Geithner’s hair of the dog plan for banks

By J Saft
February 18, 2009

jimsaftcolumn– James Saft is a Reuters columnist. The opinions expressed are his own. –

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. –

23 comments

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Most of us accepted the financial equations where the asset value increased as interest rates declined. The lowest rates were normally found on short-term debt where holding on to the security for a couple months is not a big deal. What people describe as toxic debt resulting in insolvency reflects an inability of banks to sell securities at extremely low rates. I question the underlying valuation model. Because to me it seems debt should be nearly impossible to sell at low rates. Certainly as a security that can be traded, such debt at least on the mid- and long- range has no value in comparison to various competing financial products. So we have debt owners under the impression that their portfolios are worth a lot while prospective debt buyers have just the opposite opinion. We also have a python in the markets preventing rates from increasing and preventing spending. Because banks carrying a lot of debt – as banks have been known to do – are having great difficulty selling the debts to offer investment capital. The government will offer financing to stimulation. They will do this by borrowing money. But here we have a brick wall. If they simply print money, all the portfolios get permanently impaired, leading to widespread fear and panic. Yay.

Posted by Don | Report as abusive

Does this portend DEFLATION? If so, buying gold would be a bad protection move.

Posted by Pure Magic | Report as abusive

Well, this person does not see absolutely anything positive. I appeal to him to be a bit more balanced.

Posted by Marco | Report as abusive

What incredible fiscal insanity. We have a consumer driven, demand economy so give each taxpayer a $10,000 tax refund check and let them buy, pay down debt, or save it. Regardless of what the consumer does, it will provide an immediate boost to the economy. Its cheaper than a trillion dollar subsidy to prop up failure. Further, so called toxic assets are just assets which were overvalued for the debt placed against them. Previous support has not worked so let them fail. Housing must be purchased with true income declaration from tax returns, and there is full recourse for the lender we are wasting trillions of dollars. Until this change is made we are on a path of incredible fiscal insanity, and the end of free enterprise as we know it.
Buy the Feb 16 edition of Newsweek and see why Canada has ZERO problems like this.

Posted by tourist | Report as abusive

The Mother-of-all-Investment Banks: The U.S. Treasury. This is insane, but what could you expect of the likes of Paulson, Geithner, Summers, Rubin? Exactly.

Posted by Robynne | Report as abusive

Talk about moral hazard. In order to prop up this bankrupted system run into the ground by an elitist corporatist (the opposite of socialist) Bush administration, we are now actually subsidizing an economic downward spiral in order to make the climate for corporate/political piracy endure until every last sucker is played out. But then again we have been in the twilight zone for many years now.

I don’t think anyone is really surprised. But when people are starving (as is beginning now) the endgame may come quickly into focus – social unrest, authoritarianism, civil collapse and a military state. All because we stubbornly refuse to hold the elite corporatists/politicians accountable to the laws of malfeasance, misfeasance and nonfeasance. Too big to fail, indeed!

Posted by Jonathan Cole | Report as abusive

Why the step into Socialism? Let the teetering banks fail; let the ones with power buy up the (so-called) toxic assets & turn them around. Failing companies should FAIL; let the performing companies TAKE their market share & perform even better! Let the failing customers FAIL & declare bankruptcy & start over. Allow the market to work out which companies are STABLE while the unstable ones FAIL. The previous 3 sentences are the result of CAPITALISM at work, best here in the U.S. Leave the socialism to France, Sweden/Denmark, Russia & other countries which are NOTHING on the world stage next to American capitalism. Stop this financial madness!

I fully agree with Mr Saft’s analysis. It’s time to nationalize those institutions which are insolvent, wipe out the shareholders and at the least the majority of the bondholders, liquidate the toxic assets at whatever the market will pay in cash (however little) place the institutions on a sound footing (fully transparent) and offer their shares to the public.

Posted by Big Al | Report as abusive

a solution to the downward spiral in asset valuation would be to cancel all personal mortgage/secured debt. the advantage would be to force a market bottom which would be 0 then rapidly rise as owners would be free to sell and and buyers would be able to enter the market. the economy would also recover quickly as without mortgages spending would rapidly increase and owners would be able to borrow against a 100% owned asset. The banks would take losses on a massive scale probably enough to bankrupt them, but they are bust anyway. the government can then choose which ones to save, probably those with a good management history. Investors may be wary at a government doing this repeated but the government can reassure them that it will happen every 50 years giving each generation an opportunity to live debt free at least for a while. mortgages can be structured on this basis. ed

Posted by ed | Report as abusive

Nice analysis – as usual.
And whilst Geithner & Co construct the fig leaf, market prices on toxic assets are depressed since:
Why buy now if the government is going to subsidize you to buy later?

