The Geithner Plan

From the WSJ:

However, the financial system as a whole is still working against recovery. Many banks, still burdened by bad lending decisions, are holding back on providing credit. Market prices for many assets held by financial institutions -- so-called legacy assets -- are either uncertain or depressed. With these pressures at work on bank balance sheets, credit remains a scarce commodity, and credit that is available carries a high cost for borrowers.

.....

Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity. Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

This program to address legacy loans and securities is part of an overall strategy to resolve the crisis as quickly and effectively as possible at least cost to the taxpayer. The Public-Private Investment Program is better for the taxpayer than having the government alone directly purchase the assets from banks that are still operating and assume a larger share of the losses. Our approach shares risk with the private sector, efficiently leverages taxpayer dollars, and deploys private-sector competition to determine market prices for currently illiquid assets. Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience.

.....

We cannot solve this crisis without making it possible for investors to take risks. While this crisis was caused by banks taking too much risk, the danger now is that they will take too little. In working with Congress to put in place strong conditions to prevent misuse of taxpayer assistance, we need to be very careful not to discourage those investments the economy needs to recover from recession. The rule of law gives responsible entrepreneurs and investors the confidence to invest and create jobs in our nation. Our nation's commitment to pursue economic policies that promote confidence and stability dates back to the very first secretary of the Treasury, Alexander Hamilton, who first made it clear that when our government gives its word we mean it.

Let's move through this paragraph by paragraph:

1.) First -- I like the term "legacy assets". It's a nice and polite way of saying, "we're stuck with some really old garbage".

Now -- let me back up a bit further and provide a bit of a history lesson here. Securitization -- the process of taking single loans, pooling them with other loans of similar qualities (same interest rate, maturity date etc..) has been around for about 30 years now. For anyone who wants to really delve into this process, read any of the fixed income books by Frank Fabozzi. In other words, the problem hasn't been the system of securitization. Instead the problem has been the "lend to securitize" market of mortgage lenders that sprung up over the last 15 years like weeds. These lenders had no incentive to make quality loans because they sold the loans off faster then the loans would go bad.

These are essentially mortgage related assets who's value is depressed right now thanks to the housing market. There are a lot of questions related to these assets. Let's start with the big one: what are they worth? The problem is most of these assets are "thinly traded" -- meaning there aren't enough trades to determine an "average price". And therein lies the real problem with most of these bonds -- we can't figure out what they are worth.

Secondly, is their price unrealistically low right now because of the problems in the housing market? That is, are prices unrealistically depressed? There is no answer to this question. Most owners would say yes -- which explains why they are arguing for a relaxing of the mark to market rules. In general I would agree with this sentiment, but only by adding this very important caveat: prices are depressed if the owner's intention is to hold the asset to maturity. Finally, will these assets increase in value over time to where a profit can be made? No one really knows the answer to this question either, although assuming the maturity date is far away enough (say 10+ years) the answer is probably yes.

Here are the underlying principles:

Three Basic Principles: Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets - with the potential to expand to $1 trillion over time. The Public-Private Investment Program will be designed around three basic principles:

* Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in partnership with the FDIC and Federal Reserve and co-investment with private sector investors, substantial purchasing power will be created, making the most of taxpayer resources.

* Shared Risk and Profits With Private Sector Participants: Second, the Public-Private Investment Program ensures that private sector participants invest alongside the taxpayer, with the private sector investors standing to lose their entire investment in a downside scenario and the taxpayer sharing in profitable returns.

* Private Sector Price Discovery: Third, to reduce the likelihood that the government will overpay for these assets, private sector investors competing with one another will establish the price of the loans and securities purchased under the program.

Here are the advertised merits:

The Merits of This Approach: This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases - along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets.

So -- the government provides some funding, to be matched by the private sector. The plan states this will "maximize the impact of each taxpayer dollar" and "share the risk", both of which are fundamentally true assuming, of course, there is a desire by the private sector to participate. Assuming that is true, then the two propositions are true.

