Geithner's Plan May Not Be So Bad

I really disliked Tim Geithner's 'stress test'. Taking over companies that could be insolvent in the future is a horrible precedent, setting a vague standard for solvency, because if you are insolvent in the future under the government's opinion, you are insolvent today. Thus, insolvency is not the exit criteria, rather one has to plan for future 'future' insolvency as defined by the government. This is a political football, meaning, it's all lobbying and appeasing regulators to maintain market power and beat down new entrants. I noted in his WSJ editorial, Geithner mentioned that people will be more confident in banks after having passed this vetting process, and that may have been the motivation, but passing a politically infused stress test is not reassuring.

On the other hand, his new plan is to basically match/fund private investors in buying distressed securities, with over $500B set aside. This mitigates poor incentives, because they are not providing the first loss or senior piece, just sharing parri-passu. They are not giving purchasers leverage, even. An investor who thinks it is a bad risk-return investment will not be incented to invest, because this government involvement does not change the payoff space. This is just adding liquidity, and is not a subsidy, because the expected value of this is zero if we assume market prices are expected values of future payoffs. The cost is actually negative if we think the markets are in a panic, but costs are quite high if we think this is the mid point in a massive financial cataclysm.

Thus, Krugman thinks this is a huge subsidy because he thinks market prices are way too high for CMBS and RMBS securities, though I think this is really because he believes anything that would justify greater government control of economic activity. He has presented absolutely zero data on the prices and corresponding historical loss curves for the various vintage-product types (eg, Alt-A mortgages, 2006, average current price and losses). He doesn't have the data, he wouldn't know how to set it up. It's the kind of detail he is ignorant about but does not think is important. Details matter. Subprime, Alt-A, conforming, vintage, seasoning all matter. AAA 2007 subprime tranches trades at around 25% via the Markit ABX index. Is that really reasonable? What are the losses on the collateral? He just wants to take over the banks asap because asymmetries and imperfect information prove markets are inefficient (heh).

I found 94 subprime mortgage tranches, and some referred to the same underlying mortgage pool. You can find these by going to the Markit ABX index page, looking at the constituents, and see they refer to 20 tranches that vary by seniority for the various grades (eg, CWALT 2007-21CB M Mtge, BSABS 2007-AQ1 A1). Anyway, the average cumulative 90+ delinquency is about 25%. That's pretty high historically, but after seasoning 21 months, this means a conservative estimate of total 90+ delinquency is going to be around 50%, and losses on those delinquencies no more than 50% (housing prices did not fall more than 50% in most places, on average). That's for all of subprime in 2007. The market price for AAA rated assets (better than average) is a mere 25 cents on the dollar, suggesting the average subprime mortgage is priced below that, say 10 cents on the dollar. This is way too low.

I suspect most banks will be unwilling to sell off assets at market prices, because the market prices are so low. In that case the plan 'fails', but it would also then cost us nothing, and in the meantime not screw anything up (in contrast to the stress test).

Comments

[hmorgan:]

Thanks for a good post. I agree, that Krugman seems too bias and rigid ideaologically to be taken seriously here. There is no doubt the man is bright academically, but I'm unconvinced of his street credentials in this matter. The PPIF looks sound to me, but I have yet to talk one on one with folks in that space.

Mar 23 02:25 PM

[Gtarras:]

"He has presented absolutely zero data on the prices and corresponding historical loss curves for the various vintage-product types (eg, Alt-A mortgages, 2006, average current price and losses). He doesn't have the data, he wouldn't know how to set it up. It's the kind of detail he is ignorant about but does not think is important. Details matter. Subprime, Alt-A, conforming, vintage, seasoning all matter."

Bingo!!! As a analyst on all this stuff for over a decade, I am in total agreement with you here. Roubini, Krugman et al, are smart folks but they are 1) biased, 2) have never been in the "tranches", ie observe the war from a distance, 3) use econ vs market models. Let them. Still too early to tell if it works, but if it does, I'd like to see them on John Stewart's show. Or, at least admit, they were wrong. Which, of course, wont happen.

Mar 23 03:28 PM

[Harry Tuttle:]

If you think the prices are too low, why not buy some? If most people with "10 years of experience" feel the same, then maybe we do not have a problem at all.

Society is ready to accept taxation for the public good and, Wall Street's (now true?) protestations to the contrary, it is FAR from clear that this is for the public good.

Geithner seems convinced that there is money on this because that is what he hears from the bankers. Just like Greenspan was convinced that bubbles did not exist, Bernanke was convinced that American banks were well capitalized, and Summers was convinced that CDS' should be "self" regulated.

These people are dangerous.

Mar 23 03:56 PM

[Gtarras:]

"We think its going to be a very successful program and it will be good for our investors," said Curtis Arledge, co-head of U.S. fixed income at BlackRock. He added that he believes the plan will have attractive returns for investors because many of the assets are currently being valued at well below their intrinsic value.

