The Treasury’s Financial Stability Plan: Solution or Stopgap?by Adam S. Posen | March 23rd, 2009 | 05:55 pm
I hope it works. The financial stability plan presented on March 23 by Treasury Secretary Timothy Geithner could be a part of the solution because it would remove some of the bad assets from the banks’ balance sheets and put some capital into the banks. The Treasury is clearly trying clever tactics to avoid going to Congress for more upfront on-budget expenditures to fix the banks.
Even in the best case, though, I worry that the avoidance of upfont costs makes it penny-wise, pound-foolish, for the US taxpayer. The private sector investors get a subsidy from the government in terms of both leverage and insurance against asset declines, and the current bank shareholders get higher prices for their assets via these subsidies. It may well thus cost the taxpayer more on net, between these subsidies and the lost upside gains, than if the government had stepped in more aggressively to take full ownership and pay low prices for these assets, even if it costs less upfront.
More worrisome, this partial fix might only be temporary. The banks will still have left the worst toxic assets on their books, their incentives will not have changed, and they will be playing with a fresh stack of public money with insufficient conditions and probably insufficient capital. Then, 18 months or so down the road, the US government would still have to put capital into the banks, because lending will have broken down again, and many banks will again be under water. But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out.
The explicit premise of this plan is that the real issue here is a market panic. Treasury is assuming that the private money managers on the sidelines are just sitting there because they are scared, and that the risks they fear (about the economy in general) are very unlikely to be realized, and that the banks’ investors need assurances to encourage them to buy.
While markets do get things wrong, I think the panic is a misdiagnosis of the situation.
Part of the problem is that some of these assets are genuinely toxic because they are part of larger securitized packages, and there is an inability to see what is behind them. Under this plan, those toxic assets are not restructured, because doing that would require government supermajority ownership, which will not happen. So some will fail to find a market. In that case the FDIC will end up having to pay out on the insurance for overpriced assets.
Another part of the problem is that the banks’ current management and shareholders have been unwilling to sell some of the assets for which there is a market at the prevailing low prices because they have been hoping for a government bailout. Bailout is what this plan may give them, with all the subsidies. Given the apparent deep motivation of the Treasury to minimize both on-budget costs and even temporary public ownership of anything, the Obama team is apparently willing to risk overpaying current owners of these assets rather than forcing sales.
The Treasury plan is also supposed to lead to “price discovery” through the use of auctions and then resales. This sounds very nice, but since there is no new information for the private investors, except the government guarantee and leverage terms, what price will be discovered besides the worth of that subsidy? Nothing here transforms the worth of those assets. Who will be the eventual market for these assets unless that insurance and subsidy is transferred? If that is the real asset being sold, then why not have these investment firms sell derivative contracts stripping out and offering that insurance, based on the public guarantees? I am skeptical about the amount of price discovery that will occur in such a scenario.
I and others have been arguing for a more direct government approach [pdf] not only to get the taxpayer the least cost in the end, though government should indeed be concerned with the long-term instead of temporary budget illusions. The main reason I argue for a more aggressively interventionist strategy—with clean lines between public and private ownership and more stringent pricing of bad assets—is that bolder intervention is the one proven way to resolve such a situation lastingly.
Japan in 1998 had a reformer, Hakuo Yanagisawa, come in as Financial Services Minister, and he got a bank recapitalization underway—but he did so without putting on enough conditions on the capital, and three years later the Japanese banking system failed again. Only when Heizo Takenaka became the responsible Minister, and forced the banks to truly write down the value of the distressed assets before injecting capital, was the Japanese banking crisis resolved. Various Japanese government efforts to play with bad asset purchases before that only resulted in overpayments and the eventual accumulation of more bad assets.
I hope that the current Treasury plan contributes to stabilizing the US banking system in a lasting way, even if it comes at excessive cost to the taxpayer and offers too much benefit to the private participants. But I also worry that in the end Treasury will have to just do this again with more public money for the same banks amidst renewed financial disruption a little later.