points in your article...

...TG was the Fed Governor at NYC so he is in mix of things from the start - one month in the job excuse doesn't cut it.;
...Obama made the mistake of picking TG if he didn't understand the current problems or have a solution to propose at his job interview;
...markets were disappoint on what he DIDN'T say as oppose to what he said as the expectation were built up by his boss - urgency, action, otherwise, etc. instead we got more time is needed and some vague framework which was already known.

Feb 11 11:30 PM

[SanDiego2:]

It seems to me that we have two problems. We have a classic recession combined with a credit crisis. Recessions normally work themselves out, generally, when inventories are worked off. Don’t have any idea when that will happen, the sales/inventory ratio data is not good. The credit crisis is a whole different issue and will compound the problem of the recession especially when it comes time for industry to invest to rebuild inventories.

We all know that the financial sector’s bonus payments were excessive and definitely contributed to this credit debacle. We could also lay some blame on the Treasury because money was cheap for too long. We could blame some on the government for promoting a too liberal housing policy. We could blame Ayn Rand and all sorts of others. But, it doesn’t matter. The fact that we had some thieves in the house because someone left the door open doesn’t mean the house is no good and should be destroyed. We must stop the destructive thinking that we see quoted in this article. We’ve got get smarter to ensure the safety of our house in the future.

For example, a number of bankers are claiming that their current problem of low asset value is a direct result of a change in accounting rules. They now are required to use market prices versus cost. Market pricing seems to be logical until one asks how one prices some of the assets owned by the larger banks. A CLO that has thousands of mortgages and bits and pieces of other investment vehicles would be almost impossible to price let alone sell.

It doesn’t take a genius to realize that if we’re going to use market prices for our bank’s assets from now on, then our banks are probably going to go broke every time we have a recession. Is that something we want? If accounting is the problem, we better get the subject in the open.

As to bank graft, we need some basic rules on bonus payments, maybe something as simple as restricting future bonus payments to realized (not paper) profits. Maybe this is an issue that the shareholders have to resolve. Maybe it’s an IRS issue. I don’t know but we need to get it out in the open.

Feb 12 01:54 AM

[LT:]

You are 100% right. This is the Obama plan too if you listened to his first news conference on measuring success of the plan.
1. STOP the downward sprial first, (then INFLATE)
2. Reverse the 50-100% loss everyone suffered in their 401k or portfolio, What faster way to put money in the everyday workers pocket? and This time around most consumers WILL use that to pay down debt, this over time will automatically recapitalize banks further and also eliminate the CDO's, CDS, and MBS securities that caused this crisis in the first place. This does not cost the taxpayer trillions either.
3. My father is 90 y/o and was a successful small businessman. He always said that to prosper, inflation had to be higher than real interest rates at the bank. Deflation bankrupts the country(USA).
4. We have been brainwashed by the gov't and universities that all inflation is bad. It only hurts the rich and the crooked corporate world. If you do not agree with this, How do you like DEFLATION that we have experienced for 18 months? It almost bankrupted the world.

On Feb 11 04:11 PM Dirk McCoy wrote:

> Watching the bank CEOs today, it seems unanimous amongst them that:

>
>
> A. They're going to repay the TARP funds, with 5% interest;
> B. They're going to come out healthy with profitable operations;

>
> C. They expect the world to continue to revolve.
>
> The problem I have with some plans is they stop the world. OK, the
> world will keep spinning, but nationalizing THE BANKS says to everyone
> who would ever invest in a bank again that YOU'RE AN IDIOT. Because
> the Fed can jack up interest rates whenever they want, create an
> economic downdraft, throw you into insolvency, and you lose- everything.
> OK, investors maybe keep investing, but interest rates will be about
> what you get from the payday loan outfits or Guido and Johnny. And
> if you think we're going to put gigawatts of solar or millions of
> electric cars or expand much of anything with 20% interest rates,
> you're dreaming.
>
> Instead of bankrupting the banks and cramming down principle for
> the sole purpose of proving Roubini and Brown and Schiff and Marx
> were all smarter than the vast majority of humankind who thought
> there was no problem with expanding credit, the internet, and new
> houses, why not do the obvious? Inflate. Home prices go up, China
> goods and oil go up, and confidence is resumed while Americans are
> forced to go to work again. It's clear that retirements will be
> postponed. Is it any worse for that retirement to be postponed a
> bit because a steak costs $10 instead of $5 than for it to be postponed
> for decades because people have lost 50-100% of their wealth (except
> for those parked in gold and cash who may not have done a single
> productive thing in twenty years except whine about risk)?
>
> I won't claim to have a Black-Scholes-like model that tells me how
> much of which assets the Fed needs to buy to create inflation, but
> inflation they must create.

Feb 12 06:25 AM

[John Lounsbury:]

Listening to the bank CEO testimony before Congress yesterday, they all seem to believe they have good prospects and need limited additional direct government help. Are they simply holding weak cards and making poker players' bluffs?

Let's take these testimonies at face value. What then should be done with the next $350 Billion in TARP money?

Let me throw out a wild idea for discussion. Take $200 Billion of the TARP II and provide investment capital to establish 10 new national commercial banks. This is $20 Billion per bank. The management structure for each bank should be recruited from the private sector and each should have its own individual board of directors, with one government representative on each board. These banks would be unencumbered with legacy assets and liabilities. This would give them much more flexibility than the existing banks in how they deal in the credit markets. This would distribute the banking sector risk across a larger group of banks and make future regulation against monopolistic concentration of banking power more tenable. Getting rid of "too big to fail" banking structures would be easier in the future.

In the next few years, these new banks would be taken public with IPO's, the proceeds repaying the initial capitalization and providing some combination of capital gains for the taxpayer (at a prespecified maximum government return, say 15% per annum) and additional capital for the banks (above the government's capital gains).

Okay readers, what's wrong with this idea (besides being off-the-wall)?

Feb 12 01:08 PM

[john s. gordon:]

hopflcd - you are correct about the fraudulent practices of many executives in the financial industry about self-enrichment through bonuses & fees. it is the job of the directors to prevent such practices, but too many ceo's have the directors in their pocket. whatever happened to the move toward independent directors?
> jack

Feb 12 02:24 PM