Restoring the Health of the 'Too-Big-to-Fails' Also Restores Them to Power

I often wish I were Mark Thoma. If I were Mark Thoma, I could be smart and paying attention without being bitter.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Unfortunately, I have a darker temperament, a spirit less generous and optimistic than Mark's. I am filled with despair, not because what we are doing cannot "work", but because it is too unjust. This is not my country.

The news of today is the Geithner plan. I think this plan might work very well in terms of repairing bank balance sheets.

Of course the whole notion of repairing bank balance sheets is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by legacy bankers.

I think that critics of the Geithner plan are missing some of its tactical brilliance. My guess is that behind the scenes, Geithner has arranged a kind of J.P. Morgan (JPM) moment. You know the story. During the Panic of 1907, J.P. Morgan locked a bunch of bankers in a room and insisted they lend to stave a panic. We've already seen one twisted parody of this event, when Henry Paulson locked a bunch of bankers in a room and insisted they borrow money from the Treasury. This second one is more clever. I don't think the scandal of the Geithner plan is going to turn out to be the subsidy to well-connected investors embedded in the non-recourse loan put option. On the contrary, I think that Treasury has already lined up participants for the "Legacy Loans Public-Private Investment Fund" and persuaded them to offer prices so high that despite the put, investors will expect to take a major loss. My little conspiracy theory is that the Blackrocks and PIMCOs of the world, the asset managers who do well by "shaking hands with the government", will agree to take a hit on relatively small investments in order first to help make banks smell solvent, and then to compel and provide "good optics" for a maximal transfer from government to key financial institutions.

Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢, thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner's plan, PIMROCK's $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK's $10B is wiped out entirely, as is the Treasury's investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss. But, as Calculated Risk likes to say, "Hoocoodanode?" These were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing.

Welcome to America, 2009. Change we can believe in.

The scenario I've presented is a variation on this by Karl Denninger (ht Tyler Cowen).

I liked this post Monday by Matt Yglesias:

My biggest concern about the PPIP approach to the banking system is that even if it works, what it does essentially is return us to the pre-crisis status quo — banks that are so large that they’re too politically powerful to regulate effective and too systemically important to be allowed to fail. That’s a recipe for dishonest transactions that produce short-term profits at the cost of blowups. One appealing element of nationalization is that it can easily be made to end in a world in which there is no institution named "Bank of America" or "Citi" and no such gigantic institution.

On the bright side, I'm thankful that we have people like Paul Krugman, Simon Johnson, and Willem Buiter, who fight the good fight while being too eminent to ignore.

On the dark side, try here, here, and here.

Comments

[An American...:]

When the dominant players in a market begin to faulter and the interconnectivity of flows of value (widgets, services, and credit or cash) become disrupted, it creates significant new opportunities.

This is the time when disruptive technology, disintermediators and fresh, new players with fabulous ideas could enter these markets conducting the old business in new and more efficient ways.

Why invest $5,000 in your 7-year old GM car to keep it running for a couple more years, when you can buy a new car for $15,000 that will give you another good 7 years, maybe more?

Why invest $1T in your old banking system to keep it running for a couple more years, when you could reengineer, retrench, rebuild a better banking system with that $1T that will last another century, but also, create jobs, boost morale and stimulate the economy?

Would we not rebuild if it was to change the status quo? If it was to shift power to a new group of players? If it was to force obsolescence on the old boy network and restructure where it must be so?

Mar 24 08:33 AM

[pacman1947:]

Steve,
You have banged the nail squarely on the head, "Of course the whole notion of repairing bank balance sheets is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets." Truth personified. Great observation.

An American Gone Wild, just above, has the key idea that may help achieve that improved balance sheet at home: Disruption. We need a system designed to last, not to fail.

We must learn to allow capitalism to do its job. We need the banks that floundered to either fail or reorganize around the devastation they caused, with their own money, not ours.

Bankruptcy is the medicine that they need to take, not government doles.

Stronger banks will take their place and grab their good assets at a fair price. What if it's not fair? The price is agreed to by both parties, not a third party. Capitalism allows the free choice of buyer and seller. There are no winners and losers, just buyers and sellers.

The government should just stand in the crowd and watch for cheaters. That, my friend, is all it should do.

Mar 24 09:40 AM

[The Cynic:]

Like the author, I've got a darker temperment. His scenario is plausible. The current power structure otherwise known as the status quo won't die without a fight, they've got too much at stake. My theory is that the Jekyll Island deal also included an agreement that the banking sector would underwrite the activities of the two main political parties one way or another. So neither the politician nor the banker has any interest in seeing the structure fail despite any rhetoric to the contrary. In the end, the only way the change will come is when Americans either stop paying their taxes or at least make the credible threat thereof. And this would be a monumental task for someone credible to lead and think of the shit that would be thrown her/his way!

Mar 24 11:33 AM

[JohnL:]

You are an informed patriot Steve. There are so few.

And the Left blames the free market for monopolies! Once again it is government intervention -- not the free market -- that helps consolidate economic power, along with the political power and corruption that go along with it.

Mar 24 11:54 AM

[monday1929:]

Exactly. The brilliance of this theft, they think, is that it pushes out those losses a few years, when they assume all will be well, or more importantly, they will be richly retired. Bill Gross WAS someone I once admired. Now I believe Bill Gross sold his soul to the Treasury.
As I have suggested in the past, he should be investigated, with Paulson, for his antics buying tens of billions of Fannie/Freddie months ago. He either betrayed his fiduciary responsibility to his clients, or, he had been given assurances by Paulson/Bernanke that he "could not lose" on those purchases.
Sounds similar to this deal. If the truth ever comes out about these events, we will find that numerous illegal acts took place under the guise of "National Security". That these acts profit a small Elite is just icing on the cake, for them.

Mar 25 07:51 AM

[monday1929:]

Well, the unregulated unfree market promoted by the Right certainly helped push things along towards Hell.


On Mar 24 11:54 AM JohnL wrote:

> You are an informed patriot Steve. There are so few.
>
> And the Left blames the free market for monopolies! Once again it
> is government intervention -- not the free market -- that helps consolidate
> economic power, along with the political power and corruption that
> go along with it.

Mar 25 07:53 AM