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Market Likes Geithner Plan: Why?   March 23rd, 2009
It seems today's amazing rally might be irrational exuberance       


More observations...

This is a good day for President Obama and Treasury Secretary Geithner. It marks the first day they've said anything significant about the economy and the market didn't dive. In fact, the market reacted very positively: A rally of almost 500 points (6.8%). That's an amazing one-day rally by any standard.

It seems the market reacted a bit irrationally to the Geithner plan. The plan announced today basically seems to be the same as the original TARP plan proposed by former Treasury Secretary Paulson last September (but later abandoned), whereby the government would buy toxic assets. The only real difference seems to be that they are trying to use some incentives and participation by the private sector to help determine the value of the toxic assets.

In short, the plan seems to amount to: The Federal Government will buy all the toxic assets, assumes virtually all of the risk, and shares any profit with private investors whose only real assistance is in helping the government determine the purchase price for assets.

Reviewing the Problem

The problem is that banks have "toxic assets" (which the Treasury plan is calling "legacy assets") on their books. These are assets that have a certain value on paper, but which no-one is really sure is a realistic value. Since lately many mortgages are going bad, the bank doesn't know how many of the mortgages making up the asset will go bad and so the asset might be worth far less than what it's worth on paper.

This presents a problem because banks require a certain amount of capitalization, or "reserves." If a bank has $1000 in assets then it may be able to loan out $800 (80%). But if one of those assets is a $100 asset that might only be worth $50 (or, in an extreme case, nothing), then the bank isn't sure whether it has $1000, $950, or $900 in assets. As a result, the bank doesn't know whether it can loan out $800, $760, or $720. Since the bank is nervous, it doesn't want to loan out $800 and then find the value of the asset is only $50 which means they only have $950 which means they should've only loaned out $760.

So the problem is that while these assets are on the banks' books, the banks are less likely to lend since they don't want to be caught undercapitalized if the asset turns out to be worth less than they think. They would just assume sell the asset to some investor for $100 so they know they have $100, but investors don't want to pay $100. Since the asset is probably worth less than $100--but no-one knows exactly how much--the investors might offer the bank $50 or $60. The bank, assuming the asset is worth $100, laughs in their face. They'd rather keep the asset than get half of what they think it's worth.

So the "toxic assets" remain stuck with the banks and the banks get stuck not loaning as much money as they otherwise might be able to. Plus the $100 value of the asset might continue to drop... and, again, since the bank wants to have sufficient capital to cover the possibility of further drops, the bank will tend to hold on to cash rather than loan it out to prepare for the possibility that that $100 asset will be worth $90 tomorrow.

But it should be mentioned that there are potential investors out there already that'd be willing to buy the assets... it's just that they want to pay a lot less than the price at which the banks are willing to sell.

An Example of "The Plan"

Here's an example of how the plan proposed today might work.

As above, a bank has a $100 asset that might be worth less. It wants to sell it but can't find a buyer at a price the bank likes.

So the bank would go to the FDIC and let them know it wants to sell the asset. After a review, the FDIC would set up an auction so that potential investors can bid on it. One investor might offer $50, another $60, and another $84. The investor that offered $84 would win--the bank would immediately lose (write-down) $16, but would have $84 in cash... presumably to lend out.

Of that $84 paid to the bank, the FDIC would put up 85% ($72), the U.S. Treasury would put up 7.5% ($6) from the TARP funds and the investor would put up 7.5% ($6)--but the investor might borrow the $6 from the federal government. If the value of the asset drops from $84 to $64 (a loss of $20), the investor would lose the $6 he invested and the government would lose $14. If the value of the asset rises from $84 to $108 then the government gets $12 and the investor gets $12.

This is potentially attractive to the private investor because, in the above example, he invested only $6 but earned $12--that's a 100% return. And if the asset drops $20, he still only loses the $6 he invested.

Meanwhile, the government would put up $78... if the asset drops by $20 then the government loses $14 (since the other $6 would be lost by the investor). But if the price rises by $24, the government only gets $12.

The investors puts up less but stands to gain a far higher percentage. The government puts up more but stands to gain less and can lose far more.

