GEITHNER PLAN PASSES WOLF AT THE DOOR

The above graphic is from the FT (11 Feb).
Congress and then the Senate agreed a compromise $789bn fiscal stimulus deal on 11 Feb (as Tim Geithner faced criticism that his separate US financial rescue plan for how to deploy the remaining $350bn of TARP funds lying with Congress that his plans lack specifics). The Stimulus package was caught up by the 'earmarks' that legislators can't resist attaching - it's how they pay their voters and their corporate sponsors - i.e. constituency-specific and industry-specific spending schemes, while TARP2 was unclear about whether to use the 'bad bank' option or credit insurance approach (my preference). Arguing about these matters is the political equivalent of head-banging by rutting bulls.
The stimulus package that tops up almost $500bn budget deficit based on election promises will signed by President Barack Obama by his target date of Monday 16 Feb, is smaller than both versions individually passed by the House and Senate.
After days of debate, speedy agreement reflected pressure by the White House. It trimmed tax cuts and health and education spending to keep the figure below $800bn, a ceiling insisted on by some Republicans and Democrats in the Senate. Geithner will urge other nations to join the US in taking aggressive action to fight the crisis at this weekend’s meeting of finance ministers and central bank chiefs from the G7 industrialised nations. Brown has gathered similar support among EU states (including the €80bn European Recovery Plan) to match the proportionality of the UK fiscal stance that is in turn proportionate with that of the US (8% ratio to GDP).
A US Treasury spokesperson said, “We will certainly be asking the others about their plans and encouraging them to take bold measures to help sustain the global economy.” The US understands countries had “different scope for actions” and indicates the US would seek to establish whether countries were doing all they are able to do, given their existing debt burdens. “That discussion needs to take place,” the official said.
Mr Geithner will set out the US Administration’s position in favour of reform of financial regulation that would make regulation “more consistent across the globe” and ensure “high regulatory standards that are applied across jurisdictions”. This is central to the G20 agenda. He told the Senate regarding the financial rescue plan: “I completely understand the desire for details and commitments. But we are going to do this carefully.” He left the door open for more bail-out funds at a later date. “We want to be careful before we come to you and ask for additional resources or authority that we have done so with as much care and consideration on design as possible.”
Most importantly he said regulators would use a stress test for big banks under the rescue plan to “provide a more realistic, forward-looking assessment” of the losses they might face. This could require banks to step up provisioning. The federal Reserve, like the Bank of England and the ECB are capable of doing these aggregate stress tests for the whole of their banking sectors. This data is essential to the banks own stress tests, because only by correlating themselves to the aggregates can they see the macro-picture of their risk stance.
They then must detail their own economic capital models. This requires a host of techniques and computing power that can be gleaned from www.union-legend.com and also www.bis.org for detailed quidance. It is this precise and complex area that banking regulators such as the FSA and the other EU national regulators have been chronically weakest on in advising their respective banks, insurers and other financial institutions! Weakness here is a failure of their fiduciary duty under the law as much as it is a faikure of the European banks under the law (Basel II, Solvency II, CRD, and now also IFRS7 accounting standards etc.)
The rescue plans are still attracting political criticism in the US. But Lawrence Summers, director of the National Economic Council (Economic Advisors to the President), said it reminded him of the initially negative reaction to the successful 1994 Mexico bail-out.
A second senior administration official said the plan was intended to ensure banks had access to a larger capital cushion to withstand the recession. This is somewhat disengenuous insofar as it presupposes that it is merely additional to minimum regulatory capital reserves, when actually double these are required. But, my view presupposes the results of the stress test, given that I've already done one for US banking (see www.union-legend.com). He also said the administration decided against providing insurance-style guarantees across the banking system because “guarantees could leave the government with risks it cannot price and cannot manage, and it looks like you are trying to avoid dealing with the reality of the situation”. This is opposed to my advice and the work undertaken at Columbia University that specifically recommends the insurance option. If the insurance option is couched in Basel II terms it is possible to provide a cap and therefore not to leave the matter open-ended. In any case, it is not the open-endedness that categorises the matter of the insurance option.
One reason for preferring the bad bank approach - essentially buying in illiquid assets - is to get these right off the banks' books. But, then while this frees he banks in the short term, they still should register the asset writedown losses and that hit their p/l severely short-term. After that, freed of having to work their way out of the illiquid assets, what are the safeguards in place to ensure they restore lending levels and do not build up new toxic assets oe become liable for credit derivatives they no longer have the underlying to support?
