The Geithner / Obama Plan Will Fail

The title of this post is fairly provocative and categorical. This is by design. For I see Obama's banking plan as more of the same -- not 'change we can believe in.' And we all need to be clear about the need for Obama and his team to correct their course of action. Whilst there may be plenty of other reasons to support the President, this is not one of them.

Now, late last year, I predicted that the Obama Administration would not change course significantly on the economic policy front. This was largely due to the make up of his proposed cabinet and their previously stated positions on economic policy. Frankly, they are subject to cognitive regulatory capture and beholden to the same special interests in the financial sector that the Bush Administration were.

Rather than repeat myself, I would like to use today's commentary from Christopher Wood of CLSA to demonstrate my point. Wood is a well-regarded investment strategist based in Asia who in the early 1990s wrote the book, "The Bubble Economy" about Japan's own tussle with debt deflation and deleveraging. He now writes a newsletter for CLSA appropriately called GREED & fear. Clearly he knows a thing or two about banking crises. I have highlighted the most interesting bits.

US Treasury Secretary Tim Geithner failed to deliver any hard details on what the Obama administration plans to do about the banking system. This is shocking to GREED & fear because it is such an obvious public relations disaster. If the Obama administration has not yet figured out the best way forward on the banks, it would have been better to have said nothing at all rather than disappoint expectations so much. But beyond the public relations issue, it is also shocking that after so many weeks to think about what should be the key issue for the new Democratic administration, the Obama team has clearly not yet figured out the best way forward. Remember there was an eleven-week interlude between the election and the inauguration. What were they all doing?

The result is that the American policy making establishment is now looking ever more Japanese in its continuing failure to face up to the painful consequences of what is a massive systemic crisis. This is clear from the continuing talk about, and evident desire to resort to, politically convenient "backstops" and "guarantees". This is also clear from what seems the latest ruse to attempt to jump start securitisation with a massively expanded Term Asset-Backed Securities Loan Facility (TALF). That is to provide sweetheart non-recourse financing to hedge funds and the like to buy asset-backed securities. In GREED & fear's view this effort to get the game going again is doomed to fail. But it is also a shocking misuse of taxpayers' funding. Yet, unbelievably, the case for recognising reality and "nationalising" the worst banks is still deemed as way too "radical".

In a nutshell, Geithner is unwilling to nationalize any banks, preferring to roll the dice on a scheme whereby the Fed and the Treasury buy up toxic assets in order to provide liquidity to the market for those assets. The theory here is that these assets have fallen in value by much more than is necessary. If the market for the assets has more liquidity, these assets would rise in price and the problem of poor bank capitalization would be solved.

But, is that really true? What if many of those assets have a lower real valuation than is presently used on banks' books? What if the government is creating a market in something that is still overpriced? Remember, we still have a shed load of commercial real estate loan, credit card loan and auto loan losses to writedown. Add in the leveraged loan, student loan, and prime mortgage loan writedowns and you have a problem. Under that scenario, FAS 157 -- otherwise known as mark-to-market -- comes into play in a negative way. And that would mean everyone needs to mark those assets down, not up.

Now, I am not saying that the 'toxic' securities have further to fall at all. The fact is no one knows how much some of these derivative instruments are really worth (in part because the economy has yet to bottom and the scale of credit losses is not yet known). However, while making a market in illiquid markets is a commendable thing, I fear Geithner is playing a very risky game. Moreover, this is the exact same plan that Henry Paulson presented us originally under the TARP (Troubled Asset Relief Program). We have seen this all before.

Let's get back to Woods' comments for a second because he makes a few notable additional comments about the politics of this. Again, I have highlighted the appropriate areas.

The result is that GREED & fear's fears about the dysfunctional nature of Obama's economics team look at this juncture ever more justified. Hopefully, the US stock market's bearish response to Geithner's ill-fated press conference this week will prove a wake up call for a president whose political honeymoon is already over. But for now this looks like a continuing misguided effort to create an economic policy via committee consensus when what is needed is firm leadership from the top.GREED & fear is also beginning to wonder if the new president understands conceptually what is at stake with the banking system. It is natural that he wants to leave the technicalities to the experts. But there is a need here for the president to govern and that means taking responsibility for the most important policy decision. That is not the fiscal stimulus or what to do about the housing market. This is why mundane waffle about the merits of the mostly pork barrel fiscal stimulus is not sufficient. It also does not inspire confidence that Obama delegated the drafting of the fiscal stimulus to House of Representative Democrats.