Potential Problems

There are quite a few potential problems here.
  1. Will banks sell assets? If a bank has an asset it thinks is worth $100 and the auction only returns an $84 bid, would the bank be willing to immediately lose $16 by committing to the sale? A very cautious bank might look at it as an opportunity to cut its losses, but it might also prefer to just wait it out and see if the value of the asset eventually recovers.
  2. Is it fair to banks? Think about the example above where the bank agrees to sell it for $84 and then the price later rises to $108. The bank will have lost $16 but some investor that only put up $6 would stand to reap a profit of $12. Is it fair for an investor that only risked $6 to get a $12 payout while a bank that risked $100 loses $16? Will banks go for that?
  3. Why should banks have to sell? This basically amounts to a government guarantee if (and only if?) a bank sells the asset to someone else. In other words, if the bank keeps the $100 asset on their books and doesn't sell it, they have no protection regarding the value of the asset. But if they sell it to someone else then that "someone else" buys it for $84 and knows it won't be worth less than $72. Why should the opportunistic investor get a minimum value guarantee from the government but the bank, which might hold on to the asset at no cost to the government, can't get that same guarantee?
  4. Will FDIC bids be higher? As mentioned, there are already buyers in the private sector willing to buy these assets. The problem is they may only be offering $50 when the banks are asking $100. An important question is whether this auction plan will generate bids that are high enough to get the banks' interest. If the bank asks for $100 and investors were offering $50, will an auction really generate an $84 bid, or would the bid maybe only be $80 or $70? And would the bank really go for that offer?
  5. How does government pay for it? In this plan the investor is only paying about 7%. The Federal Government and/or the Federal Reserve pays for 93% of it. For all sense and purpose, this plan amounts to the Federal Government buying the toxic assets. Where does the government get the money to do this? Are we just going to keep printing it? The plan says that 85% of the money will come from the FDIC, but the FDIC doesn't have any money.
  6. Why share so much with investor? If an investor is only contributing 7% to the purchase, why give him 50% of the profits? The argument is that this is necessary so that the investor will participate and market forces can determine the price of the asset. But a consensus of a few investors making a competitive bid is not certain to correctly price the asset anyway. It's not clear how much pricing information this process will really provide. If it were this simple to determine the price of the asset, banks would already be implementing some market-based system to get investors betting on the price... then the price would be known and the bank could keep the asset at that known value. A half dozen blind investors that don't know the value of the asset aren't going to produce a significantly better estimate of its value than one blind investor (or the bank itself).

Complaints and Observations from Around the Country

Democratic Representative Brad Sherman complained about the unequal sharing of profits and losses between the investor and the government:

Rep. Brad Sherman, D-California, slammed the plan, saying it treated banks better than taxpayers...

Taxpayers "are going to overpay for some, they are going to underpay for others. They are going to make money on some. They are going to lose money on others. [But] when they make money, half the profit goes to Wall Street. When they lose money, 94 percent of the loss goes to the taxpayer."

Others observe about whether or not the banks will participate. As mentioned above, there are already potential buyers for the toxic assets... the problem is that the banks aren't willing to accept the price that the investors are willing to offer. So will this FDIC-based auction system really produce bids that are high enough to motivate banks to participate?

"The continuing unaddressed issue is why the banks will sell to market bidders under this program when they haven't been willing to sell to market bidders previously," said Brian Olasov, a managing director at law firm McKenna Long & Aldridge, which represents distressed loan servicers, investors and sellers. "Cheap leverage through FDIC guarantees helps, but won't bridge the bid-ask spread for a number of distressed debt investors."

Banks might also be hesitant to participate because they fear the government will change the rules after the fact:

Another factor that could limit the program's success is fear among investors that Congress will reprise its role in the AIG bonus scandal of recent weeks and decide after the fact to impose restrictions on participants.

"The rhetoric of Congress might increase the risk premium investors demand, which would reduce prices," said Todd Cohen, who manages the CRA Qualified Investment fund, a medium-term fixed-income fund that invests in government-related securities. "Last week added a lot more risk to the program."

