Tuesday, March 24, 2009

If $1 Trillion Is Not Enough to Address All Toxic Assets, Why Bother in the First Place?

It is generally agreed that the size of the problem is 2x-3X larger than the Treasury Department's Public Private Investment Partnership (PPIP) announced last week. The mechanics of the plan can be found here and I wrote about it in two posts below, focused mostly on the incentive scheme. So, what's going on here? Is the administration totally tone deaf to the magnitude of the problem? If not, why not use the Powell Doctrine of overwhelming force and summon enough fire power once and for all? And what about the question of whether this will work at all without nationalizing the problem banks?

To answer these questions involves a great deal of suppositions but maybe here's whats going on:

1) In light of the administration's ambitious fiscal agenda (and no intention to scale it back) , combined with tremendous bailout anger/fatigue, the political will to ask for (and secure) more funding than available from TARP does not currently exist,

2) nor does the appetite for full scale bank nationalization,

3) PPIP will force price transparency for toxic assets (currently absent) and, when combined with the "stress tests" to be finished sometime in April, will more clearly delineate good (viable), bad (viable with assistance) and ugly (insolvent) banks, so

4) the good banks will be able and willing to begin cleaning up their balance sheets, paving the way to recapitalization and the ability to begin lending again, at which point with the financial system partially under repair it will

5) be apparent that PPIP has done some good but requires more funding to finish the job and

6) at that point it will be significantly clearer which major banks will have to be nationalized and how that would affect counter-parties (not readily apparent today) so we don't repeat the enormous dislocation caused by Lehman's failure.

So while academics and textbooks might clearly tell you where you need to get to and to do it posthaste, in practice, there are speed bumps caused by the mechanics of politics and more importantly the difficulties of renovating when plans are still mostly wanting or suspect. There are clearly many risks in this incremental approach but here are some of the bigger ones.

1) The two step process of the government inducing and funding private bidders is overly complicated and no one shows up for the party---I doubt it, the incentives are enormous in general and with respect to the part of the program focused on purchasing asset backed securities (see my posts below) the bidders will be hand picked (and/or arm twisted) by Treasury.

2) You don't get the full price discovery needed as banks choose not to offer all their assets at auction---Treasury through its TARP investments and the Fed through its oversight role will clearly have to apply appropriate pressure where needed.

3) The auctions make things much worse for some banks as the bids come in materially below where they are willing to part with the assets, and whether they take those bids or not, are forced to materially mark down those assets to the point of insolvency---the significant non-recourse leverage provided bidders incents them to bid significantly higher than the current "unlevered" environment (where bidders can't get private sector loans) and, again, perhaps the plan is to rapidly separate "wheat from chaff" on the road to specific nationalization of large banks.

4) We're just putting lip stick on a pig, creating a new set of "off balance sheet" (from the banks' perspective) special investment vehicles (SIVs) that will inevitable blow up 8-10 years down the road. That's one way to describe what's happening but practically speaking, these portfolios will get priced, one way or another, to yield hefty cash flows (even with big defaults) which when compared to the low cost of money borrowed from the government, should ultimately earn handsome returns for patient (mostly taxpayers who have no choice) investors. If the prices paid for or used to mark the portfolios of a given bank, and add up in total to something less than liabilities, then they are headed to the nationalization butcher shop in those specific circumstances.

5) What the plan clearly doesn't do is prevent this mess from happening again in the future. That will fall to new regulatory schemes which I will not deal with here but the most important aspects will be a) putting all derivatives into a box where they can be dealt with (read my post below) and b) moving from a mindset of "too big to fail" to "too big to begin with" (you must read Simon Johnson's article in the Atlantic).

So, this plan is a good start at the current toxic asset (therefore toxic bank) mess but clearly just the beginning of a multi-step process, the later details of which are still waiting to be written. It will certainly help to separate the good (banks), the bad and the ugly --- paving the way for the good to get back in business, the bad to get help and the ugly to disappear altogether. And it will hopefully set a marker for what Europe must begin to do to address its even bigger banking problem, which up to this point they have been largely avoiding. And with that I await to see what of substance will come out the G-20 summit---unfortunately and in all likelihood, nothing.

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