Submitted by Edward Harrison of the site Credit Writedowns
Edward Harrison here. This is a post I published just last night over at Credit Writedowns with some minor edits.
Barack Obama’s presidency will likely be decided by one single issue – his ability to deal with this financial crisis. With the release of his Treasury Secretary Tim Geithner’s Public Private Partnership Investment Program two months into his administration, we now have a fairly comprehensive view of Obama’s strategic approach. Will it work?
To cut to the chase, I believe this strategy could be successful in rekindling some increasing credit liquidity and, therefore, some consumer demand. However, the strategy will not be successful in eliminating the underlying causes of our crisis – excessive leverage and insolvency — and therefore systemic risk will remain.
My baseline view is that an unresolved crisis could lead to a worsening economy. The loss of political capital and popular support that would result would cripple Obama’s administration. Nevertheless, President Obama may yet be successful in reinvigorating the economy due in part to economic and fiscal stimulus — and, thus, escape a worst-case outcome.
In looking forward, four critical factors will be determine Obama’s fate:
- Success of Geithner’s Plan: in my view, Barack Obama’s fortunes depend in the main on Geithner’s Public-Private Partnership Plan. If this plan is unsuccessful, Obama is sunk. The plan has merits, but many deficiencies as well.
- Efficacy of Economic Stimulus: I have said often that Obama’s stimulus will not be sufficient given the state of the economy. Recently revised budget projections from the Congressional Budget Office confirm this — the budget deficit, therefore, will be significantly worse than originally projected. Nevertheless, the Japanese experience in the 1990s demonstrates that even a depressionary economy can experience brief respites from economic turmoil. This could be Obama’s saving grace.
- Ability to connect with disenfranchised: Populist sentiment is running high because people have finally realized that the last quarter-century or more has seen a massive divergence of economic fortune between the wealthy and everyone else. In essence, while credit was flowing and asset prices rose, ordinary Americans appeared to prosper along with the wealthy. However, now that credit revulsion has replaced easy money, it is plain to all that standards of living will decrease. President Obama would be wise to use his inner Bill Clinton and demonstrate he can “feel your pain” or he risks being perceived as aloof.
- Will in setting political agenda: The Republican party was in tatters after the 2008 election, giving Barack Obama a free hand. In my view, Obama has grossly miscalculated politically on numerous occasions. This has cost him political capital. Whether he can reassert his agenda now — with Democrats in Congress responding to populist sentiment out of self-preservation and the Republican party newly reinvigorated — remains to be seen.
I think it is important to lay out the background before going into the specifics of this plan. Let me say upfront that this financial crisis — in term of scope and complexity — is as great as any the world has ever witnessed, including the Great Depression. Indeed, its complexity may make it even greater. However, it is the policy response that can alleviate or exacerbate the severity of such a crisis.
Leverage, in a nutshell, is what led us to this point. For a variety of reasons (which I don’t have space to review here), the leverage in our global financial system – as represented by credit outstanding and credit derivatives has mushroomed out of all proportion to the underlying economy. This was a credit bubble, plain and simple, and it was destined to pop.
When it did pop, it was manifest first in the U.S. subprime market as this was the weakest link in the chain. However, policy makers were unable to ring-fence the problem and the crisis crossed over into numerous related and unrelated markets which have become dependent on leverage or liquidity.
Eventually, this credit crisis became a full-blown banking crisis as the attendant de-leveraging created such tremendous asset price deflation that financial institutions were forced to write down their assets by hundreds of billions of dollars. Therefore, capital adequacy at many financial institutions reached a distressed level, triggering a crisis of confidence and the bankruptcy of major institutions like Lehman Brothers and Washington Mutual.
After this point, the main question for most policy makers was this:
Has the de-leveraging and asset price declines which triggered the banking crisis been excessive? If asset price declines have indeed been overdone, many troubled institutions are stressed more due to ‘irrational despondency’ than any inherent capital inadequacy. On the other hand, if asset price declines represent a reversion to the mean, large swathes of the banking sector are effectively insolvent.
In my view, the Geithner Public-Private Partnership plan implicitly takes the former view – that asset prices are artificially depressed, creating weakness that should not exist. Treasury’s press release yesterday says as much (note the sentence I have bolded):
The challenge posed by these legacy assets began with an initial shock due to the bursting of the housing bubble in 2007, which generated losses for investors and banks. Losses were compounded by the lax underwriting standards that had been used by some lenders and by the proliferation of complex securitization products, some of whose risks were not fully understood. The resulting need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.
