Treasury Tries Again
Treasury Tries Again
The Obama administration’s latest effort to clear the financial system of toxic assets boasts promise and pitfalls, write Michael Ettlinger and David Min.
The federal government has tried many ways to get the financial sector to stand on its own two legs over the past year. It has injected cash, bought debt, loaned money, cajoled, pressured, and threatened. Only in a few cases, where some small- and moderate-sized banks have become incontrovertibly insolvent has the Federal Deposit Insurance Corporation taken over a bank and cleaned up the mess.
With the Obama administration’s so-called Public-Private Investment Program announced today, the government will take one last crack at partnering with the private sector to solve this problem. The administration, of course, has not called it the “last crack” at working with the private sector, but it’s hard to see what’s left except a much greater, more direct, government intervention into the marketplace—nationalization in one form or another—if this doesn’t work.
Let’s recap. First, way back in the Bush administration, which ended all of two months ago, the Treasury lurched from ad hoc measure to ad hoc measure, saving a company here, a company there, getting $350 billion in Troubled Asset Relief Program funding from Congress then using it for entirely different purposes than described, and injecting capital into a number of banks.
The Obama administration decided to approach the continuing financial crisis much more systematically which, to the chagrin of many, resulted in a lack of rapid action. That’s why, so far, the most visible government actions these past two months were time-gaining mini-bailouts reminiscent of the Bush team—even though the purpose has been a bridge to a comprehensive solution. The administration, however, was working on that solution. It was sketched out in rough outline on February 10 by Secretary of the Treasury Timothy Geithner, with details dribbling out in March and actual action just starting to occur.
The Obama administration’s Financial Stability Plan addresses a number of different problem areas in the financial system, including stabilization of the housing markets through loan modifications and refinancing—further details of which were introduced in early March—alongside direct intervention into the troubled consumer and small business credit markets, again with further details introduced in early March. These moves were accompanied by a bid to restore investor confidence in large financial institutions through a combination of stress tests—which have reportedly already begun—and more transparency, recapitalization, and the removal of so-called “toxic assets” from bank balance sheets.
This last piece—addressing the toxic asset problem—is the purpose of the Public-Private Investment Program. Dealing with the toxic assets held by banks—the mortgage-backed securities, other asset-backed securities, and collateralized debt obligations tied to exotic credit derivatives that have deteriorated in market value over the past two years—is a critical lynchpin to the overall plan. The devaluation of these assets is what has our biggest financial institutions teetering on the brink. For those institutions to be restored to health, and go back to performing their needed role in the economy, the bad assets must be dealt with.
The program has two parts—one to buy loans off the books of banks and the other to buy securitized debt, mainly mortgage-backed securities. Although the two parts accomplish it in different ways, the key new element in both is a partnership between government and private investors (with the private investors subsidized and protected) that buys suspect assets off the books of banks and other institutions. The government and the private partner put up equal amounts of equity. Then the government lends the partnership an additional amount. The amounts can vary substantially, but the total equity portion on the loan part of the program appears to be typically about 15 percent and the debt piece 85 percent. On the security side the equity is likely to be a larger portion. In both cases, the fund is managed by the private partner. The plan envisions, and relies on, there being multiple such partnerships.
The way the price is set for the assets bought by the partnerships is different for the loan and security parts of the program. On the loan side, banks decide what loans they want to sell and the FDIC puts them up for auction among the partnerships. On the securities side, the partnerships shop on the open market. The idea is that:
- The private auction-bidding process will get the price right for the loans.
- A well-funded and vibrant securities market will get the price right for the securities.
- Government lending will increase the funds available to purchase the assets and make the investments more profitable for private investors.
- The profitability of the investment, and the federal equity share, will ensure that taxpayers benefit from future increases in asset values.
The theory behind this plan is that a shortage of debt financing available to big investors is preventing them from seeing a path to sufficient profit from buying up these assets—at least at the prices at which banks and others are willing to sell them. Debt financing is a common means for high-dollar investors to increase their profits. To oversimplify, if an investor has $10 of capital and gets a 20-percent return, then they earn $2. If they have $10 of capital and borrow another $90 then a 20-percent return nets them $20 less the interest on the debt (which is much less than 20 percent).
In the administration’s plan the debt will be offered at very low rates so the potential for profit is great. In addition, the debt will be “nonrecourse.” This means that if the asset turns out to be a lemon, the investor can default on the loan, hand over the devalued asset to the lender (the government in this case), and be out from under the debt without any further obligation to make the lender whole. Thus, while the upside for the participating investors will be high, the downside risk will be relatively low. For taxpayers, the upside is just as high as it is for investors, but as the lender to the partnerships the government carries most of the downside risk.
