GEITHNER PLAN FOR BAD ASSETS

For the full plan text click on 'comment' at the end of this blog. The popular criticism of this deal assumes that these assets will not recover value in the medium term and that they are so toxic that the defaults on the underlying assets will merely cost the government and FDIC (aka taxpayers) while banks and hedge funds (who will buy the bonds with TARP subsidy and FDIC insurance guarantee) will both make money. Geithner believes that the interest on the loans to the bank asset buyers plus a shared risk/return will in time prove profitable or negligible loss for government? This is part of a masterplan.Prof. James Galbraith, Univ. Texas, author of 'The Predator State' and Prof. Paul Krugman both are highly critical of the Geithner Plan. Krugman's view is that it is a complete mess based on a misunderstanding of how important 'confidence' is and that this is merely a repeat of the response to the S&L crisis. One context for this is the stress-tests dictated by FDIC for the top 19 banks. Krugman finds the stress factors to be too mild (see 3 charts on US economy below). The forecasts may be politically adjudged or simply the usual consensus type that smoothe everything and are unable to foresee short term shocks. Galbraith says that from Obama to Geithner to Bernanke, policymakers are like doctors dealing with a "mildly ill" patient vs. treating one who is "gravely" ill. The economist fears the economy is in terminal condition requiring much more intervention than already prescribed. Certainly, when for the first time in memory world GDP in aggregate is in recession and there are no external pull factors, only internal push, then fiscal stance and other measures have to be that much stronger. Krugman accuses Geithner of believing that if only the problem of toxic collateralized debt assets and their writedown effects can be cured, then the economy will pull through. Another way of putting this would be the idea that Geithner thinks if the CDOs are quarantined the following charts could be replayed backwards? Galbraith believes government "doctors" are engaged in a lot of "happy talk" about recovery based on a "fundamentally flawed model," hinged on the idea the economy is self-healing and only needs a booster shot before it "naturally" returns to trend growth and unemployment in the 5% range (the natural rate of unemployment concept that he rightly despises). He says success for the Geithner Plan is highly unlikely as it is framed so far, with limited direct scope for helping millions of Americans grapple with a crushing level of household debt. To help replace consumer spending, massive additional government action is necessary, he says, as discussed in the accompanying video link (URL at end of this blog) and in a recent Washington Monthly article.
I disagree that the assets are so toxic as the economists broadly suppose. The loan pools are amortising fast in the period when other measures are mitigating foreclosures and will in the medium term naturally improve in quality with much of the edge taken off by credit enhancements and foreclosure mitigation measures. Therefore, the defaults will not rise as high as otherwise. If the assets are representative of RMBS then 25% is sub-prime and default rates are heading for half of that. But the assets are already discounted 12-20% at the highest rated end, and first loss tranches may be witheld and kept on banks' books for work-out, assuming that is the nature of the $3-400bn of ABS and other impaired bank-credit derivatives left on the books on the top six US banks. My numbers are: Therefore the Geithner Plan may work in a contributory fashion, maybe, by helping the banks maintain a higher regulatory and economic capital reserve. My view is that these reserves need to be up around the $1 trillion level to cushion the next waves of credit risk losses that will eat into all of this. Geithner's economic modeling I believe, along with Krugman, is based on factor values of the mid-1990s to the 2001 recession. The world context is however more severe more aligned cyclically thanks to financial and trade globalisation than in previous recessions. The world's trade patterns are wholly disrupted and we have no certainty about the new shape to global trade and payments. In moving from a period of a decade or more when the US deficit was the counterpart to most of the rest of the world's trade supluses, now the rest of the world has to resort to domestic growth policies and had politically and otherwise almost forgotten how to do that! Geithner is buying time until end of September when the next federal budget is formed and the stress-tests are part of this. The banks will have their capital reserves next re-set in September. meantime he may hope that the credit default spreads that price the banks' CDOs will continue at a more realistic level. And then one consequence of that could be an easing of the interbank funding market. In my view, the Fed and US Treasury should simply de facto nationalize the interbank funding market for financing the banks' funding gaps. But there is immense political objection to more £trillions being facilitated. the general public do not understand what is on and off the taxpayers' federal budget balance sheet. The bailout measures are almost all off-budget and there is a balancing of assets and liabilities achieved to do this. It is not therefore taxpayers' money except in the broadest democratic political sense. To be effective the