Investors (hedge funds) said they could be interested in investing in toxic assets alongside the government providing there was attractive government financing and guarantees – but that is a wholly unclear prospect. The FT has become during the credit crunch, the global paper of record, noit just for facts but for expert opinion and global debate. In the FT, Martin Wolf, engaged in a most unusual and important questioning (under the above cartoon, which while funny is an extreme simplification unfair to both Obama and Wolf's article). Woilf asks, "Has Barack Obama’s presidency already failed?" His political catchphrase for this is, "Doing too little is now far riskier than doing too much." By this line, Wolf is saying timing is more important than precision or trying to be so efficient that there is no redundency. It has been always part of democratic governments self-proclaimed prudence on behalf of the shareholders (taxpayers) interest that it should only spend the minimum necessary to achieve anything. In this case, facing the unknown, Wolf's argument is like that of a bridge engineer or dutch sea defences, better over-engineer, build higher, there may be worse to deal with than we think we know now. "If he fails to act decisively, the president risks being overwhelmed, like his predecessor. The costs to the US and the world of another failed presidency do not bear contemplating."
From a risk management perspoective this is sensible thinking, sound warning. The opponents of the idea are in various forms, those who view markets as incredibly delicate and complex that we can only tamper with gingerly, and those who are positioning to profit out of the crisis, the carpet-baggers who don't want to see the knocked-over chess pieces and broken china all set upright and glued together again occupying in their old places just as before. Wolf says, "Hoping for the best is foolish. He should expect the worst and act accordingly."
The banking programme seems to Wolf to be "yet another child of the failed interventions of the past one and a half years: optimistic and indecisive". Central to this view is how to balance two views of the crisis:
1: CONFIDENCE: it is a matter of restoring confidence, essentially to end the panic. Loss of confidence drove prices of bank assets below their long-run value.
2: SOLVENCY: it is a problem of insolvency i.e. financial, a matter of capital reserves because large systemically important financial institutions are technically insolvent: assets worth less than liabilities.
Taking the first view, governments step in to make a market, buy assets or insure banks against losses, the rationale for the original Tarp and the “super-SIV (special investment vehicle)” and the liquidity infusions by other central banks.
Taking the second view, given potential losses on US-originated credit assets alone of $2.2 trillion (€1,700bn, £1,500bn), $800bn more than estimated last October. (from possible peak losses on US ABS of $3.6tn, of which half were sold abroad).
Personally, I see this really as a timing probably, buying time. Confidence is a complicated phenomenon. It is very political. The US public did not want to vest confidence in the outgoing discredited Bush administration, but the want to find it in Obama. Brown found himself on both sides of that transition. He went through a period of dramatic loss of political support and is not clawing it back. Industries and many others including taxpayers and local governments all are scrambling to stake their claims to relief aid, sometimes to cope with budgetary difficulties they would have less grounds to complain about if there was not a recession and a banking crisis to blame.
The official response to the crisis has been to solve the financial crisis first and then to partner with the banks to solve the economic recession by together acting counter-cyclically to climb out of the trough and up into recovery and expect the good sense of this to be recognised and confidence then is restored. That gameplan may now have to be reconsidered? The answer depends on which will take longer to achieve, restoring confidence or restoring financial solvency? Both look as though they have long unravellings yet to come. The finance sector, the major banks especially, is proving to have more unplumbed depths and ramifications that are international/global as the world economy deteriorates, and will become ever more so. Tha answer may have to be tackling confidence and solvency, credit crunch and recession together at the same time as rapidly as possible, a shock-recovery as rapid nearly as the shock-collapse. One reason why is because time is not necessarily the healer when there is so much that has to unravel.
There are those who won't want a rapid recovery. They want to know the who, what and why of how we got into this mess and have those questions answered and the problems solved first. There are others who are positioning to be the new financial powerbrokers, the carpet-baggers, all those waiting to buy productive and financial and property assets dirt cheap. The idea of replacing the chess men on the board, the broken china figurines re-glued and back on the mantlepiece is anathema to many; they want radical change. That response is intllectually as well as emotionally a very strong one. An alternative to to put everything back as fast as we can so that economic dusruption to the world and our economies is less not more, and then at our leisure sort out the problems and fix the regulation etc. But, of course, do that and many will start saying where was the problem really, not a problem really that much at all? After all, Spring will come again and the flowers bloom around the Old Lady of Threadneedle Street. But is this the heart of the matter? Buying time and providing some cushioning still relies on the sensible shape of our capitalist system having enough shape-memory that all will spring back into good and sensible working? This is hoping for the best. Wolf's answer is that "rational policymakers must assume the worst". If the delicat swiss watch system of our financial economy is broken do we know enough about the bits and pieces to put build it all back again in good working order? Do we understand out own system that well? To some such questions may appear pointless or plain daft - of course we do and if nothing else we have to assume we do! Well, just as we are finding that the 1930s are not buried in the past, so too may other nightmares of the twentieth century be less lost to history than we have hitherto hoped and expected.
