Tuesday, March 24

Defending the indefensible

I don’t think the latest Geithner plan to create a private/public partnership to buy up to 1 trillion of toxic assets from the Banks represents the zombie solution as described by many leading economists.

I think whether or not you nationalize some Banks makes less difference than is contended, since in my opinion it all boils down to how they are regulated and managed- albeit very poorly in the past. The latest Geithner plan proposes an auction purchase system of the the toxic assets held by banks by investors with up to 97% in non recourse funding whose risk and funding can be as low as 3%. In other words a Hedge Fund bidding 70 cents in the dollar for $100 million of debt securities held by Citicorp would purchase the $70 million dollars of securities but only be on risk for $ 2.1million or 3% of the $70 million dollar security parcel purchased.

These established Funds would be available to investors and 401K superfunds and so on.

The arrangement as I understand can be described as follows:

1. The FDIC (Federal Deposit Insurance Corporation) guarantees 85% of the value of the loans without recourse.
2. The Treasury provides further capital for 80% of the balance(balance is 15% after 85% guarantee by the FDIC )to cover 12% from TARP Funds leaving a balance of only 3%.
3. The balance of 3% represents the capital used from Private Investors (Hedge Funds) who risk losing all their capital (assuming they are unable to hedge their investments by buying credit default swaps) and who bid at auction for parcels of the securities to establish a market.
4. Banks holding the Toxic Assets will sell them to the highest investor Bidders (Hedge Funds)which will then enable eventually a resumption of normal lending.
5. The taxpayer effectively takes on 97% of the risk by virtue of the non recourse loans.

The concerns over taxpayers costs hinges on the economic outlook over the next 3- 4 years and the extent or otherwise of recovery in house prices and the general economy. In the event of a recovery, losses may be minimal, if any, with possible gains but should the reverse occur the consequences will be disastrous to the extent the whole economy collapses. The banking system may be equally badly off with no less in future challenges, but that would also signal even more deep seated economic woes at that time.

However a more pertinent argument is about whether or not you allow the banks to fail or as the case may be to recover of their own volition. Due to the very low funds cost now available (with Fed easing) margins have improved considerably, hence, putting aside additional write downs from prior toxic assets sales and bad debts and assuming economic recovery I would estimate all the write offs could be absorbed within a four year time span. But in the meantime the credit squeeze and all of its misery would continue with the risk of further contraction which clearly politically has become an untenable option.

Hence, if you are in favour politically of a bailout, you cannot avoid risk by nationalization as it involves simply transferring risk from the private sector under government regulation to the government under government regulation.If you are not in favour of bailouts you would argue it is better to do nothing and not risk further taxpayer money, but you cannot have it both ways and assume government nationalization would somehow provide an immediate superior solution.

Furthermore Bank nationalization is both complex and costly and for it to work would entail the need for a broad guarantee of the entire USA banking system obligations which would make people even more unhappy.

I don’t particularly like Geithner's plan but its worth trying. In the meantime it is sensible to enact new legislation to allow a single government regulatory agency( like the FDIC ) to vest with sufficient power, when necessary, to safely dismantle all big financial institutions so as to minimize damage to the financial system and overall economy.

10 comments:

Gary said...

You're my smart Australian friend :)

This is such good writing Lindsay. As I understand you, future regulation may even be more important than who owns the banks or whether this approach will mitigate the disaster sooner or later.

Thanks.

Seraphine said...

oh good. the government is going to backstop the risk with fdic insurance.
nevermind that fdic insurance is almost broke.
maybe we should pay off our debts with music instead.

lindsaylobe said...

Hi Gray & Sera
Gary - yes - that is my conclusion.
Sera -Singing for your supper is not necessary when you can print more money, since both the TARP funding and FDIC guarantees are essentially government risk capital- the government can seek more funds from Congress to cover shortfalls at any time. Given the patient – (the economy) is in such a dire situation I think life support measures take precedence over fears about additional debt (undoubtedly much more funding will be required) or future inflation fears to co inside with any eventual recovery. Concurrent with that action, as I mentioned in my posting is the urgent requirement for a legislative plan with improved regulatory controls to administer a more sustainable healthy future. I think the current administration is heading in the right defection on both counts- resuscitation of the economy and in improved regulatory control measures.
Best wishes

gfid said...

it's the size and scope of the whole thing that just won't fit between my ears, lindsay. and the greed that created it. if it wouldn't hurt so many little people, i'd say "let the bloodsuckers crash and burn". but i'm a wee bit grumpy this evening. i like the pmt with music idea Sera suggests. ....or maybe poems.

lindsaylobe said...

Hi Gfid
The current turmoil all originated from very bad practices of USA institutions engaged in lending and in the bundling of those loans into securities that were sold off all as highly rated parcels all over the world. Subsequently the general economy of most countries has also deteriorated as consumers spending tanked and many ordinary folk are being very adversely affected.

Hence it is entirely understandable that folks are outraged over the foolishness and greed of the few that managed to create the havoc in financial and general markets but the effect is in marked contrast in different countries.

In the USA banks have not passed on any of the reduced interest rate costs to consumers despite their lending costs reducing substantially which contrasts with other countries, such as Australia where rates have halved, meaning our housing market is holding up very well.

The reason the USA banking system has not passed on the reduced rates is because banks are still restricting credit due to their weakened balance sheets full of these toxic assets and many are technically already insolvent.

The lack of finance has also impacted on credit for cars, exasperating the already weak market and helped place the car manufactures on the brink of insolvency. If you allow the car Industry to fail because of a lack of credit and government bailout money (which is unpopular) you risk over 1 million in additional unemployment.

Hence I dont think it is as clear cut as many commentators would have you believe. What I have attempted to do is to analyze the proposal and point out that by simply nationalizing the banks you do not avoid the more difficult political questions about using public money to bail out the system and help ordinary folk stay in sustainable employment.

The whole system also needs to be changed and I think the current administration is also attempting moves along these lines, for which it to be commended.

best wishes

Seraphine said...

the main thing is to place some kind of value on 'toxic assets' so we can figure which financial institutions are adequately reserved, and which need to be closed.
frankly, not knowing the extent of the problem is costing taxpayers too much money, because the net result has government throwing money everywhere rather than targeting the monies where they are specifically needed. IMHO.

lindsaylobe said...

Sera, the Bank plan which was the subject of my post (however flawed) is not a bailout of the banks as such and values the toxic assets by virtue of the auction system. If it fails through insufficient interest then it may be the catalyst for the government to take over the insolvent banks and restore them so that eventually they can be resold back to the public later as viable entities. Such a move by the government will precipitate similar sale/ liquidation of the toxic assets.
The Obama administration in my opinion has to be given some considerable credit for some progress during their relatively short period in office. The $ 800 billion stimulus package was needed but infortuneatedly is spread over too long a period to have the desired immediate effect and the tax cuts are mostly being saved. The mortgage programme is better than that which was offered under the previous administration and the bank plan (the subject of my post) is also the best one put forward and deservers a try.
Best wishes

gfid said...

btw - i love that phrase, 'toxic assets' it says so much in two little words. i once belonged to a women's investment group; we called ourselves 'nice assets'.

Kraxpelax said...

Buying Bank shit, paying Fed farts? Excuse my brute language, but truth is not always nice.

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