fiscal deficit needs the support of bank lending levels being kept up. The fear is that banks would have to deleverage by 30% or more if their capital reserves get wiped before debt recoveries start to flow back onto the banks' books. A remaining problem for the banks is financing their funding gaps. The US banks have had low issuance last year and this too so far compared to Europe. And that seems a major problem right now as I do not see the $1 trillion of assets to be sold off (beginning with $500bn only) to approved buyers as sufficient to solve that. There is little evidence of what the banks are acheiving in filling the $5 trillion or so refinancing they require for their funding gaps. Covered bonds and MT Note programs by banks are either down or out of sight. There is a fear that deleveraging will hit industry and corporate bond defaults will balloon. But, the publiv mood when the $trillion numbers get aired is very hostile and fearfully so. The government, banks and hedge funds all look like carpetbaggers to an angry mob. Underlying all this is the risk of prolonged recession (already 15 months old). Currently, it looks as if the majority of businesses are just about earning enough profit to make their debt interest payments. New corporate bonds are high coupon (junk bond rates) even for top retailers and manufacturers. Therefore, not a sign of restructuring of corporate debt to take advantage of historically low central bank rates. (For an exhaustive rip through the carpetbagger culture develeoping in the US see bankingeconomics.blogspot.com. 'The Great Game'). I prefer more repo swaps (after 25-30% haircuts) of the assets at the Fed liquidity window along the lines of the Bank of England's SLS and APS. In the US, if the assets all come off the top six banks' books who hold over 80% of banks' impaired securitised structured-credit assets then $1 trillion is a substantial cleaning out that should restore the banks' ability to hold or grow lending in the recession. This is not all totally toxic. In my alternative defaulting mortgagees motivated by negative equity to quit their homes should be banded together to gain direct benefit from the discounting of their mortgage debts and remortgaged to reflect that fall in the value of their mortgages. This is better than hedge funds being subsidised to gain the 17%-25% returns they are seeking from buying these bank assets. Hedge funds are evidencing some distress with number being bandied about that their funds are down from over $2tn to $1.4tn or $1tn only and how 20% of hedge funds are folding. But there are thousands of hedge funds and a mass of them are always folding, especially among the 1-5 man little hedge fund LLCs. And, sure, some big ones are in trouble, but there is no talk of these 'shadow-banks', including big private equity funds, are posing a systemic risk, unless maybe to some 'money market funds' but these are mostly bank-owned and robust. At the same time I also agree with Galbraith's alternative recommendations, which he says will cost $1-$1.2 trillion above plans already enacted, include: - Higher Social Security benefits: This will aid seniors hurt by the downturn in home prices, financial assets and the dollar's purchasing power. - More government hiring: Infrastructure spending can help, but major building projects can take years to gear up (a point also made by Prof Larry Summers, Geithner's colleague and ex-boss), and they can, for the most part, provide jobs only for those who have the requisite skills. Galbraith wrote, "So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing - why not?" I totally agree with this for a whole raft of reasons. Galbraith proposes a payroll tax holiday: "This is a particularly potent suggestion, because it is large and immediate," and puts income in the pockets of working families, he says. For me a key to recession-busting as it also is for development aid to poor developing countries, how to productively put money into the pockets of the poor, including poor pensioners especially, who all have the virtue that they spend what they get. Also, from Galbraith, Fix Housing: Put a moratorium on foreclosures and have the government buy homes from those homeowners who have no hope of making their mortgage payments, as detailed in a forthcoming segment. We may assume that the mortgage debts are thereby wiped out. This is implicit in the USA where the only collateral for the mortgage is the value of the home. In other countries any remaining debt remains an obligation on the mortgagee, and in Japan that can be multi-generational! Helping Main Street is already on the US policy agenda in the form of Fannie Mae and Freddy Mac re-negotiating mortgage contracts to restructure the interest and repayment burden to not more than 30% of mortgagee incomes. I would go for a halfway solution too, that of passing the debt discount right back into the original mortgage agreement thereby cutting back much of the negative equity problem. There is a logic, however, to the public housing solution in that the sub-prime crisis had its origins in the cutbacks by governments of spending on social housing to zero for nigh on two decades! Galbraith's view is that any or all of these programs "can be scaled back" as growth resumes, but that the government cannot afford to hold back any ammunition in its fight against the deflationary forces of the credit crisis. This echoes a similar view expressed by Martin Wolfe in the FT that I also very much agree with.