On Mar 23 03:56 PM Harry Tuttle wrote:

> If you think the prices are too low, why not buy some? If most people
> with "10 years of experience" feel the same, then maybe we do not
> have a problem at all.
>
> Society is ready to accept taxation for the public good and, Wall
> Street's (now true?) protestations to the contrary, it is FAR from
> clear that this is for the public good.
>
> Geithner seems convinced that there is money on this because that
> is what he hears from the bankers. Just like Greenspan was convinced
> that bubbles did not exist, Bernanke was convinced that American
> banks were well capitalized, and Summers was convinced that CDS'
> should be "self" regulated.
>
> These people are dangerous.

Mar 23 04:08 PM

[freeeee:]

What's the incentive to not use the program to prop up your existing positions? This is akin to asking the bank to lend you more money so you can keep propping up positions you have.

Mar 23 04:14 PM

[VP of Commo...:]

First off, many many people would like to buy these assets at $0.25 on the dollar, but no one is selling.

Second, what happens after a specific loan defaults? It can't simply go to zero. Someone takes possesion of that property, liquidates it, and then that money, which is likely 60-80% of the orginal loan value, must go back to the security holder, after fees of course.

This why I am convinced that only C tranches and below (is there a below?) can go to zero unless housing prices fall more than 50% AND there is a near 100% default rate.

Mar 23 05:02 PM

[mr. burns:]

why cant a bank put an "asset" up for auction under TALF and if the bid isnt high enough place a bid on the asset itself , offering a price high enough to be to the banks liking. Since the bank will be buying the asset from itself it doesn't cost the bank anything , instead the bank gets to immediately monetize 85% of the fictitious price of the "asset" , while transferring the risk for that 85% to the taxpayer.

Is this possible ?

Mar 23 05:28 PM

[Socialism c...:]

The problem with this plan is it assumes the existence of the plan will provide causality for a rebound of the value of these assets...a boot-strapping effect, if you will. These asset values have much farther to fall, IMO, and cannot be reinflated -- that is the inherent nature of a bubble. In essence, this will be money flushed down the toilet...we will be losing by a multiplier effect here...the benefactors of further government leveraging with tax dollars. Bad news. VERY bad news. The markets ought to be way down on this plan. And I think in a day or two, they will be...once people have had a chance to step back, get off the market momentum bandwagon, and realize what this plan really means!!

Mar 23 06:50 PM

[j_remington:]

"I suspect most banks will be unwilling to sell off assets at market prices, because the market prices are so low. "

Banks like this plan because they can delay further dilution or nationalization.

Does this solve the economic crisis? NO

Markets will hit decline again soon. And new quarterly financials in April will indicate nothing has improved.

Mar 23 08:31 PM

[Trillion wi...:]

The question is going to be how toxic are your assets in your opinion.

How long until Obama in the boys start deciding which of a bank assets are toxic and which are not.

The question is though where do you go from here?

Can't invest in US based stocks because this scheme is doomed to fail and large corporations will have no capital to grow, can't invest in bonds because not only is the government printing money at a break neck pace but soon will begin to buy its own bonds.

Do you invest in the vast socialist empire that is the EU or should I just cash out, buy gold and dig a hole in my back yard?

Mar 23 09:12 PM

[einniv:]

No one has called off the stress tests. That you seem to think someone did undermines your credibility. For me it takes it to about zero since it says to me that you don't really know what is going on.

You also somehow seem to have missed out on the fact that the government has always set capital requirement levels for banks. It is not anything new. The idea that we should be providing program after program and even capital to banks without even bothering to look at what shape their books are actually in is... well, I can't even think of a good word for how stupid that is.

For the record those banks that eventually reach levels where they are forced to raise capital will be required to participate in these auctions. This new piece was always part of the larger plan and is not something new or a replacement of what Geithner said before. It was just that they didn't have the details worked out completely yet. I guess it got drowned out by the noise from fools who thought he should announce something anything immediately without thought or planning... like by not even bothering to look at the bank's books for instance!

Ha! What a joke.

Mar 23 10:31 PM

[einniv:]

Below is the text of Geithner's press conference from back in February. I would love to hear what part of what the administration is doing now is different from this outline he laid out back then. I'm sorry if my comments seem a bit harsh but it really ticks me off to have people saying how they hated the old plan but like the new one when they apparently never had any idea what the original plan was in the first place!

=======================
First, we're going to require banking institutions to go through a carefully designed comprehensive stress test, to use the medical term. We want their balance sheets cleaner, and stronger. And we are going to help this process by providing a new program of capital support for those institutions which need it.

To do this, we are going to bring together the government agencies with authority over our nation's major banks and initiate a more consistent, realistic, and forward looking assessment about the risk on balance sheets, and we're going to introduce new measures to improve disclosure.