Success can still mean defeat
Unfortunately, Geithner’s view is not a correct interpretation of events. While prices have declined considerably in a number of markets, often to excessively low levels, there are many other assets which will become impaired going forward or have been impaired, but have yet to be written down. Commercial Real Estate, credit cards and prime mortgages are all distressed markets where one should anticipate further writedowns. So, even if the Treasury’s interpretation of events is correct — that many asset prices have fallen too far — it is irrelevant because there are so many more writedowns still to come.
Let’s assume the Geithner plan will be successful in increasing the prices of the assets it targets (even though this is far from a good assumption. See Yves Smith’s take on this). But, we have a workable plan here, and let’s assume it can get the job done to boot. Mark Thoma does a good job in presented a balanced picture.
I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be “socialist,” and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear…
So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none – to me – is so off the mark that I am filled with despair because we are following a particular course of action…
What’s important to me is that we do something, that we adopt a reasonable plan that has a decent shot at working and that satisfies the political test it must pass (though the administration could certainly do more to sell the plan to the public and help with this part, so passing the test is partly a reflection of the effort that is put into selling it). We’ve been spinning our wheels for too long, and it’s time to get this done. We can’t wait any longer.
So I am willing to get behind this plan and to try to make it work. It wasn’t my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There’s still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.
What’s more, we have the TALF (Term Asset-Backed Securities Facility) and other programs sponsored by the Federal Reserve as well. That’s a lot of firepower.
But, what happens then if economic weakness creates more losses on other asset prices? As an example, what if credit card charge-offs increase much more than is anticipated and prime mortgage defaults increase equally dramatically?
In that case, this program will be insufficient and another round of asset buying, bailouts or nationalization would be necessary. Given the bailout fatigue we are already seeing, I reckon it will be impossible to allocate more federal monies to bailouts or buying toxic assets.
I do anticipate many more writedowns irrespective of what happens with the TALF, TLGP , the Public-Private Partnership or any of the other plans. Therefore, the likely result of this program is the nationalization or bankruptcy of a more weakened banking system down the line. This will end up costing considerably more to fix than had the nationalization/ bankruptcy been achieved on the first go round.
So, to be clear, even if Geithner is successful here, I believe the plan will end costing more than had he bitten the bullet now. This will weaken the economy and cost Obama politicially.
Stimulus too small
Meanwhile, I also have lingering doubts about President Obama’s stimulus package. The Obama Administration based its stimulus on projections for unemployment and economic growth which have proved optimistic. The loss in spending from consumers and local and state governments will be too great for the stimulus to have an overriding influence on the near-term economy. (See my posts “Obama takes middle road on stimulus and taxes that leads nowhere” and “Will federal largesse be countered by state and local cutbacks?” for a fuller analysis). If you believe fiscal stimulus is the correct way to combat this crisis, then you are likely to be disappointed by the outcome.
But, does that mean Obama is sunk here? No. If one considers the Japanese experience, it is obvious that even in the face of a weak banking sector, asset price and retail price deflation, and depression that cyclical rebounds are the norm. If you recall, Japan had several upswings during its lost decade. Events could turn out similarly in the United States.
Nevertheless, the underlying leverage would still remain even if we were to experience an upswing due to monetary easing and/or fiscal stimulus; the financial system would still be in a state of stress. As in Japan, the systemic weakness — and with it asset price weakness –would reassert itself when the economy turned down until the leverage was worked away.
Therefore, I strongly suggest that we are on course for a Japanese outcome at best here.
Where I am most worried going forward — as it relates to a positive outcome for the economy and confidence in our system — is in regards to the Obama Administration’s inability to stay on the right side of the rising tide of populism. Arianna Huffington says this well:
On February 10th, the New York Times reported that there had been a “spirited” battle within the Obama administration over restrictions on executive pay and bonuses, and over attaching stringent conditions to any bailout money given to banks.
The clash pitted Tim Geithner, who opposed the restrictions and conditions, against David Axelrod, who favored them. According to the Times, Geithner had “largely prevailed.”
In light of what has happened since then, that outcome must now be viewed as a tragic surrender to Geithner, Summers, and the political/Wall Street class — a “victory” that could lead to the unraveling of the president’s entire economic policy.
Maintaining the public trust is always important for a leader, but especially so during hard times. There is a fascinating chapter on Nelson Mandela in Stan Greenberg’s new book, Dispatches from the War Room, in which Greenberg writes about how even the revered Mandela suffered a loss of public confidence when change did not come fast enough after he took office. “Don’t assume the current euphoria, even with your high approval rating will carry you through,” Greenberg counsels Obama, stressing the need to try to build up enough trust so that the public will stay with the president until they can actually experience change.
