Geithner’s hair of the dog plan for banks
U.S. plans for a public-private fund to buy up toxic assets are likely to amount to a fig leaf with which to hide subsidies to failing banks.
It is also, inevitably, an entirely new subsidy to outside investors, who by definition will only participate if they get better terms than now available in what we formerly thought of as the free market.
Treasury Secretary Tim Geithner last week announced the plan, which will provide between $500 billion and $1 trillion of financing to private sector funds which will use the money to lever up their own capital and make offers for complex and doubtful securities now clogging balance sheets. Further details are to follow.
But it’s likely the plan won’t work, if by work we mean come up with a believable price for these assets.
Banks won’t sell at market prices because to do so would make many fall over bankrupt. The U.S. can surely manipulate prices by providing cheap and plentiful leverage – sound familiar? – but that will be seen for what it is; a subsidy for the funds and the banks rather than a firm base to allow confidence to return.
As it is, there’s a standoff in markets as to how to price these assets. For the sake of illustration, let’s pretend that banks have a security marked on their books at 90 cents on the dollar, while similar securities change hands at 60 or 65 cents when bought and sold in arms length transactions.
The first thing to recognize is why the market and bank prices are so far apart for these assets, many of which are tied to real estate or consumer loans. It partly reflects uncertainty about how the underlying loans will perform given the poor economic outlook. But it also reflects the potential that assets will get cheaper still, that banks will become forced sellers later and so why commit your capital now as prices may well fall when banks disgorge.
It finally and powerfully reflects the fact that there is very, very little secure term funding at a reasonable price available with which to buy this stuff. That means you have to be a cash buyer with a long time horizon, meaning the return has to be pretty juicy.
The banks have a partly legitimate beef with what they see as a market failure and partly are applying self-serving valuations in order to avoid going bust. The assets may throw off more income than implied by market prices, in other words those returns to cash buyers may be a bit rich, but on the other hand these high carrying prices are very convenient for the banks which would fail if market prices were applied.
BETTER THAN PAULSON BUT STILL FLAWED
The earlier Paulson held-to-maturity plan was aimed at buying up these loans at higher than market prices, the justification being that there was a market failure and the government would actually make a “profit” on the deal.
That plan failed while the new one hopes to use private investors to set prices, thus justifying the numbers. It will avoid some issues, lessening the chances that banks just fork over the worst loans or that the auction is corrupt, but it won’t achieve a market price.
Imagine for a moment that you are a hedge fund manager and in your subjective view a security now held by a bank will generate a return of five percent over its lifetime at the price at which the bank is willing to sell. No deal.
But if the Treasury will lend you eight times your capital for five years at 2 percent, well then that works pretty nicely, at least from the hedge fund’s point of view.
Competition between funds for access to the leverage can improve the outcome for the taxpayer, but banks have to be willing to sell and won’t do it if it drives them under. The U.S. can and I fear will simply increase the amount of leverage it will give relative to capital until the returns to the funds are good enough to justify them buying the asset for a price that keeps the banks magically solvent.
Sound familiar? It should because that kind of leveraged speculation is everyone was doing until the summer of 2007. Only then they were doing it with money borrowed from banks, now they are doing it with taxpayer money. Actually, in retrospect it always was taxpayer money.
So, it’s a bit better than the Paulson plan, and maybe we want to spread subsidies across funds and banks to help soothe the problem. But will it work to restore faith in banks? I am not sure it is enough money to do that without getting a multiplying effect from the rest of us believing the prices. If the result appears to be fixed, that won’t happen.
— At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns, click here. —