That one word assessment of the Geithner plan, as previewed in the New York Times tonight, comes from reader Scott, and is good enough to print.
I am so disgusted with this entire proceeding that I am going to dispatch it quickly.
Let’s start with the basics. The US banking system is insolvent. Got that? Insolvent. That does not mean every bank in the US is toast, in fact quite a few are probably just fine, and another large group is no doubt hurting and undercapitalized, but a couple of years of not shooting themselves in the foot again would enable therm (via earnings) to rebuild their equity bases sufficiently to proceed more or less as normal.
The problem is that a significant portion of the very biggest banks are insolvent. And on top of that, most of them have very large capital markets operations which have bean the nexus of credit intermediation. The regulators spent the last decade plus being in studious ignorance of those businesses, at least the complicated ones where all the risk resided. The SEC never was very interested in bonds, and the Fed took a hands-off, “let a thousand flowers bloom” approach to risk management, derivatives and what was called innovation. Author and market observer Martin Mayer warned “a lot of what is called innovative is simply a way to find new technology to do that which was forbidden with the old technology.”
But the history of major banking crises unambiguously shows that insolvent financial institutions need to be resolved. There are variations on the theme: the government can take them over and recapitalize them, clean them up and re-sell them, a la Sweden; you can wipe out equity investors and bondholders; you can try new twists, like various good bank proposals that have surfaced lately (making new entities out of the deposits and good assets and leaving the dreck with the existing bond and shareholders). While there would be many important details to be sorted out, this is not path breaking, except in the scale at which it needs to occur. And now, having had four actute phases of a credit crunch, the Fed and other central banks have plenty of liquidity facilites ready to deal with any initial overreaction. Rest assured, although radical measures would not be pleasant or easy, there are plenty of models and precedents.
But…here we have another scowling Treasury secretary, with a bit more hair than his predecessor, serving up the same fatally flawed approach as before: let’s just throw money at the banks and hope they get better. This is tantamount to using antibiotics to treat gangrene. You waste good medicine and the progression of the rot threatens to kill the patient.
In fact, the state of affairs may be even worse that I thought. I had grumbled about the fact that the earlier leaks of this plan, like the MLEC and the TARP, seemed little more than a sketch, when its success or failure founder on key details.
The elephant in the room is how do we solve the heretofore insurmountable problem that the market price of the bad assets is well below what the banks are willing to sell them for? Paulson was unable to find a way to finesse the problem to get private investors to pick up even a cherry-picked portion of the junk in the MLEC incarnation; in TARP, he (presumably) planned to have Uncle Sam buy the paper at a price the banks would find acceptable but somehow camouflage the subsidy. He abandoned that course of action quickly, perhaps because the magnitude of the payment over market prices would be so large as to be politically explosive were the bagholder taxpayer ever to find out.
There is no evidence in the various elements leaked that this impediment has been overcome, which raises the real possibility of a Paulson-like seemingly bold advance followed by an equally hasty retreat. Inviting investors in with you on the buy side does not address the issue of the pricing gap, unless the deal with the investors is intended to help obfuscate the overpayment to the banks.
Note I have no objection to equity infusions if accompanied by sufficient ownership, controls, and a methodology for the goners, say taking over or putting into receivership. No private equity investor would put 20% into a company without getting lots of goodies, such as veto rights, antidilution provisions, a board seat, etc.
Now in fairness, Geithner may treat the banks more consistently than Paulson & Co. did. But that is cold cheer if the basic approach is still fatally flawed.
In fact, the present course is the worst of all possible worlds. AIG has demonstrated that a player deemed to by systemically important has a blank check. Not only did they get additional dough with few questions asked, they got improved terms on their initial loans. Let me stress, for those not familiar with the ways of deal-land: if you ask investors for money and maintain it is enough to achieve X (get you to break even, get your first product launched) and then come back not having done what you said you promised, the next round is on MUCH more punitive terms. Having a party that badly underestimated its needs come back, get more dough, and get relief on its inital loan is from an alternative reality.
In addition, AIG had given large numbers of staff very large retention bonuses. This is when the loans per employee are $1.4 million. Now the retention bonuses may very selectively be warranted, but they have been handed out like candy, and AIG is know for generous pay, so even if extra comp might have been necessary, query whether at this level. Given the less than rosy hiring conditions in the insurance industry, a lot of these payments appear flat out unnecessary and were thus effectively looting right under the government’s nose.
Thus, the banks get funding on an open-ended basis, with no requirement to write down or sell the dreck. And even if some miraculously does get unloaded via this process, we wonder how far it will get to really cleaning up the banks. Ken Rogoff estimates US credit losses at $2.0 trillion; this plan appears likely to fall far short of that, which means we still have a lot of sick banks, just somewhat less so. (We’ll need to wait to see how this unfolds, but since the banks have no reason to part with bad assets and take a writedown, this is the scenario they are trying to avoid, we still have crappy assets being funded at fictive prices, but this time by you and me rather than by Citigroup). The failure to clean up the banks and write down bad assets was a big contributor to Japan’s lost decade.
Now to get to the punch line, let us turn to the New York Times. The headline “Geithner Said to Have Prevailed on Bailout,” is already bad news, since as we have discussed, Geithner is a living, breathing example of cognitive regulatory capture. But here is the troubling bit:
In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.Mr. Geithner, who will announce the broad outlines of the plan on Tuesday, successfully fought against more severe limits on executive pay for companies receiving government aid.
He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.
Because of the internal debate, some of the most contentious issues remain unresolved.