The Axelrod camp understood this and, according to the Times‘ February story, argued that “rising joblessness, populist outrage over Wall Street bonuses and expensive perks, and the poor management of last year’s bailouts could feed a potent political reaction if the administration did not demand enough sacrifices from the companies that receive federal money.”
Axelrod was right. And his loss has already cost the young Obama administration a lot.
In my view, the Obama Administration, through its actions to date, has already politically cast its lot with the monied class. On Obama’s watch, we have the Citigroup situation, the Bank of America bailout, the Merrill Lynch bonus scandal, the AIG bailout and bonus scandal, the furore over golf tournaments and the backdoor bailouts under TALF and the Public-Private Partnership. All of these events demonstrate a transfer of wealth from taxpayers to the monied interests of the financial sector. Yes, none of these events individually is a fatal problem. However, taken as a collective, the preponderance of evidence points toward an Administration which will increasingly be seen as more aligned with Wall Street than Main Street. This is a catastrophe for a man who campaigned on “Change you can believe in.”
And, what’s more, with the die now cast on most of the major financial crisis efforts, Obama has no obvious opportunity to win back all of his credentials as a man of the people. I see this as a ‘Katrina’ event, which changes the perception of the public inexorably. Therefore, the Administration will come under greater scrutiny by the media and the public going forward. New York Times columnist Frank Rich wrote an excellent article detailing this:
To get ahead of the anger, Obama must do what he has repeatedly promised but not always done: make everything about his economic policies transparent and hold every player accountable. His administration must start actually answering the questions that officials like Geithner and Summers routinely duck.
Inquiring Americans have the right to know why it took six months for us to learn (some of) what A.I.G. did with our money. We need to understand why some of that money was used to bail out foreign banks. And why Goldman, which declared that its potential losses with A.I.G. were “immaterial,” nonetheless got the largest-known A.I.G. handout of taxpayers’ cash ($12.9 billion) while also receiving a TARP bailout. We need to be told why retention bonuses went to some 50 bankers who not only were in the toxic A.I.G. unit but who left despite the “retention” jackpots. We must be told why taxpayers have so little control of the bailed-out financial institutions that we now own some or most of. And where are the M.R.I.’s from those “stress tests” the Treasury Department is giving those banks?
That’s just a short list. In general, it’s hard to imagine taxpayers shelling out billions for a second bank bailout unless there’s a full accounting of every dime of the first, and true transparency for the new plan whose rollout is becoming the most attenuated striptease since the heyday of Gypsy Rose Lee.
Another compelling question connects all of the above: why has there been so little transparency and so much evasiveness so far? The answer, I fear, is that too many of the administration’s officials are too marinated in the insiders’ culture to police it, reform it or own up to their own past complicity with it.
The “dirty little secret,” Obama told Leno on Thursday, is that “most of the stuff that got us into trouble was perfectly legal.” An even dirtier secret is that a prime mover in keeping that stuff legal was Summers, who helped torpedo the regulation of derivatives while in the Clinton administration. His mentor Robert Rubin, no less, wrote in his 2003 memoir that Summers underestimated how the risk of derivatives might multiply “under extraordinary circumstances.”
Given that Summers worked for a secretive hedge fund, D. E. Shaw, after he was pushed out of Harvard’s presidency at the bubble’s height, you have to wonder how he can now sell the administration’s plan for buying up toxic assets with the help of hedge funds. It will look like another giveaway to his own insiders’ club. As for Geithner, people might take him more seriously if he gave a credible account of why, while at the New York Fed, he and the Goldman alumnus Hank Paulson let Lehman Brothers fail but saved the Goldman-trading ally A.I.G.
As the nation’s anger rose last week, the president took responsibility for what’s happening on his watch — more than he needed to, given the disaster he inherited. But in the credit mess, action must match words. To fall short would be to deliver us into the catastrophic hands of a Republican opposition whose only known economic program is to reject job-creating stimulus spending and root for Obama and, by extension, the country to fail. With all due deference to Ponzi schemers from Madoff to A.I.G., this would be the biggest outrage of them all.
Obama is weakened politically (not unlike George W. Bush after Katrina). He is not perceived as the change agent he has claimed he would be. The media are certain to pick up on this and start asking difficult questions. Congress will be emboldened to go against his counsel as well. All of this will make his job as President considerably more difficult.
There is no second go round
As a result, I do not believe that Barack Obama will get another chance at stimulus or at bailouts if the economy sinks. He has expended too much political capital in achieving what he has achieved thus far.
This is why I have decided to get onboard with this package. Honestly, I do not think it will be entirely successful – the writedowns in commercial real estate for one are too many. But, too much time has passed and there is zero opportunity for another solution at this point. The Geithner plan is all that we are going to get for the majority of 2009. So we better hope it works.