The other interesting and also troubling development is the news reports over the past week that Paul Volcker, chairman of the President's Economic Recovery Advisory Board, is upset that he is being sidelined by the Director of the National Economic Council, Larry Summers, in the formation of economic policy. One point would seem clear. That is that GREED & fear finds it hard to imagine that policies based on backstops, guarantees and non-recourse loans to hedge funds and the like would find the wholehearted endorsement of the former Fed chairman.Volcker surely understands what need to be done. That is to get rid of the zombie banks, whatever the cost to bank shareholders and bank bondholders. For this is a problem of solvency, not liquidity......

GREED & fear would also say that offering private investors non-recourse taxpayer-financed financing to buy asset-backed securities is also not in keeping with the times. And indeed it is likely to prompt a hostile response from Joe Sixpack. In this respect nationalisation of the bust banks and separation of good assets from bad assets is the only honest way forward, politically, for dealing with the current escalating mess in the American financial system. In this respect GREED & fear is of the view that ordinary Americans want to be told the truth and are fed up with gimmicky solutions involving adding debt on debt. It is also the case that the Obama administration risks a populist backlash on any policy based on bailing out banks. This is why it is even more amazing that Obama does not understand the political appeal of the nationalisation option.

I would agree whole-heartedly with the thrust of this argument. President Obama has a limited window of opportunity here. He will need to decide the correct path and delegate appropriately. Sidelining Paul Volcker for Larry Summers does not leave one with a good tingly feeling. Bailing out banks when populist sentiment is rising shows a tin ear to the shift in national sentiment. On the whole, I am very worried that Obama does not see the poor optics of all of this. Politically, this is not a good plan.

When Obama spoke to Terry Moran of ABC News about all of this recently, he suggested that his plan is actually crafted because -- despite rising populist sentiment -- Americans will not tolerate nationalization. The exchange went as follows.

MORAN: There are a lot of economists who look at these banks and they say all that garbage that's in them renders them essentially insolvent. Why not just nationalize the banks?

OBAMA: Well, you know, it's interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what's called "The Lost Decade." They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn't see any growth whatsoever.

Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you'd think looking at it, Sweden looks like a good model. Here's the problem; Sweden had like five banks. [LAUGHS] We've got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would -- our assessment was that it wouldn't make sense. And we also have different traditions in this country.

Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America's different. And we want to retain a strong sense of that private capital fulfilling the core -- core investment needs of this country.

And so, what we've tried to do is to apply some of the tough love that's going to be necessary, but do it in a way that's also recognizing we've got big private capital markets and ultimately that's going to be the key to getting credit flowing again.

I suggest that Obama try yet more 'tough love' because this plan is not going to cut it.

Sources
Fiasco - Christopher Wood, CLSA
Obama: No 'Easy Out' for Wall Street - ABC News
No Tough Love for Bankers - Robert Scheer, The Nation

Comments

[CautiousInv...:]

I think you are right about Volker; Larry Summers is jealous about turf and does not want anyone to crowd his space.

And while I am not wild about TALF, at least the Feds hold securitized collateral for a period of one year. This aspect of the program is designed to support credit card, student and auto loans.

More troubling is agonizing lack of detail with regard to stress tests, write-downs and liquidity injections. We know these things will happen but we do not know when, what standards will be used or whether some banks will be allowed to fail.

The fate of shareholders and bond holders is equally unclear.

Feb 13 08:09 AM

[Ferdinand E...:]

"Sidelining Paul Volker for Larry Summers does not leave one with a good tingly feeling". Funny, but it leaves me with one. Volker is smart but Summers is brilliant, and brilliance is what is needed now. Of course, as Napoleon once said: "I know that he's brilliant, but is he lucky."

Feb 13 09:01 AM

[Tim Miles:]

So your solution is for the USG to let the zombie banks fail and to nationalize the rest? What other ideas do you have? Tough love is an easy thing to recommend, but hard to do when there are so many lives at stake. There are also those out in the ozone who are paranoid about the "nanny" state. How do you deal with them?

Please don't think I am being flippant. I have checked out your credentials and respect them. I would just like all of the critics to offer some positive and practical solutions.