In other words, Geithner followed the Paulson script of pushing hard to make the bailout industry friendly, to the extent of compromising the effort to get the plan fleshed out in adequate detail.
We’ll see if the notion of a $500,000 salary cap survived. Lucien Bebcuck, Harvard Law professor and corporate governance expert, pointed out that in fact, that provision is not terribly restrictive. There are no limits on deferred pay, pensions, or incentive compensation in the form of equity. And executives have often taken non-recourse loans secured by shares.
The plan is terribly sketchy. Even the numbers have not been nailed down:
It intends to call for the creation of a joint Treasury and Federal Reserve program, at an initial cost of $250 billion to $500 billion, to encourage investors to acquire soured mortgage-related assets from banks.The Fed will use its balance sheet to provide the financing, and the Federal Deposit Insurance Corporation might provide guarantees to investors who participate in the program, which some people might call a “bad bank.”
A second component of the plan would broadly expand, to $500 billion to $1 trillion, an existing $200 billion program run by the Federal Reserve to try to unfreeze the market for commercial, student, auto and credit card loans. A third component would involve a review of the capital levels of all banks, including projections of future losses, to determine how much additional capital each bank should receive.
The capital injections would come out of the remaining $350 billion in the Troubled Asset Relief Program, or TARP.
A separate $50 billion initiative to enable millions of homeowners facing imminent foreclosure to renegotiate the terms of their mortgages is to be announced next week.
And my sense that Team Obama is making this up as they go was confirmed by an e-mail from Robert Radano:
Treasury briefed the Senate Banking Committee tonight regarding Geithner’s plan to be announced, tomorrow…Tuesday.There is no plan.
The Senate received no briefing, no documents. Press reports, leaks mostly, are as accurate as anything the Admin. has discussed with the Hill.
There are only two conclusions to draw from this. Either Treasury has not yet decided on a plan. Or for some unknown reason has decided not to confide in the Senate Banking Committee.
The markets have anticipated both a stimulus bill and a comprehensive TARP 2. Instead, markets will get a stimulus bill with marginal value and a muddled TARP.
As one astute reader commented yesterday:
At least Paulson announced his plans. Not that he ever did anything he announced, but that’s a small technicality. These guys can’t even make an announcement.
Let us not forget that Paulson did manage to dispense the better part of $350 billion in a blinding show of Mussolini-styled corporatism. The new Treasury secretary exhibits similar Italian fascist tendencies, with even less ability to make the trains run on time.
Anonymous 
Posts
I just sent this letter to my Senators:
Senator Baucus,
According to this article in the New York Times (http://www.nytimes.com/2009/02/10/business/economy/10bailout.html?_r=1), the Obama Administration, under the advice of Treasury Secretary Timothy Geithner, will unveil a new bank bailout plan tomorrow which will “[abandon] any pretense about limiting the moral hazards at companies that made foolhardy investments, [and] will not require shareholders of companies receiving significant assistance to lose most or all of their investment.”
We’ve tried this approach since October 2007. It has failed every single time, and the nth iteration, if allowed to pass, will fail once again.
The entire venture of bailing out U.S. banks by purchasing or guaranteeing their assets is based on the premise that the market is somehow failing to identify their true value. Secretary Geithner wants to hand out guarantees and swap “cash for trash” in the hopes that, somehow, these assets will someday recover in value, and the taxpayer will be made whole.
Secretary Geithner could not be more mistaken. If he is allowed to implement this plan, taxpayers will ultimately be saddled with even higher losses than they have already borne, as the credit quality of these assets continues to deteriorate.
The NYT article claims that “there is no market value” for these assets, because they are not trading. In reality, there are plenty of people who would pay 20 or 30 cents on the dollar to take them off the banks’ hands. However, the banks will never sell the assets at this price, because to do so would expose their own insolvency. In New York, Chicago, and the other financial centers of the world, these securities could easily trade at such depressed values, because that is what they are worth. Only Washington policy-makers possess sufficient hubris and magical thinking to believe they “know better than the market,” and can turn a 20 cent security into an 80 or 100 cent one just by holding on to it for awhile.
If there’s no one in the market willing to take the bet that these assets are worth more than 20 or 30 cents on the dollar, why should Secretary Geithner be permitted to place that bet with the collective earnings and savings of U.S. taxpayers?
I believe it was an act of gross injustice to ask taxpayers to bear even one cent of the cost for the bad loans made by the banks. Those costs *should* have fallen on the banks’ shareholders and bondholders, who raised no alarms as executives levered up the banks’ balance sheets to place huge bets on real estate, (and even paid them lavish salaries for doing so!). However, even if you once believed that such an approach could save our banking system, surely you must agree that the taxpayer has been asked to bear enough, and a new approach is needed.
The fact is, the market has already pronounced these banks insolvent. They continue to exist only as beneficiaries of the Fed’s and Treasury’s largesse. I am as free market as they come. I voted for your Libertarian opponent. But even I would prefer either temporary nationalization or, better yet, a “cramdown” conversion of bank debt to equity (and dilution of current shareholders), to the continued transfer of wealth from taxpayers to bank shareholders and executives that Secretary Geithner’s plan represents.
The points I have made in this email are the same ones being made by economists and traders on the financial news every day. As the Chairman of the Senate Finance Committee, you are in a unique position to ensure that taxpayers are not stuck with the raw deal that the Obama Administration’s plan represents. Please, stand up for the taxpayer, tell the truth about this plan, and oppose any further bailouts or guarantees for bad bank debt.
Regards,
Andrew Bissell