Those institutions that need additional capital will be able to access a new funding mechanism that uses funds from the Treasury as a bridge to private capital. The capital will come with conditions to help ensure that every dollar of assistance is used to generate a level of lending greater than what would have been possible in the absence of government support. And this assistance will come with terms that should encourage the institutions to replace public assistance with private capital as soon as that is possible.

The Treasury's investments in these institutions will be placed in a new Financial Stability Trust.

Second, alongside this new Financial Stability Trust, together with the Fed, the FDIC, and the private sector, we will establish a Public-Private Investment Fund. This program will provide government capital and government financing to help leverage private capital to help get private markets working again. This fund will be targeted to the legacy loans and assets that are now burdening many financial institutions.

By providing the financing the private markets cannot now provide, this will help start a market for the real estate related assets that are at the center of this crisis. Our objective is to use private capital and private asset managers to help provide a market mechanism for valuing the assets.

We are exploring a range of different structures for this program, and will seek input from market participants and the public as we design it. We believe this program should ultimately provide up to one trillion in financing capacity, but we plan to start it on a scale of $500 billion, and expand it based on what works.

Third, working jointly with the Federal Reserve, we are prepared to commit up to a trillion dollars to support a Consumer and Business Lending Initiative. This initiative will kickstart the secondary lending markets, to bring down borrowing costs, and to help get credit flowing again. In our financial system, 40 percent of consumer lending has historically been available because people buy loans, put them together and sell them. Because this vital source of lending has frozen up, no financial recovery plan will be successful unless it helps restart securitization markets for sound loans made to consumers and businesses – large and small.

This lending program will be built on the Federal Reserve's Term Asset Backed Securities Loan Facility, announced last November, with capital from the Treasury and financing from the Federal Reserve.

We have agreed to expand this program to target the markets for small business lending, student loans, consumer and auto finance, and commercial mortgages.

And because small businesses are so important to our economy, we're going to take additional steps to make it easier for them to get credit from community banks and large banks. By increasing the federally guaranteed portion of SBA loans, and giving more power to the SBA to expedite loan approvals, we believe we can turn around the dramatic decline in SBA lending we have seen in recent months.

Finally, we will launch a comprehensive housing program. Millions of Americans have lost their homes, and millions more live with the risk that they will be unable to meet their payments or refinance their mortgages.

Many of these families borrowed beyond their means. But many others fell victim to terrible lending practices that left them exposed, overextended, and with no way to refinance. On top of that, homeowners around the country are seeing the value of their homes fall because of forces they did not create and cannot control. This crisis in housing has had devastating consequences, and our government should have moved more forcefully to limit the damage.

As house prices fall, demand for housing will increase, and conditions will ultimately find a new balance. But now, we risk an intensifying spiral in which lenders foreclose, pushing house prices lower and reducing the value of household savings, and making it harder for all families to refinance.

The President has asked his economic team to come together with a comprehensive plan to address the housing crisis. We will announce the details of this plan in the next few weeks.

Mar 23 10:56 PM

[Chris B:]

"I suspect most banks will be unwilling to sell off assets at market prices, because the market prices are so low."
----------------------...
This is the essence of the problem. Banks are refusing to lend because they are trying to maintain enough capital so that they can continue to hold their mortgage backed securities until either their value recovers or maturity. The ROI for holding these depressed-price assets (50-100%) exceeds the ROI of making new loans (maybe 2%). This is exactly what happened in Japan. No lending, just bank hoarding of assets.

2 possible solutions:
a) Flood the banks with liquidity so they have enough capital to resume lending while holding their so-called "toxic" assets to maturity (e.g. govt. purchase of bank bonds and equity).

b) Have the government force them to sell the assets at current prices - perhaps to the government (e.g. TARP, TALF).

1 long term solution:
Commercial lending and aggregate economic activity would not have been so severely impacted by falling investment values if commercial banking and investment banking were still separated, as mandated by the Glass Steagal act of 1933, which was repealed in 1999 under intense lobbyist pressure and money to allow for the formation of Citigroup, etc.

Unless we again separate these functions, and set regulations accordingly, this situation will repeat again and again. Investment banks can and should be allowed to fail. Commercial banks should be backed by the FDIC. This is a system that worked for 60 years before we undid it and created these too-big-to-fail unstable hybrid mutants like Citi, BAC, and AIG that privatise investment gains and socialize investment losses. Time to relearn the lessons of our grandparents and restructure banking.

Mar 24 11:24 AM

[Trillion wi...:]

On Mar 24 11:24 AM Chris B wrote:

> "I suspect most banks will be unwilling to sell off assets at market
> prices, because the market prices are so low."
>
> b) Have the government force them to sell the assets at current prices
> - perhaps to the government (e.g. TARP, TALF).

This is my exact point, in time the heavy hand of government will begin choosing which assets are toxic.

This is obviosly why we have gone into this with out looking at the books.

It will be much easier to look after the fact for toxic assets rather then identify them up front and realize that these assets are not quite toxic enough...

Mar 24 09:33 PM