This Time, Geithner’s Plan for Banks Makes Sense

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March 28, 2009
Talking Business
This Time, Geithner’s Plan for Banks Makes Sense
By JOE NOCERA
Will it work?

Isn’t that the only thing that matters at this point? The big, new plan to solve the banks’ toxic assets problem, unveiled earlier this week by Treasury Secretary Timothy Geithner, has come under intense scrutiny in the blogosphere and elsewhere. The plan would create incentives for private investors to put up small amounts of equity, side by side with the government, to buy toxic assets from the banks’ balance sheets. To sweeten the deal, the government will also be putting in debt, at leverage ratios that could reach as high as six to one — and will provide guarantees against most of the potential losses.

The Treasury estimates that the program “will generate $500 billion in purchasing power to buy legacy assets — with the potential to expand to $1 trillion over time.” (And yes, “legacy assets” is the new euphemism for toxic assets.)

Even before the program was officially unveiled, critics were all over it, from every imaginable point of view. Paul Krugman, The New York Times Op-Ed columnist, described the plan as “cash for trash,” and declared that “it fills me with a sense of despair.” There was anger on Main Street that the government debt amounted to a subsidy to help rich hedge fund guys get even richer.

Was the new program really an attempt to find “price discovery” for these assets — as the government claimed — or was it instead an effort to paper over, using taxpayer money, the true dimensions of the losses? And wasn’t leverage what got us into this mess in the first place? How was piling on more debt going to help solve the crisis?

People who believe that easing certain accounting rules, like mark-to-market, is the best solution were dismayed that the government wasn’t doing that instead. People who believe that nationalizing the banks is the best solution were dismayed that the government wasn’t just biting the bullet and taking over troubled banks.

And on and on.

Having spent the better part of this week mucking around in the details of the new plan, I concluded, somewhat to my surprise, that it might well work. By this, I certainly don’t mean that it will, all by itself, revive the economy. But I think it could put a real floor on the price of the bad assets — critically important to stabilizing the banks — and change the market psychology so that securitized assets can begin to trade again, which is important to get credit flowing. And it will give regulators a far sounder basis to ask Congress for more money to recapitalize banks — or take them over, if it comes to that.

As for the complaint that it will make rich guys richer, well, you can’t win ’em all.

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“We need to face up to it sooner or later,” said Sheila Bair, the chairwoman of the Federal Deposit Insurance Corporation. By “it,” Ms. Bair was referring to the losses still embedded on the banks’ balance sheets. To her, the Public-Private Investment Program, as the feds have labeled it, is most definitely not an attempt to disguise losses. It is, instead, an effort to shine a clear, bright light on them. “A necessary cleansing process,” says Ms. Bair.

The P.P.I.P. (inside the beltway, they have already started calling it P-pip) is, in fact, two separate programs. One deals with the kind of mortgage-backed securities that we’ve all come to think of as toxic assets. The other deals with loans that have not been securitized — for things like commercial real estate, or residential mortgages or small businesses — that banks hold on their books. The former program will be run by Treasury and the Federal Reserve; the latter will be managed primarily by the F.D.I.C.

As it turns out — and this was also something of a surprise — there is a consensus, both in Washington and on Wall Street, that mortgage-backed securities have been marked down to levels that have started to approach reality. These securities come under mark-to-market rules, so they have to be marked down as they decline in value. They are the primary reason the banks have had to take write-down after write-down, decimating their capital.

Still, to get investors to buy those assets — and get a market flowing again — they still need some leverage to bolster potential returns. Critics complain that the government-provided debt amounts to a bribe to get investors to purchase the assets at inflated prices. But I don’t think that’s what’s really going on. Instead, it appears that the government is trying to return some normalcy to the workings of the market.

“There is something called the leverage cycle,” said John Geanakoplis, an economics professor at Yale. During the bubble, he continued, when the country was awash in debt, toxic assets rated AAA were leveraged at an outlandish 16-to-1 ratio. That leverage was the primary reason those assets made such big returns. Now we’re in the opposite end of the cycle. There is no leverage at all available — yet without it, the return on these assets would simply be too small to make them interesting enough for investors to purchase. The only entity capable of injecting leverage in the system is the government.

It makes perfect sense that the government would want to supply that leverage, though certainly not at the extreme 16-to-1 ratio that characterized the bubble. Though the government will go as high as six to one, what I hear is that most of the assets will have less leverage than that. If the program works — that is, if the assets begin to make money for investors — it could draw more private lenders into the marketplace. Suddenly the market for these assets would become liquid again, and banks could mark the assets remaining on their books with some real confidence. Isn’t that what we want?

The second surprise, to me, is that the whole loan program is in some ways more important than the mortgage-backed securities program. The reason is that, unlike securitized loans, these assets do not have to be marked to market; indeed, as long as the borrowers are current on their loan payments, they don’t have to be marked down at all. And yet it is obvious that many such loans are in deep trouble — and the banks haven’t faced up to that yet.

All over the country, businesses like real estate development companies are using loans they took out in good times to finish projects that are going to be problematic, to say the least. Chances are high that those loans are unlikely to ever be paid back in full. I heard one story this week about a borrower who actually approached the bank and laid out his dilemma. The bank’s response? It granted an extension of the loan for months — with no fees. That is akin to what the Japanese banks did during their decade of insolvency: they rolled over loans to borrowers who they knew could never pay the money back, in order to avoid taking losses that would wipe out the banks’ capital.

There are plenty of investors who would be happy to take bundles of, say, commercial real estate loans off the hands of the banks and work them out — but only if they can get them for a price that makes sense. Good money can be made both for the investors and for the government, which, lest we forget, will get 50 percent of the upside. But the banks are going to be extremely reluctant to give up those loans, because by doing so, they would have to acknowledge the losses on their books.

That is why it is so important that the F.D.I.C. is managing this program. However much banks may not want to sell into the program (and for all the government’s insistence that the program is voluntary) it will be nearly impossible for a bank to resist the entreaties of its primary regulator. All indications are that Ms. Bair and her crew are going to use the program as a tool to force the banks to come clean on the health of their loans.

Once this process gets under way, does it mean that banks are likely to need additional capital? You bet it does. There are going to be new holes in balance sheets, and they’ll need to be plugged. But in the best of all possible worlds (a guy can dream, can’t he?), private capital will come in because investors will finally see that those bad assets no longer constitute a bottomless pit. Even if that assumption turns out to be overly optimistic, it will be far more politically palatable for the government to recapitalize the banks — or close them down, or even take them over, if need be — knowing that we finally can value the bad assets. You really can’t nationalize a bank without being able to make an ironclad case, to the public, that it is hopelessly insolvent. The P.P.I.P. will help make such a case.

When I asked Thomas F. Steyer, the head of Farallon Capital Management, the big West Coast hedge fund, whether he thought America was acting like Japan during its lost decade, he scoffed. “We were interested in some of the assets in Japan, but whenever we asked them when they were going to start dealing with them, the answer was always ‘in two years,’ ” he replied. “Japan fell apart in 1989, and we were having those conversations in 1998 and 2000. Our country is moving on this. This administration has only been in office for a little more than two months, and they are already grappling with this.”

Is the plan perfect? Surely not. Is it guaranteed to do the trick? Of course not. But it is an effort to try something that seems to make a certain amount of intuitive sense, and could, in the best case, make our banks a little healthier and a little better able to extend credit.

It doesn’t represent the end of the crisis, not by a long shot. But it represents the beginning of something we should be applauding, not condemning: cold, hard reality.