Can the stress tests breathe new life into PPIP?

By Felix Salmon
April 24, 2009

According to the FT today, there are increasing signs that the PPIP is going to go the way of the MLEC — which is to say, nowhere. Potential buyers are worried about regulatory uncertainty, while potential buyers have very little interest in selling at fire-sale levels.

Meanwhile, Ryan Avent reckons that the government is going to have to come up with hundreds of billions of dollars, somewhere, to recapitalize banks in the wake of its stress tests — even as it doesn’t have hundreds of billions of dollars, and there’s no chance that it will be able to get hundreds of billions of dollars from Congress.

Are you thinking what I’m thinking? Just as the original TARP was designed to buy up toxic assets and then got repurposed to inject capital directly into the banks, might the same thing happen with the PPIP? Might it be the case that investors who are wary of buying up hard-to-value toxic assets might be more keen on leveraging FDIC guarantees to buy common stock in public banks? And if Timmy asks her nicely, is there any way that Sheila Bair could say no to such a plan?

I’m not clever enough to come up with a structure which would make such a plan workable — it’s hard to see what kind of event would trigger the FDIC guarantee. Still, I’m sure there’s an options whiz out there who could construct something. The market could then be asked to value those equity-like securities, and any private investor — even you or me — would have the ability to buy them at the market price, thereby helping to recapitalize the banks concerned.

Neither the stress tests nor the PPIP has really gone according to plan since they were announced: maybe some kind of marriage of the two is the only way of saving them.

3 comments

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There is a common thread on many of the posts here, whether it’s about banks, auto manufacturers and dealers, or mortgages. They all need re-structuring because their debt is too large to be serviced. Bailing them out is not fair, and letting them fail would invite chaos, which is one of the things we expect our government to prevent. Effectively, debt needs to be written down and converted into equity, which isn’t easy to do when there are lots of bondholders.

So what we need are pre-packaged bankruptcies and foreclosures. Let’s start with mortgages, because their devaluation has led to the collapse of many banks. The securitization of mortgages has made it difficult, if not impossible, to renegotiate them, so the borrower either has to make payments or default. Let’s create a program that combines a foreclosure with a short sale back to the homeowner at a lower price, with the lower payments that the federally subsidized interest rates would allow. The CDO that owns the mortgage has to be able to deal with foreclosures, so this would appear like any other default, and it would then establish a real value for the mortgage, while permitting the homeowner to stay in their home and stay current on payments (obviously not all borrowers would qualify for this plan, only those who actually live in the houses and have a verifiable income, the kind of things you used to have to prove when you took out a mortgage).

If banks can provide a believable estimate of what their loans are worth, they can raise enough capital to become solvent. If they can’t sell common shares on their own, the government should buy enough to make them solvent, and fire the management, and then start selling the shares on the open market. It might take a while, but I haven’t seen any other way to get rid of the entrenched management, whose top priority seems to be to protect their jobs and lifestyles.

There is no viable solution for GM and Chrysler other than bankruptcy. They have too much debt for the level of business they can profitably generate, so if they are to stay in business, they need some combination of write-downs and conversion of debt into equity. They can’t get ALL of the bondholders to agree, so they all have to get the same punishment from the teacher, I mean the same devaluation from bankruptcy court. The unions and dealers won’t make enough concessions, so they will have to start all over with new contracts. We don’t need to have the two companies file for bankruptcy and then die off while they are reorganized, it can be done in advance.

The PPIP was a gift to the banks, as it basically guaranteed loans for buyers of toxic debt, but the intended participants of this plan are too stupid and greedy to realize what a great deal it is for them. Their mistakes, which resulted in false profits that spawned giant bonuses, would be effectively swept under the rug and paid for by the government, in the name of keeping the banking industry from collapsing. That’s not good enough for them, they want their old jobs back, with their old salaries and bonuses, and nobody to tell them what to do. They don’t want this deal? Fine, see you at Chapter 11.

Posted by KenG | Report as abusive

Why all the financial engineering shenanigans?

