Tuesday, March 24, 2009

The New Geithner Bank Bailout

So Monday saw embattled Treasury Secretary Tim Geithner reveal to the public the details of his public-private investment plan designed to rid the large U.S. banks of the troubled assets on their books, threatening to make the entire system insolvent in their wake, and the market reacted in a majorly positive way, rising 7-8% across the board on the day as Geithner finally won the approval of investors around the world after several attempts. I spent much of the day reviewing the details provided by Geithner, and I think I have come to my conclusion.

I like it. I really, really like it.

I mean, let's take a step back for a minute. I have made no secret here of my lack of fandom for throwing all this money at the banks. There is little doubt that the administrations of our current and last president were staunchly in favor of gifting funds to the banks it deems "too big to fail" for risk of them damaging our entire financial system beyond easy repair. This is something which President Obama has not even tried to deny, stating repeatedly that despite personal and public feelings around the essential fairness of bailout out Wall Street fat cats, it is common knowledge that the economy simply cannot and will not enjoy meaningful growth again unless and until the banks start easing up on credit. So the thinking is that, even though we all kinda hate it, we simply will have to hold our noses and print money for these banks to replace the capital eaten away by losses on all the troubled assets, bad mortgage-backed debts and other crap sitting on banks' balance sheets after the last ten year or so of irresponsible consumption and investments. Personally, I think given how far the market fell, it is likely that allowing the Citi's, the AIG's and some other financial institutions to fail on their own would likely have resulted in no worse declines in the stock market and probably no worse systemic shock to the financial system either, so these moves have probably not been necessary in actuality, nor did they prevent much of anything in the end result. I think it would probably be ok to continue to let the most struggling banks die out even now, and I am willing to suck up the near term pain, including further market losses, more economic deterioration and likely significantly more job losses in the near future, in an attempt to simply stop printing more and more money and rewarding the bad acts of these Wall Street jackasses who can't even stop paying themselves million-dollar bonuses and buying six-figure area rugs for their offices, even when on the dole from the public.

But putting all that aside, once we accept the Obama plan to shore up his own legacy by speeding up that process by actively taking those bad assets off the books of the biggest banks, I have to say that I think the Geithner plan is a good one, at least in theory. And if you read here with any frequency then you know I have not been a big fan of Geithner so far, but in this case I think he's hit the mark with this public-private investment idea. The whole reason the first attempt at such a plan to buy banks' bad assets by former Treasury Secretary Hank Paulson was scrapped in favor of direct equity investments in the banks is that the government could not figure out how to properly value those assets when making the purchases. Value them at their values as currently marked on the banks' books, and we would be grossly overpaying for those bad loans, thereby ensuring that the government, and therefore we taxpayers, take a huge bath on the deal. Value them at their current market values, however, and most of the banks in the country would instantly be insolvent because the losses recognized on those sales to the government would have completely wiped out the already weakened capital position these banks are currently faced with.

Hank Paulson and his team quickly decided that they simply did not feel like dealing with this whole issue of valuation of banks' bad assets, so they decided instead late in 2008 to invest directly in preferred stock of the banks in exchange for billions of dollars of cash from the original tranche of last year's TARP plan. The problem with this, it turns out, was that the banks did not use those extra billions to ease up the credit markets at all. Instead, they used it to finance acquisitions of other healthy banks, to pay dividends, to pay bonuses to their employees, and most of all, to hoard the cash. They hoarded it because they are still sitting there, looking at the many many billions of dollars of crappy loans on their books, and knowing that there is the potential for still many tens of billions, and in some cases hundreds of billions, of dollars in writedowns coming on those asset portfolios. I mean, even $25 - $50 billion in direct investments in companies like Citigroup and Bank of America did very little to offset the potentially $200-$300 billion of bad assets held by the country's largest banks. And that is where we cue Mr. Geithner's new plan.

So the purchase of direct stakes in the banks in exchange for cash was not nearly sufficient to get credit flowing again through these financial institutions, in no small part due to the massive amounts of troubled assets still sitting on the banks' books. Geithner's new plan is a bold, innovative assault launched directly at the root of that problem. Geithner is tackling the valuation issue head-on, proposing that the government partner with private sector entities -- large asset managers, hedge funds, pension funds and other similar private enterprises -- in purchasing pools of loans from banks and prices determined by the market for those private enterprises. So no longer will the government be forced to decide what value to pay to take the bad loans off of the banks' books; now, the most accurate and fair system we know of here in America -- the free market -- will determine that value. The hedge funds and asset managers simply will not participate in any deal that involves overpaying for the assets, because they are in it to make a buck after all, and the government will simply go along with whatever price is established by the free market negotiations between the parties. Geithner shrewdly has included as a key part of his plan that the government itself will provide the financing for the purchases, in addition to participating itself as a co-investor with its own new funds, which also eliminates perhaps the other biggest problem with banks liquidating these assets themselves -- with credit so frozen right now, no one has been willing to finance purchases of risky, unknown loan pools from crumbling financial giants. Now, with the government stepping in to not only provide its own money to invest in these assets, but also loaning the required funds to the private sector to entice them to be involved, the two main barriers to the process of actually purchasing our banks' troubled assets should be eliminated.