Feb 13 10:20 AM

[Asbytec:]

So, is the author saying a shift toward Keynesian spending is not a significant change? Is the author saying the broader stimulus/spending bill being passed is no different that the weak Bush administration efforts, namely to give our tax dollars to zombies and Bush's inept excuse for a stimulus package?

I think Obama is right on track, getting something - anything - passed despite it's flaws, and has done more in one month in office than Bush did all last year. That's significant. He's trying to get money flowing and soon. Bush was pushing a string. Money in the hands of the consumer should tug on that string, provided the log jam of toxic debt doesn't snag it...which it probably will.

It is a banking crisis, let the Fed take care of it or die trying. No more tax dollars to fund huge parties, executive jets, golden parachutes, and pay off lost bets. There is not much Obama can do other than push TARP 2 with accountability and hope the patient come out of a coma. (Personally, I hope it dies...and new, more solvent banks will - should - rise to the occasion. But, that's another story.)

Feb 13 10:41 AM

[Tim Miles:]

I just worry about the human carnage. How many watched CNBC's program "House of Cards" last night? I have bought three homes in my lifetime and always had difficulty figuring out what I was going to face when I closed on them, not to mention the fine print below my signature on the loan documents.

Feb 13 10:52 AM

[Edward Harr...:]

Tim,

Thanks for the question. My solution might be something similar to the RTC that was used for the S&L crisis. I have also recommended using the Swedish solution as a model. This is something I recommended 6 months ago, but it has not been done for ideological reasons.

What is most important is to create banking entities which have sufficient capital, no overhang of bad debt and credit unworthiness, and willingness to lend. Geithner is attempting to do this by, amongst other things, buying up illiquid assets and using a public/private partnership to inject private monies into things. The underlying premise he makes in so doing is that these banks (the larger banks) are mostly still solvent if assets traded at levels consistent with their underlying value.

I believe this premise is false as do many others who have studied debt deflation and banking crisis episodes. At a minimum, the risk is high that the U.S. banking system is in aggregate bankrupt i.e. future losses of loans already made exceed capital by a large margin. We are talking about CRE, Construction, Credit Card, Leveraged, Prime Mortgage, Alt-A and other loans that have yet to sour. I am also talking about high yield bonds and asset backed securities which must be marked to market according to FAS 157. Certainly, a few of the major banks are effectively insolvent and should not be propped up.

In my view, Geithner is 'beholden' to the financial services industry because his world view sees a maintenance of the existing financial structure as desirable, even at the risk of his plan failing. This is not a risk worth taking.

Nouriel Roubini has a better plan:

www.washingtonpost.com...

That plan incorporates many of Geithner's elements and also protects against the downside risk of bank insolvency. Her are the critical elements:

"First, and this is by far the toughest step, determine which banks are insolvent. Geithner's stress test would be helpful here. The government should start with the big banks that have outside debt, and it must determine which are solvent and which aren't in one fell swoop to avoid panic. Otherwise, bringing down one big bank will start an immediate run on the equity and long-term debt of the others. It will be a rough ride, but the regulators must stay strong.

Second, immediately nationalize insolvent institutions. The equity-holders will be wiped out, and long-term debt-holders will have claims only after the depositors and other short-term creditors are paid off.

Third, once an institution is taken over, separate its assets into good and bad ones. The bad assets would be valued at current (albeit depressed) values. Again, as in Geithner's plan, private capital could purchase a fraction of those bad assets. As for the good assets, they would go private again, either through an IPO or a sale to a strategic buyer.

The proceeds from both these bad and good assets would first go to depositors and then to debt-holders, with some possible sharing with the government to cover administrative costs. If the depositors are paid off in full, then the government actually breaks even.


Fourth, merge all the remaining bad assets into one enterprise. The assets could be held to maturity or eventually sold off with the gains and risks accruing to the taxpayers. "

This is a very thoughtful plan and is one Geithner himself may take onboard in due course. In the meantime, I expect more stress n the banking system and hope it doesn't lead to another crisis like the one we had last September.

