My last post on the PPIP drew strong opinions - on the government's strategy behind the plan.
The key reasons for the opposition are:
1) How can the government 'waste' tax payer money on helping unfreeze MBS/ABS/CMO and other securities and asset markets, and hence proppping up the same set of institutions that has caused the market crash in the first place?
2) How will the government ensure its not taken for a ride - through participants in the plan colluding and creating flawed price discovery?
3) It's a better long-term option to let the situation play out i.e. let weaker banks fall, let asset prices find their true values etc - isn't that a more balanced long-term strategy?
Let's take the points in the inverse order above - first looking at the option of letting the crisis play out in its 'normal course'. Apart from the agony associated with prolonged recession and persistently high unemployment, i would question the very premise between this argument.
Take a look at the Japanese economic crisis of the 90's - Bank of Japan took 7-9 years to meaningfully relax interest rates, and close to 8 years to meaningfully inject public money to help banks; while there were changes in rules and regulations in the interim. Thus, BoJ basically played 'prudent and waited/allowed the crisis to play its course. Though many observers quote the Japanese and US crisis to show case the evils of deregulation, the parallels hopefully stop there. Because apart from what's commonly known as 'the lost decade', we didn't see any medium term gains from BoJ's wait-and-watch plan. On the other hand, if we can have a counter-balancing force of strong regulatory supervision and revival of corporate governance and risk monitoring, a government-facilitated resuscitation can help the economy revive short-term while laying the foundation for more meaningful growth longer-term.
In a different kind of comparison, some including Roubini have been advocating a repeat of the bank nationalization that happened in Sweden in the early 90's. However, the size of the Swedish economy (less than 3% of the US economy) and the relative size of the banking institutions clearly means we are not comparing apples to apples. As an example, our mortgage debt book size itself is 12 trillion plus - as compared to the Treasury balance sheet of USD 9 trillion. This is only a part (if not tip) of the iceberg - if we add notionals on derivative instruments, it reaches gargantuan proportions. To presume that the US government has the appetite to nationalize and turn around at such scale is being naive.
As for flawed price discovery and the government being taken for a ride, i don't think there is more at stake compared to what has been already done - or forced to be done rather.
A realistic assessment would tell us that the worst case downside is probably USD 200-250 bn (asset and security prices falling a further 50% from current levels, and the government losing its equity investments apart from losses on guarantees/debt). The amount is not trivial; but not as large if we compare current stake that the government has already assumed, the impact that the lack of a forceful plan would have on (continued) depletion in asset prices, further bank delinquencies (and hence FDIC money-on-the-table), continued slump in the economy and a long period of depleted tax revenues.
Taking a look at the dynamics of price collusion and flawed price discovery, there are enough reasons why this should/would not happen in a rampant fashion. To presume that institutions which have already taken a severe jolt would further collude to take more risk is basically assuming there's a total lack of regulatory oversight, share holder vigilance and corporate governance. More over, if the treasury can get the right financial expertise (we are already seeing increased recruitment of such kind from all govt agencies including the SEC), its common sense to assume that it can have a fairer estimate of the valuation to prevent participants from playing foul!
Lastly, on the point that tax payer money is lost, the counter argument is - who else bears the brunt of the crisis if it is prolonged? Are we saying we can live with a 5-year recessionary cycle, 10%+ unemployment and every thing else that comes with it? I hope not - unless there's a meaningful (&practical) alternate option where frozen markets can be resuscitated without heavy government intervention. Also, to look at it from another angle, the government has majority equity stakes in AIG, Freddie (FRE) & Fannie (FNM), a significant stake (with inbuilt clauses for expanded stake) in institutions like Citi (NYSE:C) and several such. So, tax payers are assured of a similar share in the upside. Going back to the Swedish example, this is similar to what the Swedish governmant did too - resulting in a net total (tax payer) cost of less than 1-2% of GDP at steady state.
Having said the above, I cannot agree more with the opinion that any revival not built on a stronger strategic/long-term foundation of risk monitoring, regulatory oversight and fiscal prudence is unsustainable. Though we haven't seen a lot of details on this front yet from the government, we did see an outline of upcoming changes - strong monitoring of systemic risk, stronger liquidity monitoring for bigger banks, increased capital cushions for the bigger banks, mandatory stress tests for bailout package recipient banks, increased regulatory oversight and reporting norms for alternative investments etc.
There might be some who say we need the above first and every thing else later i.e. effect stronger regulations, let the market play out its course and then think about fiscally-prudent long-term growth. But considering the impact that the crisis had on institutions like AIG and Citi, and subsequently, the larger US and global economy, this approach is very text-book by nature. Nor are other stakeholders (EU, Japan, China) going to abide by such a long-drawn out plan.
To put it in simple terms, unless we have key large participants in the system functioning normally, we cannot either talk about revival or sustainable growth. Because we need to first stand up before we can run or even walk!
Disclosure: No positions