Even liberal economist Paul Krugman, a Keynesian that is basically on Obama's side of economics, is not optimistic:

Why was I so quick to condemn the Geithner plan? Because it's not new; it's just another version of an idea that keeps coming up and keeps being refuted. It's basically a thinly disguised version of the same plan Henry Paulson announced way back in September.

Meanwhile, Republicans still believe their alternative (proposed but largely rejected during the TARP debate in September)--is the better solution:

Cantor, the No. 2 Republican in the House of Representatives, argued that Geithner should have instead adopted an insurance-based plan put forward by the congressional GOP last fall.

Under that plan, banks would have paid over time for any assistance required to clear their books of toxic assets.

"The Republican insurance-based model institutes a system of government insurance guarantees to provide certainty to investors," Cantor said. "It would act as a containment plan to wall off toxic assets from the rest of the economy and bring liquidity back to our financial markets."

So Why did the Market Rally?

As we've seen, the plan has some serious logical flaws. It also seems that it has been panned from both sides of the aisle and from both Keynesian and Austrian School economists. It's been overwhelmingly recognized by both sides as a thinly veiled revision of the original goal of the TARP bailout: Buying out the toxic assets. It also isn't clear there's enough money for the government to do all this purchasing.

So we have politicians on both sides attacking the plan, economists on both sides skeptical of the plan, and it seems pretty clear this is just a rehash of the same failed TARP package.

So why the excitement in the market? I suspect people with a lot more market experience than I will be making suggestions. But I'm going to make a few of my own.
  1. Bank Rally. At first glance it would seem this is a way to get rid of toxic assets which would help banks. Perhaps in a rush to judgment, investors in the market assumed this would just work without asking themselves "how." How will it work if the auction doesn't provide a price that the bank is willing to accept? Perhaps this is a simple rush to an irrational first reaction without adequate thought.
  2. Certainty. Regardless of the effectiveness of the plan, investors may simply feel there is some certainty to cling to. If anything has been missing since Obama took office, it's details. And the market can hate uncertainty as much--if not more--than the certainty of a bad plan. So maybe this is just a reaction to having some certainty as to what to expect in the future.
  3. No Socialization. While this plan institutes significant levels of moral hazard, at least there was no apparent indication that the administration wanted to nationalize banks or further dilute shareholder value. Maybe that's enough to cause excitement at this point.
  4. Profit Potential. Perhaps the same investors that moved the market today were excited because they realized they could invest $6 and get $12 or more back. The investor that puts up 7% to the government's 93% has the possibility of making some serious money. It's certainly a good deal for the investor. So maybe lots of market participants became encouraged because they see this as an awesome opportunity.
I honestly don't know. I was completely surprised to see this rally. The plan seems to me (and apparently many others) to be a rehash of the old plan but with the new detail that any profit that might possibly materialize will now be split with a private investor; and with the little detail that the government doesn't have the money to adequately fund this proposal anyway.

Perhaps the market reacted positively because it sees this as huge profit potential with the government taking on almost all the risk. But it seems like this rally would have to be short-lived because eventually the market is going to realize that it won't automatically make the bidder and banks see eye-to-eye regarding the value of the asset, and the market will realize the government doesn't have enough money to pay for this... unless it prints more money and further devalues the dollar.

The Republican Alternative

As Eric Cantor said in a quote above, a far better solution would be the Republican insurance-based approach.

The insurance-based approach would simply require banks with toxic assets to pay a premium to the government in exchange for some guarantee of value. That would allow the banks to know the value of their assets with certainty and would require the government to pay far less for the assets... the government would only have to pay money if/when the asset lost value rather than come up with the money for the majority of the value of the asset right now--even if the asset eventually doesn't lose value. Why should the government spend billions of dollars on assets that might not lose value?

Equate this to homeowners insurance: You pay a premium for homeowners insurance and the insurance company only needs to come up with money if your house burns down. That's the Republican approach. The administration's approach basically amounts to the insurance company buying every house it insures even though most of them won't burn down. Why would an insurance company do that? It wouldn't make any sense.

I continue to be amazed at the continued insistence in buying all these toxic assets when the government could collect premiums to insure the value of the assets at far less cost and with far less complication.

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