When the subsidies are finally rolled out, then in areas where they are pitched too low, then the market remains frozen. In areas where they are pitched too high there is a scramble to buy. Those who are best connected in Washington will probably scoop the best deals.
This kind of nonsense is is pretty much inevitable when the government tries to play the market with lots of cash. It looks more like embedding bad practice than a cleansing.

There doesn’t seem to be a lack of thoughtful analysis anywhere except where it is needed most, by the one pulling the strings and levers.Is any one else getting the feeling that we have yet to pull back the curtain on the wizard? It seems as though the biggest Ponzi scheme in history is the returns the Fed and Treasury are offering in these “solutions”. Where’s Toto when you need him?

I seem to remember this happening when I was pre-teen in the early 60′s. Then there was a spate of credit card deliveries in everybody’s mailboxes. Anyone that had a bank account got one (or more). Now, when I go to the grocery store and they give me a little sample of shrimp cocktail on a toothpick, I know they “hope” that someone will buy more, but I seriously doubt that they bank on selling out day after day after day from now until eternity. But it sure looks like that was the corporate attitude in the U.S. for the past 20 or 30 years. I think they thought the well would never go dry. I also think that we all believe that we won’t have to do anything about global warming either. However, unlike some here, I do believe that the role of any government is to take care of the security and welfare of it’s people, and that is to say that in times when “the private sector” isn’t behaving themselves the proper agencies need to step in and restore order. So which is best, so-called Socialism or corporate anarchy?

Posted by Niel | Report as abusive

Identify all the underlying mortgages for a toxic assets, and have the government refinance them, with the money loaned being used to close down the toxic asset. A loss will occur to the holder of the toxic asset, but cash now is better than a long term question of value. In the alternative, have a good bank (one without toxic assets, probably regional) refinance the same loans and cash out the toxic asset.

Posted by MarkJohnHunter | Report as abusive

People who call bailing out corporations, “socialism”, don’t know what they are talking about. Socialism redistributes wealth to real people. Corporations are fictional entities. When the government redistributes wealth to corporations, that would be called corporatism, generally indistinguishable from fascism.

Posted by Jonathan Cole | Report as abusive

Hair of the Dog Plan? Oh Jimmy, Jimmy, Jimmy that has to be the best tag line I have ever read, I just love it when someone can condense the essence of complexity into a simple and easy to obtain understanding of the innate characteristics of what is going on. As a reductionist, I can only applaud this as potentially the defining sentence of this entire crisis and how it happened.

The Hair of the Dog Plan

How every addict avoids the symptoms of withdrawl

You sir, are a true genius.

With things this far out of whack in asset prices, it makes no sense whatsover to attempt to support some sort of contrived notion acceptable or negotiable strike prices. Institutions carrying assets worth 25% of face are bankrupt, you need to get that through your heads. Take them over and the sooner the better. It’s the only solution.

Posted by Chris | Report as abusive

Capitalism is a flawed system.
The only time it works is when asset prices go up! When the myth of the perceived wealth is evaporated, then there is nothing to stem the fear and the freefall begins.
Without social handouts the bankruptcies would still be continuing and the American way of life would cease to exist
To suggest we let a third of all banks fail, in some bizarre ‘Darwinian’ example of economic survival of the fittest is naïve at best and down right dangerous at worst.
If some of the commentators here are so convinced that they have a ‘superior’ system, which is based on pure greed and no protection, then maybe they should get ready for the next phase of the cycle: That being social unrest, anarchy and a breakdown of the rule of law, then followed that with the form of government control we all witnessed last time we had such economic woes, protectionism, leading to fascism, leading to…….. Well that really would be government intervention now wouldn’t it!!
Those that are thrown out of their homes, who lose their life savings, or watch as they become worthless due to Hyper-inflation, those who have no hope and no food to feed their kids, do you really think they will all sit patiently for the capitalist system to ‘fix ‘ itself, or do you think they might just get tired of the inequality, break into the shops and steal the basics that capitalism has taken away from them.
A country where the system has failed, the government turns its’ back, where the support structure crumbles is a country where all hope is gone.
So is this what you advocate!!??
Regulators stand back and let ‘natural selection’ be the policy to protect those with a lot from those with nothing!!??
It’s a policy to guarantee that the overwhelming problems we face will bring us all to despair.
So why not forgo your purist thoughts, adapt to the reality that capitalism by its very nature is greed.
That to gain wealth somewhere, someone must lose it otherwise it never existed.
Social capitalism is the only alternative for Humanity if it’s looking to benefit as a whole and not as individuals.
Then again, in a country that pertains to be the richest in the world but can’t even afford universal health care, yet they spends billions in subjugate wars worldwide!!!
Well that’s maybe the sort of society we should see fail. It is bankrupt of ideas, compassion and understanding, yet somehow it thinks it superior to the few European nations who’s governments actually act responsibly to there citizens.
So America, carry on like you have been blindly believing in free markets and then ask yourself again why the rest of the civilised world was turning its backs on you.
Anyway, my words are advice are only my opinions, based on a deranged mind that actually finds great comfort in the idea that the community I belong to might actually help me in my times of trouble, and we are only just entering that territory.