Here's how it would work:

* Banks Identify the Assets They Wish to Sell: To start the process, banks will decide which assets - usually a pool of loans - they would like to sell. The FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee. Leverage will not exceed a 6-to-1 debt-to-equity ratio. Assets eligible for purchase will be determined by the participating banks, their primary regulators, the FDIC and Treasury. Financial institutions of all sizes will be eligible to sell assets.

* Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.

* Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.

* Private Sector Partners Manage the Assets: Once the assets have been sold, private fund managers will control and manage the assets until final liquidation, subject to strict FDIC oversight.

All of this hinges on two points:

1.) The banks wanting to sell an asset, and

2.) Private bidders arriving at a price the banks are willing to take.

These two points are critical. There is nothing forcing banks to participate in the program. And that is the real problem. And there is a big reason keeping the banks from participating: finding out that various assets aren't worth anything.

However, assuming banks are willing to play this isn't bad. I would change a few things -- the most important being the government provided leverage. I think the private sector should pony up a whole lot more. But that's just my opinion which is completely unsolicited.

In addition, no plan is perfect. There are no guaranteed solutions to any of our problems right now. Specifically, nationalization has a ton of problems associated with it. However, overall I think this is workable.

Comments

[dsws]

"I would change a few things -- the most important being the government provided leverage."

The government-provided leverage is the reason the banks have an incentive to participate. Consider the incentives in the following simplified version.

On each dollar, the buyer puts up a nickel and borrows 95 cents. If the security is worth less than 95 cents, the buyer walks away and loses a nickel and the FDIC takes a loss on the loan. If it's worth more than a dollar, the buyer makes money.

Now, suppose you're the only bank, with only one asset to sell. It has a 90% chance of being worthless and a 10% chance of being worth ten dollars, so its (simplistic) value is one dollar. You can hold out for up to $6.89. At that price, the buyer put up .05 * $6.89 = $.3445. They have a 10% chance of making $10 - 6.89 = $3.11 and a 90% chance of losing the 35+ cents. Over ten such bets, on average, they'll lose nine times for about $3.10 total and win once for $3.11, coming out about a penny ahead.

Of course, you'll need to give them a better deal better than break-even. Maybe only you'll hold out for five times what your asset is worth instead of going for over six. That's still enough to get you to sell something you previously couldn't get fair value for.

[ClarcKing]

I really think we are spending too much time on the "plan". It is a swindle. It is a distraction from the fact that the economy must create and support the life sustaining engines and sectors of the population's physical economy. Wall St., healthy or not will always be a predatory and parasitical force on the population's economy. The creators of the plan are at least culpable for the crisis and still collaborate with the hedge fund managers of Wall St./London­. The plan proposes to entangle the U.S. and the citizenry in a usurious scheme in the middle of a monetary financial derivative debt based global economic collapse. The plan is a component of irregular warfare, financial warfare conducted against the U.S. Nation State. Geithner, Bernanke, and Summers deliver the financial coup d' tat. The U.S. and the world will answer to a group of private central bankers with the assets and debts of the U.S. controlled by the hedge fund managers. The Fed is hyper-inflating the currency, congruent with the plan, will cause the collapse of the whole system. Stop the bailouts. The U.S. economy will thrive without Wall St. As per Lyndon LaRouche: Put the Fed into bankruptcy. Create the U.S. National Bank. Currency and credits will be issued to the life sustaining sectors of the population. Introduce jobs and purchasing power in to the population's physical economy now. The U.S. must get its' priorities straight.

[Rog49Thomas]

The key would be artful re-interpretation of capital adequacy rules to penalize banks for holding the legacy instruments and thus "encouraging" them to sell. Imposition of more stringent "liquidty" rules and interpretation thereof (an area the Basel Committee on Banking Supervision is already working on).

Sort of the same strategy employed to "encourage" some banks to take TARP funds when they didn't want to.

Stress tests anyone?

[rugbymom]

I generally trust Bonddad's analysis but I'm not getting it this time. Two pieces I still don't understand:

1. If all the loans to private investors to buy junk are US government guaranteed, why shouldn't the investors be willing to pay full price (book value, 100c on the dollar) for the junk? They're spending 16c of their own money plus 84c of the government's, so they're getting the assets for 16c on the dollar. Tails they win; heads they don't lose anything. And given this, why would the banks accept any less than book value?