Edward


On Feb 13 10:20 AM Tim Miles wrote:

> So your solution is for the USG to let the zombie banks fail and
> to nationalize the rest? What other ideas do you have? Tough love
> is an easy thing to recommend, but hard to do when there are so many
> lives at stake. There are also those out in the ozone who are paranoid
> about the "nanny" state. How do you deal with them?
>
> Please don't think I am being flippant. I have checked out your
> credentials and respect them. I would just like all of the critics
> to offer some positive and practical solutions.
>

Feb 13 11:01 AM

[Tim Miles:]

Thanks, Edward. I think you have stimulated an intelligent and useful discussion. I hope the Obama team reads what you and others have to say.

Feb 13 11:08 AM

[Tim Miles:]

By the way, are you talking to anyone on Obama's staff or on the Hill, such as Majority Whip Hoyer?

Feb 13 11:11 AM

[Stock Marke...:]

One big problem with the "nationalization" idea is that the idea of "lets just wipe out the equity and bondholders" is a disaster. Do you know how many OTHER banks and pension funds own the preferreds and bonds of these banks we want to wipe out? It is a huge number, and think of the retiree's that hold, knowingly or unknowling, bank bonds (since the are secure over the last 50 years) and use the preferreds and bonds as income. What would happen to pension fund liability if we "wiped" out 10 or so banks' equity and bonds. WOW!

I am not a Tim G fan, and as you can see in my article on Seeking Alpha, it is bordering on Brewsters Millions at this point, but to "wipe out" equity holders means to wipe out retirees, pension funds, and income investors. If we were talking about talking out some risky biotech firms or some risky tech companies, "oh well, that is a change you take for a big return", but banks are another story.

Feb 13 12:14 PM

[freddie:]

Since nationalization is the only way out of this, could the "stress test" be a political ploy for nationalization down the line? I think the "stress test" is the key element. Without it, billions would be hurled into the black hole. The Obama regime could announce that private capital would not sufficiently step into the risky assets despite guarantees, which is probably what will happen, and that the stress test revealed that nationalization was forced on the government. Once in control, the govt can choose which assests, it will guarantee, eg pension fund investements, which would answer some of the concerns voiced by StockMarketSage.

Feb 13 02:03 PM

[3 degrees o...:]

I'm do not understand why Americans would not tolerate "nationalization"? Seems to me that throwing tax dollars at potentially insolvent banks and buying toxic assets of questionable worth is the more intolerable choice for taxpayers. Nationalization would wipe out the shareholders and hopefully a good chunk of the bondholders as well before the taxpayer has to pony up. Just my 2 cents worth.

Feb 13 04:41 PM

[NITRAM:]

The man in the white house ( I call him used car saklesman) has picked the weakest and most notorious staff ever. Emanuell uses everyon else to do his dirty work. Therefore, he is clean. He and the car salesman make a great team. Tweedle dee and tweedle dumb( you pick who's who).Larry Summers against Paul Volcker. Thats like picking Dr. No against James Bond.

To 3 Degrees of separation and Freddie:
You are a moron. You obviously dont know what nationalization means.
why dont you ask the people of Veneszuella? Or cubs, or the people in Darfor(if any are still alive)

Feb 13 04:58 PM

[Leftfield:]

The word "dodgy" comes to my mind when I hear "stress test." The suits who have degrees and incredibly privileged positions in our society have continually failed us to this point. The administrations latest stuff is all more of the same.

The failures to live up to previous standards are supposed to be swallowed by offering up new words and taxpayer liabilities. The suits who run pension funds, corporations, mutual funds, banks, government agencies etc. etc. want to be made as whole as possible or at least have more time to abandon the sinking ship, courtesy of the taxpayer. The damage is so deep, pain is unavoidable. Those most responsible should bear as much as possible.

And speaking of Obama's tin ear: It should send a shiver up our backs to see such a well-run corporation as Toyata cutting bait in this country to the extent it now proposes. Japanese execs are routinely riding subways and taking large hits in compensation although that was already dwarfed by American compensation.

A Chinese minister was executed for the lead paint in toys not too long ago. The world must be retching at our travails and responses to it. The contempt our politicians show them is dangerous and counter to the enlightenment Democrats always claim to bring. Washington thinks its Potemkin Village fixes will save its and its rich clients priveleges and wealth and fool the world. A lifetime of self-employment is more than enough to instruct me that their response fails to face reality in ways this article well explains.