Treasury officials hope this will create a strong incentive for the private investors to play—bringing their capital to the table and creating a market that will accurately set the prices for the assets. And, by the government joining the private investors, the taxpayers also get a good return on the investments. Perhaps more importantly, once those bad assets are off the banks’ books, the banks will be back in business—attracting private capital, maintaining solid balance sheets, and once again playing their critical role of financing Main Street.
One shadow over this proposal is that we may end up subsidizing an enormous windfall for wealthy participants in hedge funds and their kin, which are likely to take advantage of the opportunity being offered. According to research conducted by breakingviews.com (an affiliate of The New York Times), a conceptually similar program called Term Asset-backed Loan Facility should provide investors with returns of over 15 percent a year, and it is widely believed that the potential returns on PPIP will be much larger (note that the TALF is being expanded for use in the PPIP as well—but that’s another story). The profits to be made on the approximately $2 trillion of PPIP assets sitting on bank balance sheets could make the retention bonuses causing such an uproar seem like peanuts.
That this is a very good deal for investors is intentional. The PPIP needs massive buy-in from the private sector in order to get the assets off the banks’ books. The way to ensure that happens is to make these investments the best around. One good feature of the plan is that, at least on the securities side, the administration wants to make the good deal available to “retail” investors so that those with more modest portfolios than hedge fund participants can also participate—conceivably through 401ks and other savings vehicles that are broadly available. Nevertheless, it’s quite clear who will directly benefit the most from the government subsidies and protections in the program.
The subsidies for the investors also carry another risk. The plan is counting on private-sector involvement to get the price paid for the assets correct. With multiple partnerships in the market, and the private investors in charge, there will be a competitive market to accomplish this. If the subsidies are too generous, however, that could drive up the price too high. If the downside risk is held mostly by the government, and the borrowed cash is cheap, the private investors will be willing to pay more. One problem in this scenario is that the subsidy then shifts to the sellers—including banks, which we hardly want to reward. The other problem is that if the assets are bought at inflated values the government could be left holding the bag when the bubble bursts. We’ve already been down that road.
The $64 trillion question (more or less) is whether this will in fact work to get the toxic assets off the books of banks and other institutions and free them up to get back in the business of lending—something our economy very much needs. The plan here is to create a situation where there are very deep-pocketed investors with a great motivation to buy. But will the sellers be willing to sell at what the buyers are willing to pay?
For some sellers that might be very difficult. There is very little market for these assets right now so their freely traded value is hard to determine. Many banks are carrying some of these assets at greater than their actual value. Some may face insolvency and failure if they sell at the prices investors, even subsidized investors, are willing to pay. What happens if the banks don’t, or can’t, sell?
At the very least, it is likely that many banks will require an infusion of capital to offset the losses they will have to recognize on their books as a result of selling these assets at a price below their book value, regardless of the success of the program. The administration appears to be counting on much of that capital being available from the private sector once the toxic assets are gone. But there’s no guarantee that this, plus what remains in the TARP, will be enough to offset what might be some enormous losses.
If the PPIP doesn’t work, the answer then must be the type of intervention that the administration has been trying to avoid. Nationalization of banks, or something close to that, becomes the only answer. Otherwise the dreaded zombie-bank problem becomes entrenched—banks in too bad shape to do anything, in a state which, in the game of chess is called “zugzwang”—where any move makes things worse.
There are many who are already sure that the PPIP won’t work. They are certain that the assets on the books of the bank are so valueless that we’re kidding ourselves to think that value can be squeezed out of them and that the banks are already in a zombie state. They may be right, but the Obama administration isn’t there yet. The danger of the route the administration is taking is, of course, that this plan won’t work and precious time will be lost as the PPIP muddles along to failure.
The good news is that through the PPIP and the stress tests that are assessing the capitalization of banks we should know for sure what we need to do. We will, at least, if the administration sets up clear standards for success. It is important that parameters be set up of whether assets are moving and banks are being restored to health on a specified timetable. If they’re not, the administration should take quick action to move beyond the PPIP. This information should also be made public—one of the administration’s problems is that with so little reliable information available, it is difficult to tell whether its policies are the correct ones and distrust abounds. Making the information public could also create more confidence in the marketplace.
The path the administration has taken is probably more realistic than more drastic measures—whether it is ideal or not. It’s easy to say “nationalize” but for the new administration, barely 60 days into office, to sort out which banks to nationalize and which to leave, and take over the running of a number of enormously complex institutions, is a lot to ask and unlikely to be well done. What remains to be seen is whether the administration—if that course becomes the only viable alternative on the table—is willing to take the necessary steps. Hopefully, it’s not an issue it will confront.
Michael Ettlinger is Vice President for Economic Policy at the Center for American Progress. David Min is Associate Director for Financial Markets Policy at the Center. For more on the Center’s economic policy analysis and recommendations, please go to the Economy page on our website.
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Vice President, Economic Policy