If governments over-respond now with excessive money generation and credit capital support, we may end up with an over-capitalised financial system. That we can fix. If the optimistic choice of doing least turns out wrong, we have zombie banks for years and zombie economies and discredited zombie governments. When democratic governments all lose popular support the alternative is the greatest nightmare of all. Therefore that much choice is surely a “no brainer”.
US Obama's new Geithner Plan and our UK Brown Darling Plan and their EU equivalents seem to make sense if and only if the principal problem is illiquidity. By that we mean wholesale funding of the banks 'funding gaps' that large amount of banks 'liabilities' filling the gap between total loans and total deposits. In the UK it is about £800bn or more than $1 trillion. In the USA it must be (say) about $6-8 trillions. We do not know what the cost of securing and pump-priming these are. We could assume something like £140bn and $1,200bn and this should be the order of the discount on covered bonds offered as collateral respectively by BoE and The Fed. BoE has already taken in £245bn collateral for £185bn treasury bills (discount writedown plus haircut of 25%). It is therefore not yet half-way there. The Fed’s ability to create money by purchasing assets is only limited by its balance sheet. Its balance sheet liabilities consist of bank reserves held on deposit and financial securities collateral plus Treasury deposits. Recently the Treasury sold a substantial amount of debt for the purpose of depositing the proceeds at the Fed. This allowed the Fed to double its balance sheet to about $2tn. The Fed is using this extra leverage to buy assets as collateral. Chairman Ben Bernanke says the Fed is taking an appropriate haircut and the Fed can sit on assets until they mature. This is a version of the Bank of England's SLS, which launched last April and has just been closed to be replaced with a permanent "son of SLS" to include a wider range of ABS than mainly RMBS hitherto. The Federal Reserve launched the Term Asset-Backed Securities Loan Facility TALF in November limited to ABS backed by credit cards, student loans, auto loans and SBA-backed small business loans, and has announced revisions to include investors, beginning this month, February. The additional facility is permits investors (probably only banks' originated SPEs, prime brokers' collateral holdings, and maybe hedge funds) to pledge recently issued AAA-rated ABS to the New York Fed in exchange for non-recourse loans. The Fed has said it would offer these loans for three years, rather than one year. It also said it would make loans available to "all investors" rather than picking recipients via an auction.
This goes beyond offering guarantees and buying some portion of the toxic assets, limited to the $350bn left in the TARP, which is what the legislators and the public see happening, and which experts know cannot alone deal with the insolvency problem.
TARP began as a one year program, but is now extended to three years. $250bn was used as 'capital infusions' into banks. These pay dividends. The stock may be redeemed after three years and the dividend amount rises to 9% after five years. (see Emergency Economic Stabilization Act). Other measures include:
Fannie, Freddie Loan Modification Program. The Federal Housing Finance Agency, Fannie Mae and Freddie Mac announced Nov. 11 a streamlined system to modify troubled mortgages. The plan is aimed at high-risk borrowers who have missed three or more payments, who occupy the house as their primary residence, and who have not filed for bankruptcy. The goal is to achieve an “affordable” monthly payment, which is defined as a payment of principal, interest, insurance and taxes that takes no more than 38% of the borrower’s gross income. Options to reduce monthly cost include lowering the interest rate, extending the maturity of the loan, and deferring payment for part of the principal. There is no requirement to use these three tools in any particular ratio. Servicers will be paid $800 per modification, a move that ensures they have a financial incentive to use the program. (Federal Housing Finance Agency) Shiela Bair, Chair of FDIC, Comptroller of the Currency John Dugan, and Director of Office of Thrift Supervision John Reich.