I think it is a foregone conclusion that the Geithner plan will create a market for banks' bad assets, something that basically has not existed for almost two years since the credit crisis first took hold after a wave of defaults in the subprime mortgage market. Although there is always the possibility that private equity will not be interested in buying this distressed debt from banks, in reality the availability of funds from the government at reasonable interest rates should combine with the significantly cheap valuations for such debt in the current conditions to create real interest from several interested parties. Involving the private sector is in my view a stroke of genius that can really act to create a market -- and potentially an active one -- for an entire class of assets that have been more or less unsellable for the past couple of years, and getting those assets moving off of our banks' books should eliminate one more big impediment to getting the banks loaning again to help the economy to grow.

There are two issues I see with the revised bank bailout plan, either or both of which could prove to be significant. The first is the simple fact that, even with much of their bad assets removed from their books, banks are still not likely to resume lending at a pace anywhere near what was being done previously. The bottom line is, banks got absolutely burned by loaning to and investing in many, many assets which were too risky for what the banks should have been doing at the time. Mortgages were made to people who could never reasonably expect to afford the payments unless the values of their homes increased linearly literally for ever. Loans were securitized and sold in packages without the seller, or more importantly even the buyer, really knowing what was in them and how likely the component loans were to be repaid. This behavior has been significantly reeled in by the banks over the past year or more, and there is not appetite right now to revert back to that way going forward, which I think is a good thing. But the bottom line is that in the current economy, with housing prices still dropping well into the double-digits in percentage terms annually, and with economic growth prospects dubious at best, the banks are not going to start throwing money around again anytime soon, even if the risk they face from writedowns of troubled assets is significantly diminished by the new Geithner bailout plan.

The other issue I have is potentially more serious, and it's something that I fully expect we will be seeing soon, probably more likely sooner rather than later. The Geithner plan does nothing to guarantee any particular level of pricing for purchases of bank assets, nor should it. It simply guarantees that financing will be available at reasonable interest rates -- a rare commodity right now to be sure -- and works to create a market at whatever price the market will bear for such assets. Whatever the difference is between the price of an actual sale of a pool of loans, and the price that pool of loans is currently held at on the bank's books, will be a loss and will have to be recorded as such and charged against the bank's existing excess capital. The problem we are going to see, and again my guess is very soon, is that it won't be long before one of these big banks comes to Geithner and says "Mr. Secretary, at the price the private investors are willing to pay me for my assets, I can only sell them $40 billion of my $200 billion loan pool before I am wiped out and will need substantial additional equity in order to continue to survive." This I think is likely to happen with most of the large banks in this country today, as a matter of fact. So I think it is highly likely that Secretary Geithner will soon be grappling with whether or not to contribute significantly more capital to the nation's biggest, and most injured, banks' current capital reserves, a move that is likely to be politically difficult to secure and even more unpopular with the public. It is likely that the size of the revised Obama-Geithner bank bailout will swell to well over a trillion dollars before all of these extra capital infusions are going to be fully worked out.

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Blogger Astin said...

Ugh. Really? You like it?

The banks ARE insolvent, there's not "if they marked to market" crap, they have far less in assets than they do in liabilities. The only reason they're still afloat is because the government is weakly propping them up.

Public-private my ass. The taxpayer is on the hook for 93% of these loans due to guarantees by the government (6:1 guarantee on loans + 50% of the purchase price). So the private side only has 7% of the risk for 50% of the reward... yah, that makes all kinds of sense. This a taxpayer fucking, and nothing else. Hell, if *I* was offered the chance to buy something for that kind of leverage, with almost zero downside risk, I'd take it too!

The lines about free market competition guaranteeing the lowest price are also crap. Competition will ensure that the government pays the HIGHEST possible price for these loans, not the lowest. If they had ANY balls, they'd tell the banks what they're going to pay for the assets, and tell them to see if they can do better.

And at the end of the days, these assets are toxic because they're pieces of shit, not because they're "misunderstood". I guarantee the taxpayer gets screwed and Geithner's buddies get richer.

It's a plan that sounds nice on the surface, but once again fails when the simplest question is asked - "What happens if they don't increase in value?" It was the same question that should been asked during the credit boom.

As for opening lines of credit - there is NO WAY that you can spend your way out of a mess that was caused by overspending! IF another credit boom is created by the trillions upon trillions of DEBT the government is pouring into the system, it will crash even harder next time. It fixes absolutely NONE of the root problems.

For all their talk of changing the system Obama and Geithner are still using the same playbook as the past regimes.

12:51 AM  
Blogger Hammer Player a.k.a Hoyazo said...

Astin, I agree with pretty much everything you said there, including of course that ultimately what this amounts to is just another money-throw at the banks to the tune of billions and billions of dollars. I tried to capture that in my post.

But I think that, once you accept that we are cowtowing to the fucking banks again, this is a far superior system to the one originally proposed by Paulson or anything that involves the government "deciding" on the right price to pay for these shits.

And you are 100% spot on that the new administration is doing all the same (bad) stuff for all the same (bad) reasons as the previous one. You would think with how reviled the previous admin was that these guys would want to come in and change things up, wouldn't you?

6:42 PM  

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