Ten Questions for Secretary Geithner
This week, Treasury Secretary Tim Geithner unveils his plans for the financial system with a speech and testimony in front of the Senate Banking and Budget Committees.
Here are the questions (in bold) we would ask him. And, just in case any of you are involved in preparing the Secretary's briefing book, we also suggest some answers:
1. Do you agree that, to restore trust in the financial system, it is essential that the Treasury (working with other relevant US authorities) take rapid steps to "once and for all" completely recapitalize the banking system?
2. Would you also agree it is critical that you and your colleagues tell the unvarnished and unequivocal truth regarding the needs of the financial system and your plans to recapitalize banks, so that clarity regarding the policy framework can be restored and uncertainty diminished?
3. Do you agree that a one-off, transparent assessment—with the methodology and results fully divulged in public—of the solvency and financial condition of all banks is required within three months so that we can precisely define and address the problem?
The only answer that would give any credibility to questions 1 and 2 is: Yes.
4. Many banks value securities, mortgages, and other loans close to the face value of the obligation on their books, while market prices for similar assets are far below book value. Which value should be used when assessing these assets to determine if banks are solvent or not?
The only fair answer for taxpayers, and the only way to ensure that adequate capital comes into the banks subsequently from private investors, is: We will value all assets at market values. If market values are not available, then a highly conservative approach should be taken, i.e., assign a very low value. This will lead to major asset write downs at all banks and a greater need for capital, but it will ensure that this is the last time (in the foreseeable future) that the Treasury will need to recapitalize banks.
5. Some sources report that the Treasury is considering purchasing assets from banks that have been marked to market, while insuring assets that have not been marked to market. This would enable banks to avoid marking down assets, i.e., so that they don't need to recognize further losses. Why should taxpayers insure any asset at a price significantly different from the market price?
The concept of "insuring" assets that have been priced above market value is a nonstarter. It would be a means of providing taxpayer money to banks by stealth, and is not credible since it will become transparent (and face a major political backlash) as soon as the details face serious scrutiny.
The Treasury needs to state clearly that most banks need large recapitalizations based on current asset prices, and it would not be fair to taxpayers if we provided cheap insurance (e.g., as if the assets are really AAA) for bad assets that are marked too high on banks' balance sheets.
If the banks are forced to mark assets to their true prices, there is no need to provide insurance. You may as well recapitalize the banks fully to reflect those losses and then let them also manage all the remaining risk on their balance sheets.
6. How much money is Treasury expecting will be needed for the recapitalization of banks, i.e., what will be the net new injection of capital?
If the answer is not at least $1 trillion, in line with the estimates of the IMF, then it's not enough. (Note: The headline number may need to be larger, depending on the approach; focus on the recapitalization/increase in capital of the banking system as the bottom line).
We can also rely on private capital to inject funds, but only if the principles the authorities use for valuation of banks are very conservative so that there is adequate upside to new investors.
If the headline amounts are less than $1 trillion, this is surely not enough.
If the headline amounts are vague or we hear statements such as "it's too early to know," then the entire approach is not credible and we will need to reconvene when the Treasury is properly prepared and ready for a serious discussion.
7. Where will Treasury get this amount of money at short notice?
The best answer would be from a mix of private and public funding, but initially at least $1 trillion in public funding for recapitalization needs to be available.
If the answer for public funding is, "the remaining TARP funds plus backstop loans from the Federal Reserve," this is unlikely to be enough.
Treasury needs to request further funding from Congress in the next month or so, in particular several hundred billion dollars in additional debt-limit authorization; this can then be combined with Federal Reserve financing to get to scale quickly.
There is no substitute for an early and completely frank conversation with Congress regarding why this new funding is needed, how exactly it will be used, and what the impact will be on various stakeholders (including insiders at the large banks, new investors, and the taxpayer).
If the Treasury requires banks to write down assets to market prices, it will provide the clarity needed for private investors to reenter the market. The stock prices of the worst banks will fall because it will become clear that the government is not prepared to provide further cheap taxpayer money as a subsidy, but this will finally put the banks at valuations that attract new private owners willing to make substantial investments. The government will then be providing funds alongside the private sector and less government funding will ultimately be needed.
8. How many of the largest 5 banks will likely end up with the government as the majority owner?
Any honest, market-based valuation of bank assets will show that a majority of large banks are insolvent at present but can be righted with substantial new capital.
If the answer isn't "at least two," then either the Treasury does not plan to properly value assets, or someone is not yet prepared to tell the full truth.
9. How does Treasury plan to use its shares when it has a controlling stake?
If the answer is, "as a passive shareholder" (as seems to be the approach of Gordon Brown in the United Kingdom), then we are in for a rough ride.
The Treasury needs to have a plan to get shares back to the private sector quickly. We need new, strong private owners. This is the only way to restructure the banks and force the necessary changes in management personnel and systems.
10. Does Treasury anticipate changes in management at these banks as a consequence of these actions?
There is a critical need for new management in banks, but this should generally come alongside the infusion of new private capital. New private owners should restructure the banks and greatly improve how they are run.
It is important that strong antitrust provisions be attached when the government sells its stakes to new investors. This will ensure that they have an incentive to break the largest banks into smaller, more manageable entities, all of which could productively be placed under new management.
Any bank that is "too big to fail" is also "too big to exist." This should be a fundamental principle applied by both regulators and antitrust authorities overseeing all dimensions of the financial system.
Also posted on Simon Johnson's blog,