The Office of the Comptroller of the Currency on Nov. 21 unveiled a shelf charter, for how private equity firms can be approved in advance to buy a bank. This is important as private equity firms typically couldn't secure approval fast enough to bid for the assets of a failing bank. The FDIC followed that on Nov. 21 by announcing its own streamlined approval process for private equity firms that want to own banks. Both actions are intended to make it easier for private equity firms to purchase banks. (Office of the Comptroller of the Currency, FDIC) Private Equity Investments, whereby The Federal Reserve issued a 15-page policy analysis that expands acceptable private equity investment in banks and bank holding companies. Minority investors with between 10% and 24.9% of the voting stock of the company will be permitted to have a voting member on the board. It also expanded beyond 25% of equity the stake an investor may buy without gaining control of the institution. An investor may own up to 33% of total equity if it does not own 15% or more of any one class of voting stock. Finally, the Fed clarifies that non-controlling minority investors may communicate with bank management and advocate for changes in the bank’s policies and operations without being deemed to be in control. (Federal Reserve authority)
Money Market Insurance, wherebyThe Treasury insures money market mutual fund balances on deposit prior to Sept. 19, 2008. In effect, Treasury is guaranteeing the funds will not break the buck. (Treasury authority) Money Market Investor Funding Facility whereby to provide a means for money market mutual funds to become liquid even if they are investing in longer duration assets. The New York Fed will provide secured financing to five private-sector SPVs. These vehicles will purchase CDs, bank notes, and highly rated CP. This only is open to regulated money market mutual funds, and total size is capped at $600 billion.
Mortgage/MBS Purchases limited to troubled assets that are residential and commercial mortgages and related securities as well as other financial instruments that Treasury and the Federal Reserve believe it needs to buy to ensure stability. Treasury shall make purchases at the lowest cost consistent with market stability and it should use market mechanisms. For direct purchases, the price must be reasonable and reflect the underlying value of the asset. Purchases and prices must be disclosed within two days. Financial institutions in the program must provide warrants for nonvoting common or preferred shares. It does not specify the stake, but says it must be “reasonable participation” for the benefit of taxpayers. Stakes are not required for purchases of less than $1 million. This was on hold, though the new administration could revive it. (Emergency Economic Stabilization Act)
Interbank Loan Guarantees, using the FDIC debt guarantee program to effectively guarantee interbank loans. As a result, there is no need for a separate interbank guarantee. (FDIC authority) IRS Tax Change on Carrying Losses Forward. A new change permits a bank that incurs losses through an acquisition to carry all of those losses forward over 20 years. As a result, this becomes a lucrative way to reduce future IRS tax bill. Commercial Paper Market. Federal Reserve assurance to investors that if they purchase commercial paper that they will get repaid even if the company cannot rollover the debt. (Treasury, Federal Reserve Plan). Treasury officials believe they have the power to use TARP to take second loss positions and provide other types of credit enhancements, using enhancements and leaving the assets at the bank rather than purchasing them outright (e.g. the FDIC mortgage modification plan). This was used as part of the Citigroup stabilization effort. (Emergency Economic Stabilization Act).
It is hard to say, but my guess is that all these measures, the ones that are active so far, to date should have taken in about $2.5 trillions of assets in exchange for $2 trillions in liquidity infusions. This is only covering one third, possibly only one quarter, of the US banks funding gap.
Any toxic asset purchase or guarantee programme are only an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions, if government must buy vast amounts of doubtful assets at insufficiently discounted prices or provide over-generous guarantees, to render essentially insolvent (in liquidity risk terms) banks solvent.
But, I would be amazed if the discounts and haircuts are not at least 25%, which for assets that are broadly representative of bank loan assets should easily provide profitable security in short, medium and even longer term. These assets are wrapped up as long term paper. In the case of UK banks the paper is 40-50 year paper. Thus the securities have a far longer life than the underlying loans. If the banks can roll-over the treasuries obtained and continue to do so, in which case holding the treasuries on deposit at the Fed would seem a good idea, they then have a long term high grade funding program and will not need to return to interbank markets for that portion. Where government is obtaining a good interest above LIBOR this income should compensate for corporation tax losses in the coming years.
It would be inefficient if big capital injections or conversion of debt into equity are better ways to recapitalise banks, and inequitable, if big irrecoverable subsidies would go to failed institutions and private buyers of bad assets. What is at risk is if the administration trades broader economic gains for giving up the profitability to it and taxpayers of how its recapitalises and provides liquidity to the banks. That would be a weak form of just hoping for the best.
We have to precisely ask what is the exact scale of what needs to be done to be sure of a solution? The answer concerns the following: the banks' funding gaps and their losses that have to be taken against capital reserves. The capital reserves I estimate will be wiped out twice and the funding gap could need 100% funding. In total this is $10 trillions. But this can be treated as busines sinvestment and not as aid. If Government supports the banks, they surive and government should earn a business return. Currently that varies between 9% for shares and about 4% for loans. Assuming a 5% return on $10 trillions, all of which can be off-budget, then the return is (say) $500 billions, this business balances the Federal Budget.
In fact $500bn currentl exceeds the total stock market value of all US commercial banks (about $400bn).