Posted by craig | Report as abusive

Flexibility is always an integral part of any idea or school of Thought. As History has shown us, rigidity only leads to downfall of any system. Now Capitalism in US is at a very crucial Juncture. Given the options now, adopting an approach slightly deviated from core capitalistic principles will do more good than bad. That’s because the affected party here would be the common man and if the system saves him/her, his/her faith in capitalism will be reinstilled. The government can choose to allow the bad managements fail, but they will take many more people down along with them, which will be majo blow to people’s faith in the system. Moreover the change being is not a fundamental one, but a temporary one to bring back the economy on it’s legs.

Posted by Bharath Sridharan | Report as abusive

It seems that that the forces of the mighty markets have run it’s course. The article offers certain viewpoint that may be right from an investor standpoint but at the same time is riddled with number of conjectures with regards to the banks’ position. Let them worry about the toxic assets. The constant preoccupation of the government with helping the banks & Co. is worrying and clearly the recent lessons suggest more of the same will not solve the problem (have they got other vested interests there..). Never mind what the reality is it’s the perception of it that matters and it defines the behaviour including the markets. Yes it’s irrational but that’s what defines crisis. Government efforts should be aimed at stopping the job losses and stop balancing the other factors they can’t control. That is their duty. That could also help to provide a floor for the property market. Banks will eventualy come back to the party. Bigger worry is that neither the authorities nor the experts know how to handle such crisis that are likely to be repeated. Where are the think-tanks and advisors when we need them most? Nobel prices have been handed out to what seems like an academic nonsence whilst real life issues are being ignored.

Posted by Franz Kafka | Report as abusive

Saft: “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.”

This is rather myopic reasoning, given the situation, and excludes itself from the fact that the situation is drastic and requires immediate action.

The above makes common sense, admittedly, under normal circumstance — which do not prevail.

After all, the Toxic Waste exists because bankers purchased it imprudently (charmed by the waste’s fraudulent triple-A ratings) from other bankers who collected and packaged the junk lending, selling it forward and taking profit. (Which, of course, paid the handsome bonuses to those bank and credit institution managers at the time.)

In Japan and Sweden, who went through EXACTLY the same circumstance (as early as a decade ago), the same solution as today was implemented. The Toxic Waste must come of the balance sheets in order to restore solvency. They are “marked to market”, meaning that they are purchased by the state and parked in a state holding company at existing market prices — until they can be resold back into the market at some unknown future date.

The Japanese and Swedish experiences have shown that the waste comes back inevitably onto the market, if it is realty-based and bears profit to the national treasury. Meaning that residential housing can be resold to homeowners. (If the waste is consumer credit based, then it is an altogether different matter.)

The only twist on the Obama plan is to ask private funds to participate in the operation. Of course, national treasuries can wait patiently for the moment when the properties will be sold. Private investors are not so patient.

Still, what is the difference between those private investors presently who attend auctions that offload foreclosed properties (marked to market) and those far more fortunate grandees who would do the same but in a wholesale fashion?

The banks cannot have it both ways. They are responsible for this mess in their guileful cupidity (for bonuses). And they now expect to become recapitalized at exaggerated prices for their toxic waste?

C’mon, that’s way, way beyond belief.

Posted by Lafayette | Report as abusive

To balance socialism/capitalism and spread the subsidies equitably, the Treasury could give every American a time limited mortgage coupon of $3000 to buy the toxic asset with their own money of $6000 to $6500 (using your example).

Posted by Shi | Report as abusive

the value of these “assets” is at the core of the whole issue. it seems that nobody wants to truly recognoze or take losses, when truth is, everybody already knows there are losses, recognized or not.

meanwhile, there is a game of chicken going on between banks and the government and the private sector. if there is a market for REO’s, CDOs, etc. then these assets would move. but banks want the values to be what they once were, so they are waiting to see if the government will come along with a better deal then the free market.

Banks work like the heart, it pumps blood to the rest of the body. When the heart stops, you can argue all day whether it would return to normal or not. You can even argue it is only a pump and not so important after all. But you only have a few minutes before the brain, the lung, the liver, the kidneys and the rest of the organs start to fail. After that, there is no point to restore the heart — the same for the banks.

Posted by Lee Siu Hoi | Report as abusive