Our elites think mainly of retaining all privilege and gains. This isn't the free market they tout, but pure crony capitalism. Misallocation is everywhere and retaining present structures (including huge, utterly wasteful government--it can be structured to actually HELP) will send us down the drain we're circling now.

Feb 13 05:12 PM

[zanardm:]

Debt of Cards

The more debt the gov runs up, the higher yields rise, and hence interest rates. Therefore this further shuts down the housing market. Why not get debt down, yields down, and hence interest rates down for houses, cars, and consumers in general? Thus the quickest way for the economic tide to rise for all of us? Is this too simple a plan to advance and execute?

Feb 13 11:42 PM

[Asbytec:]

Ok, for those who don't like the Obama solution, tell me what was so great about the conservative one, er, or lack thereof...

Someone has to do something, and Obama has taken the lead. He may or may not have the recipe for Key Lime Pie, but he's acting. Bush sat on his a$$...and the conservatives are fighting Obama every step of the way.

This is a team effort, fellas...get busy living or get busy dying. Those are our choices, for those of us who understand this mess.

Good bank, bad bank...Fed QE...deficit spending....whatever. Do something. God knows the private sector is strapped. And wall street had a party...on our money. Screw the oligarchs and wanna be's...this is middle America at stake here.

Feb 14 10:03 AM

[vaughn:]

Fear, Uncertainty and Doubt (FUD) was explored to the extreme by vultures and shorts.

The worst case scenario for housing market is that 50% foreclosure rate with 50% recovery rate. The 50% recovery rate is well established if one just look into the auction result from auction house in the states like California, Arizona or Nevada. So, the worst case scenario will produce a 25% loss in housing. But one must also note that such loss will not happen all at one, rather such loss will happen during the full cycle of the housing, that is from 2005 to 2012, or 8 years. The current market price of senior cds-abs indicates a loss of 70% which is obviously not going to happen over the cycle of this housing market.

The banks are now earning a huge spread of 5%-18% thanks to zero rate fund rate and almost zero deposit interest. One might argue that credit loss for consumer loan is increasing which will hurt banks. But given the fact that the savings rate has jumped to 3.6% and is expected to go higher in 2009, the consumer revolving credit loan will soon start coming down big time which means the charge off for consumer loans will soon peak.

Vultures and shorts time had passed. Now, the risk/reward profile is working against vultures and shorts, soon market will realize that the total loss for the housing market will not exceed 25% during this cycle of housing (8 years), not 70% loss currently explored by shorts and vultures.

Feb 15 04:26 PM

[misolarman:]

Of course it won't change. Barney Frank and Chris Dodd are both still in charge of their respective Banking Committees. THESE were the people in charge!!! Even though both have been guilty of blatant conflicts of interest (B. Frank - Homosexual relationship with a high ranking official at an institution he was overseeing, C. Dodd for receiving financial gifts AKA free mortgage that doesn't need to be repaid) that if perpetrated in the private sector would have got them both fired. Barney Frank one year ago, was blasting the republicans stating Fannie Mae and Freddie Mac are FINACIALLY SOUND. But the media has been on a fifteenth century style witch hunt. Both then and now, the wrong people were the targets. This is why journalism is dead in this country.

Feb 16 05:00 PM

[misolarman:]

What can one say about this persons response?? You cannot teach a pig to sing so I won't even try.


On Feb 13 10:41 AM Asbytec wrote:

> So, is the author saying a shift toward Keynesian spending is not
> a significant change? Is the author saying the broader stimulus/spending
> bill being passed is no different that the weak Bush administration
> efforts, namely to give our tax dollars to zombies and Bush's inept
> excuse for a stimulus package?
>
> I think Obama is right on track, getting something - anything - passed
> despite it's flaws, and has done more in one month in office than
> Bush did all last year. That's significant. He's trying to get money
> flowing and soon. Bush was pushing a string. Money in the hands of
> the consumer should tug on that string, provided the log jam of toxic
> debt doesn't snag it...which it probably will.
>
> It is a banking crisis, let the Fed take care of it or die trying.
> No more tax dollars to fund huge parties, executive jets, golden
> parachutes, and pay off lost bets. There is not much Obama can do
> other than push TARP 2 with accountability and hope the patient come
> out of a coma. (Personally, I hope it dies...and new, more solvent
> banks will - should - rise to the occasion. But, that's another story.)

Feb 16 05:03 PM