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New Plan, Old Fears

Tuesday, March 24, 2009

The Geithner plan is particularly vulnerable to the kind of criticism that might chase away private investors.

In response to public outrage about bonuses paid out by American International Group, Congress is now working feverishly on legislation that would penalize the workers at banks and other companies that have received funds from the Troubled Asset Relief Program (TARP). This must be one of the most disheartening episodes ever witnessed in Congress, not because the bonuses deserve support but because our representatives are structuring legislation that would punish almost everyone—the guilty and the innocent, the competent and the incompetent, those necessary to run the businesses that receive TARP funds, and those who may be superfluous—in a headlong rush to pander.

This spectacle could have important consequences for virtually all current and future economic recovery plans. Congress has shown itself to be an unreliable partner, panicking at the first major public backlash and retroactively changing the rules that others have relied on. Its action raises questions whether it will be safe for private-sector companies to participate in any of the government’s current or future financial rescue efforts.

This must be one of the most disheartening episodes ever witnessed in Congress; our representatives are drafting legislation that would punish almost everyone.

Potential private-sector participants must now be wondering just how far Congress’s punitive actions and clawback principles go. Might they apply to “unconscionable” bonuses or profits for companies that are building the shovel-ready projects in the stimulus package? Will they cover the profits that participants in the Term Asset-Backed Securities Loan Facility (TALF) might earn by purchasing assets with government loans? Or the similar assets to be purchased from banks under the long-awaited plan of Treasury Secretary Timothy Geithner? Is every project, every reputation, and every dollar of profit only good until the first “60 Minutes” report? At the very least, Congress’s action probably administers the coup de grace to companies taking equity investments from the government. If there was ever a demonstration of the dangers of nationalization or even a temporary receivership, this is it.

Still, responsible people in Congress should want to press forward with TARP implementation. The original plan, to buy troubled assets off the balance sheets of the banks, remains sensible. There is no way to get the economy back on track without restoring the largest banks to health. As it happens, however, the Geithner plan is particularly vulnerable to the kind of congressional criticism that might chase away private investors. The central problem that has bedeviled the TARP since its adoption has been how to price assets that the banks believe have significant value because of their continuing strong cash flows, but which have market prices well below these values.

Market prices are low to nonexistent today primarily because potential buyers have no confidence that they will be able to resell the assets without the development of a normal trading market, and the risk of losing financing for a portfolio of assets that cannot be resold is too great for most private-sector buyers to bear. A normal market, in which mortgage-backed securities and other asset-back instruments could be readily sold, has not existed for well over a year.

The Geithner plan goes halfway toward a solution for this problem. It provides several ways for buyers to finance their purchases. Assuming that the government financing made available under the plan will not be limited in time (so that the buyers will not be required to go out and find new private-sector financing), the plan will enable private-sector buyers to acquire and hold the assets, earning profits from the difference between the costs of financing and the assets’ cash flows—in other words, exactly what the banks are doing now. In effect, the banks are being asked to give up significant cash flows at a price that is low enough to attract investors who are not usually in the business of holding assets for their cash returns.

Congress’s action raises questions of whether it will be safe for private-sector companies to participate in any of the government’s current or future financial rescue efforts.

The plan contemplates that the private investors will bid for assets offered by the banks. In this case, the investors’ profits will depend on getting a price that is low enough to compensate for the risks they will be taking, which include the possibility of declines in the assets’ cash flows (coming, perhaps, from more mortgage defaults) and that they may be required to hold the assets for an extended period without the possibility of resale. The banks themselves are willing to do this—that is their business—but others are not set up to manage portfolios of mortgages over many years. The question, then, is whether the banks will be prepared to sell these assets at prices low enough to produce profit levels that will compensate private investor groups not only for their risks but also for alternative uses of their expensive equity capital over what could be several years.

