Sunday morning (March 29) Treasury Secretary Geithner appeared on Meet the Press to explain his plan for rescue of the financial system. He described a series of actions to not only fix the banks, but to get the securitization markets working as well. For perhaps the first time we heard a (relatively) clear rationale explaining how the Treasury expects the toxic asset rescue plan to lead to the restoration of credit for consumers and entrepreneurial business.
The interview started with an explanation of the difference between bank lending and securitization. Per Geithner, “Typically somewhat less than half of lending for business and consumers comes from the securitization markets.” As I have written previously the current financial crisis was created by an explosion of debt to unsustainable levels in great part through the mechanisms of the shadow banking system, which includes the securitization markets. This created a massive amount of liquidity, much of which was not captured in traditional measures of the Money Supply. The collapse of these mechanisms beginning in August 2007 created the credit crunch. Sec. Geithner believes that, until these non-bank markets are restored, the financial system can’t be fixed.
There’s been much loose talk in the media claiming that lending to small business entrepreneurs can’t be restored until the toxic assets come off the balance sheets of the banks. Here is what Geithner said on the subject of the toxic asset bailout:
This is a better way to get these markets working again. Let me just step back for one second. What we’re trying to do is get the entire financial system – our complicated financial system - working again so that we get credit where it needs to go in the economy. And that requires strengthening our banking system. It requires making sure there is enough capital in the financial system to withstand a wider and deeper recession. And we’re going to make sure that capital comes with conditions to make sure that banks restructure; that there’s accountability for boards and management; that the firms emerge stronger, not weaker; and that there are tough conditions to protect the taxpayer. That is a critical part of what we’re going to do. But our system is much more complex, depends on more than just banks. So we have to do things to get these markets working again by providing financing directly to those markets that small business, consumers depend on. (Emphasis added.)
So what does this really mean? The last sentence above clearly states that the toxic asset rescue will do nothing directly to encourage small business and consumer lending. That’s a job for TALF. The bottom line is this. The Treasury believes that a restoration of the securitization markets is critical to restore lending by non-bank lenders. Securitization is the province of a few big banks in New York. Two of these, Goldman Sachs (GS) and Morgan Stanley (MS), have said they don’t need further help from the government. So basically the task at hand is to save the other major players (primarily the four biggest banks) on which the securitization markets depend so that they can restart the merry-go-round.
Underlying all of this is a bit of sordid history. Securitization is essentially an agency function. Prior to the repeal of Glass-Steagall, securitization was conducted by investment banks, which were limited by their (relatively) small capital bases from taking on significant principal risk. They bought loans for short holding periods during which the bankers and lawyers packaged the loans and quickly sold them off to investors. If they got caught short and couldn’t unload the paper, they were soon out of business or merged into a larger player.
By the late 1990’s Wall Street had found these limitations to be too constraining. As the instruments became more and more complex, it became more and more difficult to market the riskiest portions of the loan packages (the “toxic waste”). If the toxic waste couldn’t be sold, there would be no deal. No deal meant no commissions. And no commissions meant no bonuses. The repeal of Glass-Steagall enabled an ingenious solution. Where the investment banks had no choice but to unload the toxic waste because there was no place to hide on their balance sheets, the major money center banks had much larger and deeper balance sheets and complex corporate structures with multiple regulators. Aided and abetted by the invention of credit default swaps, which enabled the pooling of toxic waste into “investment grade” securities which could be sold to third parties or into off balance sheet conduits created and managed by the banks, the major players in these markets dramatically ramped up the securitization engine between 2003 and 2007, fostering the housing bubble.
While much of this activity was not conducted directly by the banks, the bulk of it was ultimately for the account of bank lenders, which in effect supported proxy institutions in the securitization market through lines of credit and asset purchases. This appears, for example, to have been the case with Bank of America’s (BAC) support for Countrywide mortgage. When the music stopped, the biggest non-bank participants were quickly rolled up into the major banks (Countrywide and Merrill into Bank of America and Bear Stearns into J. P. Morgan (JPM)).
