This morning, Secretary of the Treasury Tim Geithner testified before the Congressional Oversight Panel (COP) headed by Elizabeth Warren. In general, the questions were excellent; unfortunately, the answers were not forthcoming.
One excellent question was, "How does protecting the common shareholders of Citigroup (C) help the economy?" There was no real answer to that question -- just a dance about how it was not appropriate for him to talk about any individual financial institution. The true answer to the question is: it doesn't.
He said in response to questioning about the asymmetric risks and returns in the Public Private Investment Plan (PPIP) that if you had to sell your house immediately but there were no mortgages available, you would not get a very good price. I think that this is fundamentally the wrong analogy to use, and it reflects a flawed assumption that underlies the PPIP program -- namely that the buyers in the market are wrong.
It assumes that the reason that there is no volume in the market for these "legacy assets," the new term for "toxic assets," is that there are no buyers, rather than that there are no sellers. This is an unproven assumption at best, although one of the better features of the PPIP is that it should help answer the question of a lack of buyers vs. a lack of sellers.
A better analogy (or at least one that is equally valid) is: suppose you wanted to sell your home, but it has suffered major water damage and is now infested with termites. However, you owe $500,000 on it, and no buyer is willing to pay more than $250,000 for it, and you cannot afford to sell it at that price. Simply because mortgages are available at reasonable interest rates will not make buyers want to buy your house for anything like $500,000.
The big banks like Bank of America (BAC) are in this situation. The termite damage is the fact that so many of these loans are going into foreclosure, and the losses per foreclosure are much higher than originally modeled. The flood is the fact that the economy has turned sour and there are lots more people who simply can't pay the mortgage now that they are out of work. If they were to sell for a price that reflects the flood and termite damage, then their equity would be wiped out and they would be insolvent.
Geithner's analogy also makes the implicit assumption that these toxic assets are like houses where they must realistically be bought on a leveraged basis. Clearly, if everyone who wanted to buy a house had to pay 100% in cash, there would not be much in the way of real estate transactions. However, there is no reason to think that mortgage-backed securities must be bought using lots of leverage (aka margin).
They are more analogous to stocks or bonds, and most investors buy those without using margin. Indeed, a good part of the problem seems to be that these assets were originally bought using far too much leverage.
These assets are not some obscure pink-sheet company, where one could reasonably say it is underpriced due to lack of information being widely known in the market. There is no particular reason for the market to be that inefficient.
If the legacy assets were as deeply undervalued as the PPIP implicitly assumes, investors would gradually increase their bids. If the assets were really worth $0.80 on the dollar, why would potential investors insist on bidding only $0.30 on the dollar? Why wouldn't some other investor come along and bid $0.40 on the dollar, and get a lot of these assets and still make a killing? Why stop at $0.40? Is it really because they can't leverage up six to one to do so? Wouldn't a doubling from "true" value be enough to buy them on an unleveraged basis?
The PPIP will only help out the banks if it helps drive up the bids to levels that the banks can afford to accept. To the extent that that price is above the "true" value of the assets, the government (broadly speaking, including the Fed and the FDIC who are providing the non recourse loans) will end up eating the difference.
The Fed will probably deal with the loss by monetizing (turning on the printing press). The FDIC will likely come hat-in-hand to Congress after the fact, looking for a bailout.
-- Dirk van Dijk