Government financing arrangements can make the purchase of bank assets very attractive. Sufficient low-cost leverage makes small margins highly profitable. But that will mean that the division of the profits, if any, between the private groups and the government will have to heavily favor the private investors. The government will be taking the risk not only of a decline in the value of the assets’ cash flows, but also the interest-rate risk associated with making favorably priced loans to the private groups.

This is where the recent actions of Congress become troublesome. If the private groups earn very substantial profits, especially if the government suffers losses on its financing, will there be another backlash? Even if the government also profits, any report on the relative profits of the private investors and the taxpayers will likely show a top-heavy return to the private sector, and at a time of massive government deficits the possibility that Congress will go after these profits—as they are now going after the profits of private equity managers—cannot be dismissed. Only time will tell at this point whether Congress, through its populist pandering, has made private-sector involvement in the Geithner plan or any other economic recovery plan far less likely.

One other factor has to be considered. The process of negotiation between the banks and the private-sector investors who participate in the Geithner plan will be an extended one, even if the banks are willing to sell at the bid price. It will not provide the quick fix to the banking system that is necessary at this point. The Geithner plan relieves the government of the political problem of setting prices for assets that are likely to be well above market prices, but we have already wasted almost six months since the TARP plan was originally proposed, and the economy continues to languish without adequate financing. It is a legitimate question whether the taxpayers would be better served by a plan that works quickly and accomplishes the same result, rather than one that avoids political problems for the government but—if it works at all—will take many months to implement.

If the punitive congressional action on bonuses causes the private sector to shy away, there is still one plan that could work—the purchase of assets directly by the government, without private-sector involvement. Sheila Bair, chair of the Federal Deposit Insurance Corporation, noted in a recent interview that “we’re pretty familiar with the market right now. So we think that [it’s] absolutely true that assets are worth more than the current market conditions assign them.” This suggests that the government can complete the purchase of the banks’ troubled assets quickly, if it is willing to acknowledge that market prices should not determine their value.

The Geithner plan will not provide the quick fix to the banking system that is necessary at this point.

Using bank’s own cash flow valuations, the so-called “toxic assets” can be purchased at a price that is fair both to the taxpayers and the banks. The banks have priced the assets at their cash-flow values today, discounting for expected future losses. Although private-sector buyers have been unwilling to purchase these assets at the banks’ prices—because they could not be assured of long-term financing—this is not a problem for the government. Under these circumstances, even if the government were to purchase the assets at prices close to the banks’ prices, the taxpayers could profit immediately from the difference between current government borrowing costs and the cash flows the government will receive; and the government can wait indefinitely—until the market returns to normal—before selling the assets. A sale into a normal market, when the requisite private liquidity exists, could enable the government to recover all or most of what it spent to acquire the assets.

This is not to say that the government would not be taking risks. There are credit and interest rate risks involved—the same risks that the banks are taking today when they hold these assets—but we have to remember that the purpose of TARP was to help the economy recover, a result that would benefit the taxpayers as participants in this nation’s economy. Getting troubled assets off the balance sheets of the banks—and doing it quickly—is the policy that a responsible government should choose.

The administration is now clearly committed to the Geithner plan. We should all hope that it works. But if it founders on the shoals created by Congress’s actions on the American International Group bonuses, or because of its own complexity, there is a simpler and quicker plan available that will restore the banks to health without placing excessive burdens on the taxpayers.

If the administration ultimately turns to this approach, a remark often attributed to Winston Churchill will once again be proved accurate: “The Americans can always be trusted to do the right thing, once they have exhausted all other possibilities.”

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at the American Enterprise Institute.

FURTHER READING: See Peter Wallison’s essay on how the government should buy banks’ trouble assets at “net-realizable value,” a valuation based on current cash flows discounted by the expected credit losses. Alex J. Pollock suggests that entirely new banks are necessary. And Philip I. Levy argues that there is a new source of systemic risk: public outrage.

Image by Darren Wamboldt/The Bergman Group.

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