The toxic assets the Treasury is now proposing to deal with through its bailout plan are the detritus of the securitization collapse that these banks could not unload on third party investors when the music stopped in the fall of 2008. This was confirmed by Lloyd Blankfein of Goldman Sachs following last week’s meeting between the big bank heads and Pres. Obama, when he was asked whether Goldman would be selling assets into the new program. His response was that with its business model Goldman didn’t have much exposure to that type of consumer assets and what it did have had already been marked to market, i.e. Goldman (and likely Morgan Stanley as well) stuck to its knitting as investment bankers, quickly moving the paper it had created off its balance sheets and did not retain the types of principal risk taken on by the big banks.
More than half of U. S. banking assets are held by four banks that are also major players in the securitization markets: Bank of America, Citigroup (C), J. P. Morgan, and Wells Fargo (WFC). Almost certainly a far larger percentage of the securities and loans that will be purchased from U. S. based banks under the toxic asset plan will be from the balance sheets of these four institutions. If you believe that these new multibillion dollar conduits created by Treasury are going to be purchasing bad subdivision loans to clean up the balance sheet of Podunk Thrift Bank for Savings to enable it to make loans to local businesses, then I’ve got a bridge in Brooklyn I need to sell you.
So why, you might ask, should we be willing to put the U. S. Treasury on the line for $1 to $2 Trillion to bail out these banking behemoths? Sec. Geithner’s answer today is that we must save the banks to restart the securitization engine. What he doesn’t say, but which is likely far closer to the truth, is that the government is deathly afraid not to. An outsized percentage of outstanding corporate debt was issued by the major bank holding companies. When the government allowed a comparatively smaller player (Lehman Brothers) to fail, the world’s financial markets ground to a halt. Geithner’s unspoken answer: we’ve got to bail out the bondholders of the big banks because their failure will crater the system. Since it’s politically impossible to do so directly, we’ll do so by allowing these banks to unload their underwater assets on the Treasury. We’ll dress it up by getting a few friendly institutions (many of which will likely be big holders of corporate debt) to take a small slice of the risk so we can put the pricing decision on them rather than the Treasury. Once the big banks are cleaned up, they can again raise money in the capital markets and we can depend on them to again create a vibrant private securitization market so that the merry-go-round can again turn.
All of this makes me profoundly uneasy, but I am not sure that there is a good alternative to bailing out the creditors of the big banks. There may well be no other way to avoid the chasm of economic collapse than to bail out the debt holders of the big banks. To not do so could irreparably damage the U. S. standing in the world capital markets. I do object to selling this plan as being necessary to “get the banks lending again” or to provide liquidity to entrepreneurs. That’s not what this plan is about.
The powers that be hope to sell this plan without an honest public debate over its real implications for our economy and society. Inherent in the Geithner plan are a number of assumptions, which are presented as givens not open for discussion. At a minimum the following questions need airing and extensive public debate:
- Is a banking system in which more than 50% of the assets are controlled by four institutions good for the economy, the political system or the social fabric of America?
- Should the taxpayers ever be called on to preserve the equity value of the shareholders of insolvent private entities?
- Should the Treasury be committed permanently to an implied guaranty of the debt (as opposed to consumer deposits) of “systemic” financial institutions and, if so, is there a regulatory structure that can be created that is adequate to protect the Treasury from the need to conduct similar bailouts in the future?
- Is a system in which 50% of credit is created through securitization healthy for the long run stability of the economy? Do we have regulatory and monetary tools in place that can deal with the impact on the larger economy of the market swings inherent in such financing?
- Is our focus on the big banks preventing the allocation of capital to those institutions (community and regional banks) that have traditionally provided most of the financing for entrepreneurial businesses?
Let’s do what it takes to save the economy, but not at the cost of an open democracy. It’s time to demand a debate over the real issues at stake, rather than blindly accepting the PR smokescreens of those with trillion dollar vested interests in the outcome.