2. Once the first such auction is held, poof! there will be documented market values for all the toxic junk, likely very close to book value. Poof! Poof! All the other banks and all the other toxic junk can now be "marked to market" at this new inflated value. Poof! All banks are now fully "solvent," and there's "no more banking crisis."

As a side benefit, Credit Default Swaps no longer kick in to insure the formerly toxic assets, so we can stop bailing out AIG, right?

In other words, doesn't this scheme legalize the fictional values that banks etc. have been using all along, re-concealing the fragility of the toxic pyramids? And shovel another gazillion dollars into the pockets of the same hand-picked large investors and rich guys who have already looted and pillaged enough?

What am I missing here?

[jeanruss]

I read that China went before the World Court to obtain a lien against The Federal Reserve and obtained it. Their minister went to Obama and received 13 trillion payment in dollars. They refused Treasuries and wanted gold, but had to settle for dollars.

[traveler501]

hmmm, among other things...l­ots of nice cheap 4% loans will help push those values back up into what was previously "bubble" territory, but with fixed loans and a little inflation.­..is no longer a bubble. I can see this working, and in fact, I suspect there will be a rush to lend before the year is out. the key will be all those giveaway programs and infrastructure flooding in spendable income followed by investment and new energy products, middle class jobs and a huge world market waiting for a good deal on clean drinking water and cheap low-capitalized energy. it could work...gre­at time to buy a rental or two *grin*

[dsws]

"If all the loans to private investors to buy junk are US government guaranteed, why shouldn't the investors be willing to pay full price (book value, 100c on the dollar) for the junk?"

There's no possible upside at full price. They could get full value and break even after paying off the loan, or they could get anything less and lose. I posted an example calculation of what investors should be willing to pay a little up the page: http://www.huffingtonpost.com/hale-stewart/the-geitner-plan_b_178003.html?show_comment_id=22326067#comment_22326067.

[handyallen1]

my father paid his morgage he was the bread winner mom stayed at home the morgage used up 25 percent of his wages, today it takes two bread winners and 50 percent of their earnings to pay a morgage and if one loses a job or gets ill , the cards come crashing down. until prices come down to wages or wages come up this will continue .

[doogiedude]

What happened to "free market capitalism" and how does this plan address the cause of the problems?

IMHO, this plan treats the symptoms rather than the causes. It is like giving someone with a bacterial infection fever reducing medication instead of antibiotics.

From an article in BusinessWeek regarding CEO pay:
"But from where we stand, no overall system of setting pay is better than the free market."
http://www.businessweek.com/magazine/content/08_28/b4092106189628.htm

Apparently, the "free market" system is the best for setting pay and the worst for establishing the value of "assets."

The problem is not credit supply, it is credit demand. When wages are held down while prices rise, the only way to make up this difference is through credit. This should be short term mechanism used to mitigate leads and lags. Unfortunately, this mechanism has been in effect for nearly a decade. Until wages rise or prices fall to an equilibrium, the problem will only get worse.

I think the instutions should be left alone, the ones who can make it, good for them, the ones who can't should have to enter bankruptcy. This is how your average citizen lives.

Nationalization of credit rating agencies and how securities are rated, implementing Glass Stegall Act type laws, regulatory reform, and cancellation of unfair free trade agreements might be a start treating the causes.

I know it's a little late in the game, but I guess I'm just venting.

Just Sayin

[clarryr]

This doesn't address the cause of the problem at all. It's not the intent.

To address the cause of the problem we need new regulatory powers that prevent the large conglomerates of commercial banks, investment banks, and insurance companies from taking on too much debt and over-leveraging their assets. The news today is that the President is asking Congress for just that regulatory power for the Treasury.

The PPIP program is part of the effort to get credit flowing again. New, yet be legislated, regulatory powers will prevent it from happening again.

[twofish]

A couple of questions occur at this point:

1) When you buy the assets behind these securitized loans, how do you distinguish between those that have been foreclosed (the bank or someone now owns the house) versus those that are still generating income because the people down at the bottom are still making their loan payments?