Like killing two birds with the *same* issuance of low-interest federal debt, Congress should:
» Authorize and appropriate say $2 trillion to recapitalize insolvent bad banks (under the auspices of “prompt corrective action”);
» Gift the common shares (including voting rights) to the American people; and then
» Contribute them to the Social Security & Medicare trust funds to cure their $56 trillion fiscal exposure (75-year horizon).
As Albert Einstein said, the most powerful force in the universe is compound interest!

Furthermore, the *entire* (performing & non-performing) loan portfolio of the insolvent bad bank should be put into a Chapter 7 bankruptcy estate as a pure investment trust for orderly liquidation, much like an insurance company in runoff mode. The implication for unsecured creditors is that if the loans were held to maturity (e.g., Enron Creditors Recovery Corporation is still in business 7 years after Enron declared bankruptcy) they would probably be made whole! More importantly unlike PIPP, the taxpayer will not be involved with any toxic assets, and will take on only those risks associated with an ultra-clean newly recapitalized bank. And for the economy, the tabula rasa (blank tablet) loan portfolio means that there would be no excuses for the ultra-clean new banks not to lend. For example, under the 10% reserve ratio, a capitalization of $1 trillion could create $10 trillion lending capacity *overnight*. How is that for jump-starting the economy!

In addition to the lush dividends from the ultra-clean newly recapitalized banks (per the positively sloped yield curve and zero initial loan losses), I would also add interest income from the AAA-rated TALF asset-backed securities (which would also reopen the ABS markets) to the federal entitlement trust funds.

If you think about it, how else is Congress going to close the $56 trillion fiscal exposure without raising taxes or touching the third rail of cutting Social Security & Medicare benefits? Moreover for President Obama, this is how he can both balance the federal budget and pass universal health care. How is that for a magic silver bullet!

Bottom line: There is no reason for Geithner, Summers, Bair and Bernanke to engage in financial engineering shenanigans. Congress would be more than happy to authorize and appropriate trillions if the same issuance of low-interest federal debt were used to bailout both the banks and the Social Security & Medicare trust funds (and quell populist rage by having Wall Street work for Main Street). Unfortunately all this is academic and moot since Geithner’s stress test is not at all stressful. Sigh.

Posted by Mikey10011 | Report as abusive

Felix,

As you may remember, I have complained that nobody really understands the Geithner Plan and that hence it is just increasing uncertainty, instead of turning some of it into calculable risk of some sorts. Which means that the most recent non-developments are not exactly surprising from my perspective. But there is another reason why we should not be surprised by these non-developments.

I have argued that the Bernanke-Geithner-Summers policy has, in fact, committed itself to a very special sort of “triage”. Of course, not in the sense Nouriel Roubini has advocated, namely, to take over the banks temporarily and then recapitalise those that are still basically solvent and eliminate the zombies. That would be tantamount to challenging the financial oligarchy, which is something Bernanke, Geithner and Summers are loath even to contemplate.

Rather, BGS are deliberately trying to avoid tackling head-on the seemingly insuperable problems of toxic assets and the plight of people whose mortgages are already under water. Instead, their policy can be seen as “subsidizing the solvent.” So, the idea is to bolster the creditworthiness of the “creditworthy” customers and the solvency of “solvent” banks. If a relatively stable policy plateau can be reached and some sort of “return to normalcy” can be achieved, it is hoped that the rising tide will make the now insuperable problems easier to tackle.

There is no doubt in my mind that this B-G-S policy has been a major factor that explains the (undoubtedly partially correct) impression of greater stability, both in the financial markets and in the wider economy. But this policy has not been meant as a way to solve the problems of “legacy assets and loans” now; neither has it been the intention of B-G-S to do now anything substantial to help the plight of those persons who cannot refinance their loans.

Which means that if and when the nonoperative nature of the Geithner Plan becomes all-too-evident, it will be replaced by some other smoke-and-mirrors delaying tactics.

If some sort of economic recovery begins in the latter part of 2009 and it continues next year, B-G-S will stick to their policy, in the hope that they can address the truly difficult questions piecemeal and with the help of revived animal spirits.

Of course, the Four Trillion Question is whether the global developments permit such a scenario. If they do, Bernanke, Geithner and Summers will become the saviors and heroes of the establishment. If not, they will become political zombies and eventually be sacked from their duties.

Posted by chacona | Report as abusive