Some big banks that have received financial help are buying the 'toxic' assets. Citigroup and Bank of America, other banks and hedge funds, have been aggressively scooping up the discount-price securities in the secondary market. The banks' purchase of AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults. Yet both banks have been aggressive in their buying, sometimes paying higher prices than competing bidders are willing to pay. Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids. Geithner's Plan (PPIP) offers banks an arbitrage opportunity to neutralize the writedowns that the problem may require. A bank that will sell $10bn MBS to the PPIP that are on the books for 70c/1$and will sell for 50c/$1, requires writing down the 20s difference. The government has however tasked the banks to buy such assets and thereby try to bring more liquidity to the secondary market. The buying can also have been on behalf of customers. But it is also much cheaper to buy these assets than to create new assets, for the purpose of keeping up the bank's ;evel of loans to satisfy government requirement of not deleveraging in the recession. If the banks can buy artificially (turbulent market distressed prices) marked-down MBS for 30c/$1 and keep it on the books, as the PPIP makes a market for MBS off the bottom, the 30c cost basis MBS, if bought before the program starts, will now be marked up to the market price of 50c/$1, counterbalancing the bank's write down of the assests when
bought. The banks may also be helping to push up the market prices thereby revaluing all their holdings.
FDIC head, Sheila Bair, said she is open to banks taking equity stakes in those the public-private partnership funds as partial payment that will buy up illiquid loans from banks. The banks would be allowed to pay for their stakes with the very loans they are selling into the partnerships!
Citigroup, say, has CMB and RMB securities that have become toxic because Citi says they are worth 87c/$1 but the market thinks they are worth 30c/$1. Now, Bair, offers loans to buyers to pay much higher amounts for the assets because most of the purchase price will be subsidised by cheap government loans and exit clause contract. The bank then sells the assets to a special vehicle (SIV,SPE,or SPV) set up to pay for the assets. It gets an ownership stake in that vehicle in exchange for the assets. So the bank will trade the assets for ownership in a special purpose vehicle that owns those assets. Why would the bank want equity in a fund that is buying assets it is trying to get off their balance sheet - because the scheme involves a huge subsidy, allowing buyers to make double-digit returns even if half the assets they buy are worth nothing, or nothing until the property collateral is foreclosed on. Essentially, the PPIP deals allow banks to move their risk off-balance sheet, but with much of the risk also taken by government, which in itself builds in a price gain. Geithner et al is convinced that off-balance entities are the key to restoring the banks. The same has been happening in the UK with SLS and APS.

And for Tim Geithner's own views in the WSJ see: http://online.wsj.com/article/SB123776536222709061.html
Also See: http://finance.yahoo.com/tech-ticker/article/yftt_216311/Part-I-Geithner's-Plan-%22 and: http://finance.yahoo.com/tech-ticker/article/216690/%22Happy-Talk%22-Won't-Solve-Crisis-Galbraith-Says-Much-More-Govt.-Action-Needed;_ylt=AtCWuOtcOPiFarNfSB_.sHpk7ot4?Extremely-Dangerous%22-Economist-Galbraith-Says
and also
http://krugman.blogs.nytimes.com/2009/03/21/despair-over-financial-policy/
see also: http://topics.nytimes.com/top/opinion/editorialsandoped/oped/columnists/paulkrugman/index.html
Roubini echoes Krugman. He is the ultimate doomster. His economics consultancy estimates a total of $3.6tn of loan and securities losses in the U.S., including writedowns on $10.84tn securities and losses on $12.37tn unsecuritized loans ( emphasis on the word 'on' since these numbers are total outstanding). Roubini's view is that bank nationalizations are inevitable. I don't think he sees the technical problems of nationalizing without a change in the law first - the FDIC's legalistic view of the problem.
http://www.bloomberg.com/apps/news?pid=20601087&sid=aZXiD0hnsSD8&refer=home