2) If they manage to just reinflate the bubble and don't change the basic way loans and investments are made and bought and sold, where will the next bubble be? Commercial real estate? Commodity futures? I just want to know so I can stay out of it -- if I can even tell where my 401k is invested any more.

I don't have the slightest idea how to change the system, only that if you shore it up and leave it as it is, you are going to get more people chasing big returns and passing along hot potato (aka toxic) assets so as not to be the ones holding them when the bubble bursts. Again. Indeed, our whole economy seems to have become one bubble market after another.

[doogiedude]

I think you are hitting one of the nails right on the head in your mentioning of the basic way loans and investments are made.

Under the current system, the loan originator is only concerned about generating quantities of loans not quality loans. The loan funder is only concerned about selling the loans so they can make additional profit and free up capital to do it again. The loan servicer is only concerned that an adequate cash flow is maintained. We know who gets left holding the bag.

IMHO, this "unbundling" of the loan industry has created a situation where long term viability of a loan means nothing. This is one of the many things that will ultimately have to change when things get bad enough to start addressing causes rather than symptoms.

Just Sayin

[dsws]

"where will the next bubble be?"

Whatever everyone decides is a sure-thing safe-as-houses money maker.

[January]

It's a start. Everything will depend on whether the hot air will be enough to keep the balloon aloft. And, yes, it is possible that we, taxpayers, will find ourselves with a whole lot more asset-backed securities than can be unloaded in the near-term market.

My question is whether there remains a backdoor? That is, if it becomes clear at some point that the program is a total failure, can it be controlled before it becomes a whirlpool in which we all drown? If so, then it is certainly worth a try.

[doogiedude]

IMHO, housing prices are not depressed, they are disinflating from unreasonable levels.

For reference, here is a link to a chart contstructed by Yale economist Robert Shiller of housing prices in constant dollars since 1890:

http://www.businessinsider.com/the-housing-chart-thats-worth-1000-words-2009-2

Just sayin

[JimR]

Yeah, I tend to agree. We all know that many people couldn't afford the houses they were in, and with people losing jobs, how can it be sustainable for housing prices to go back up?

[Rule Of Law]

As I heard Larry Summers explain today as regards this--

"These are essentially mortgage related assets who's value is depressed right now thanks to the housing market."

He said that the value of houses has gone down because with the freezing of credit due to the bad loans, there is no lending to hold the housing market up. He said we must restore lending in order to maintain any value in our homes.

I don't like Summers. He's usually, in my opinion, arrogantly wrong. But this--perhaps it was a slip of the tongue--fits with what I know about how anything is priced. If folks want it, AND can afford it, it has value. If the money's not there, stuff is worth less. Simple.

Houses didn't just one day begin to lose value for no damm good reason. The values began to drop when the market for loans dried up due to the overextension of the banks in the derivatives markets and the sudden realization on the parts of many foreign "counterparties" that the paper they held was not AAA as they had been led to believe.

Calling this economic crisis a housing crisis, or a mortgage crisis is about as accurate as saying that a car wreck victim died because he ran out of blood.

This meltdown started at the top.

[Sundialsvc4]

I have one major, major issue with this "workable plan..."

Namely, that I regard these securities as fraudulent. If a security (like any contract) is issued contrary to the law, or if it represents an underlying covenant that is contrary to the law, then that security becomes unenforceable against both parties. It is neither an asset nor an obligation.

A rather small handful of stupendously large banks issued literally trillions of dollars' worth of securities under false pretenses, with the collusion of credit-ratings firms who knew or who had reason to know that the securities were worthless. These same banks issued loans under outright-fraudulent conditions (no collateral, no due-diligence, in fact blatant misrepresentation) in order to sell even more securities.

"Dammit, Hale, this is securities fraud!"

What you do is: seize the bank, set-aside the depositor's demand-accounts (FDIC guaranteed, as-agreed), and then systematically start unwinding all those zeroes ... after putting a large number of people into jail.

It's crime, and that's how you MUST treat it. If you once make the mistake of endorsing crime, of actually "making it pay," then you will never have the end of it. Never.

[Rule Of Law]

Yes they're fraudulent, that's why everyone of the wall street hacks in DC is working so hard to shift the cost to us and keep the unwinding of these deals out of bankruptcy court where the whole ugly mess would be exposed!

[KQuarksSuperKollider]

Huh? You cannot put people in jail who did not break the law. With no regulations this was no fraud they were safe assets made into risky assets because the loans were made to people who should not have gotten them. When they were sold as AAA loans they were sold in so called good faith because of the delusion that the value of the homes would mitigate any losses. The defaults came first, then the housing value dropped and the value of the assets dropped last. When these securities were bought and sold no fraud was involved because they were bought at the market value at the time.

[JimR]

Actually, it was all legal. That's one of the problems that needs to be fixed.

[clarryr]

So what will force the banks to participate is their competitive nature. They can take their lumps and sell the toxic assets at some pennies/dollar and get back into business with the new capital. Or they can try to hang on to the assets themselves and hope they recover value. Meanwhile they don't have enough capital to make new loans. Their choice and their own analysis will determine when/if/how they will participate. They now have an incentive to make a true valuation of the toxic assets they are holding.
It's a rather brilliant plan that may respark the capitalistic nature of the economy. It minimizes the risk to the tax-payer in that the toxic assets will eventually recover in value and be paid back.
Three questions I have:
1) What about AIG and CDSs covering these assets? Does AIG have to cover the difference between face value and true value?
2) How do you prevent the banks from participating in the hedge funds so that they would be bidding on their own assets (fixing the bidding)?
2) When will new regulations be in place to prevent a reoccurence?

[Sundialsvc4]

Exactly: they just made a fortune.

They pocketed all their profits and sloughed-off all their known-to-b­e-fraudule­nt worthless paper ... having actually managed to make a profit on that, too, because "even 'pennies on the zero' is real pennies." They've got bucketloads of new cash with which to do it all over again. Nobody accused them of any crime.

The hedge funds ... always the un-regulated "wild card" these days ... would of course have a betting-frenzy.

So it would absolutely be the best of all possible worlds for the people who committed this crime:
-> having swindled just about every adult person in the United States, they swindled the United States Government!
-> they got away with it.
-> nobody accused them of any crime; nobody ever will.
-> they made billions, AND have billions more as a free gift.
-> the United States Government can be counted-upon henceforth to, meekly and ineffectually, do precisely as they are told, after putting up no more than a token resistance.

[Robert59]

Those are good questions.
They will sell, but because AIG is the insurer and the taxpayer is on the hook to AIG will we in effect be double paying for Geithner's plan?
I would hope the SEC and other watchdogs would keep an eye out for the flow of dollars from the investment banks to ensure they aren't selling to themselves or artificially bidding the price up?

[KQuarksSuperKollider]

Finally a realistic view of the situation. There is no magic bullet like the author stated. This is an unprecedented problem and nationalization creates more problems in my opinion. Geithner's plan is workable and if these banks want to hold onto these assets let them deal with the consequences because once this programs over they have to deal with the market that is left.

[Robert59]

What happens if the banks won't sell because the price investors are willing to pay is too low?

I think there'll be alot of pressure for them to sell, to take their shave (which they really haven't done) or they will have their coffers slowly drained each time there is a call. I could also see the govt at some point telling them they get no more money because they are refusing to sell.

I agree these assets will, if held long enough, provide a return on the investment (but only if bought cheap enough). Housing starts might have posted a nice gain, but let's not forget most analysts believe house prices still need another correction of 30 percent. And the next wave of mortgages (the Alt As and Option Arms) don't start resetting until the latter half of 09 and all of 10.

[jhNY]

Amazing how resilient capitalism really is as a politcal animal-- for years, the Invisible Hand was at work valuing assets in the marketplace with unerring accuracy. Then a bunch of really important financiers speculated themselves into what would have been oblivion had it not been for their coziness with some really important people in the money parts of government, and suddenly the market can no longer be trusted as a place to determine price, and the Invisible Hand must be stayed from its usual work. Until the really important financiers are saved from responsibility from their own misdeeds anyway. Then capitalism can proceed afresh, and the Invisible Hand can once again assume its ascendance over the markets and the world, and all will be well, despite the descent into insolvency suffered by ordinary people while this sleight of Hand takes place.