Geithner's Bailout Plan: Another Recipe for Financial Disaster
Politics / Credit Crisis Bailouts Feb 12, 2009 - 09:35 AM GMTBy: Money_Morning
Shah Gilani writes: By relying on asset-backed securities, large amounts of leverage and unregulated hedge funds as its key elements, the U.S. Treasury Department's overhaul of the banking-system bailout plan is essentially relying on some of the same ingredients that caused the financial crisis in the first place.
This time around, someone should take the punch bowl away before the party even gets started. Otherwise, as Yogi Berra once said, it will be “ Déjà vu all over again.”
The only difference this time around is that the U.S. Treasury Department is calling the plays.
Backdrop on a Bailout
In a press conference Tuesday, U.S. Treasury Secretary Timothy F. Geithner unveiled the long-awaited successor to the Bush administration's Troubled Assets Relief Program (TARP). The reaction was swift. Stocks plunged after the 11 a.m. press conference began when Secretary Geithner introduced a new rescue plan that was light on specifics and stated that the new program's goals would take time to achieve .
The Standard & Poor's Financial Index plunged 10% in afternoon trading, with such stocks as Bank of America Corp. ( BAC ) and Fifth Third Bancorp ( FITB ) taking particularly bad beatings.
Bank of New York Mellon Corp. ( BK ) fell 6.3% and Hudson City Bancorp ( HCBK ) 5.4%, making them among the better performers for the day.
The reaction was understandable. The government had outlined a plan that is supposed to remove $500 billion in bad assets from bank balance sheets in the near term - and $1 trillion in the long term - by leveraging $100 billion in cash to support the eventual $1 trillion in purchases.
The proposal would require the participation of private investors, such as hedge funds, and would include government guarantees to limit losses as an added enticement. How this will all work must still be explained. And since hedge funds are largely unregulated and, by nature, highly secretive about their operations, the plan as configured doesn't appear to provide the “transparency” that U.S. President Barack Obama has promised.
But the biggest problem of all is that - unfortunately for the Treasury plan - most economists estimate that it would actually take roughly $4 trillion to buy all the troubled assets that are out in the marketplace.
Clearly, the market reaction wasn't merely an expression of disappointment with the Treasury Department's plan - it was a total repudiation of a strategy that failed to deliver what the market was looking for: a new approach to the credit crisis and to the economy's depressing decline. In short, this new plan didn't represent a big enough break from the current TARP plan.
The original TARP proposal - developed by Bush Administration Treasury Secretary Henry M. “Hank” Paulson Jr. - was supposed to employ $700 billion towards buying troubled (also known as “toxic”) assets from distressed banks. As soon as Congress passed legislation authorizing the bill's implementation and funding, two things became clear:
- First, $700 billion wouldn't be enough to buy all the toxic assets in the market.
- And second, there was no way of determining what price to pay for troubled assets.
Once that realization occurred, Paulson & Co. shifted gears and opted to spend nearly $300 billion to make direct investments in troubled banks. Worse than being merely ineffective, it enabled banks to pay bonuses and finance buyouts - instead of increasing lending, as the government intended. Worst of all: Banks themselves refused to detail how the TARP money was being spent.
The market's “no-confidence” vote on Geithner's Tuesday announcements prompted officials in the Obama Administration to characterize the minimal details given as “intentional” and to say that they will work with Congress and the public to fully develop the plans. If there's one thing that can be counted on, it is that Congress will continue to be part of the problem and not the solution. By counting on the “public,” however, some suspect players may be included.
The new twist in implementing Geithner's plan calls for the government to partner with private investors in setting up an “investment fund,” formerly known as a “bad bank,” or an “aggregator bank.” Putting aside the underlying problems of how to value the assets the fund is going to buy and the fact that $1 trillion would be not be enough buying power, there's a fundamental question that has to be answered: Just where is this “private capital” going to come from?
While the scant details provided by Treasury on this critical component of the aggregator-investment fund drew criticism, there is actually a frightening clue as to how this fund will be capitalized and just who will be providing the private capital to what is essentially a “new old” plan.
Tackling TALF
The $200 billion Term Asset-backed Securities Loan Facility, or TALF, was announced in November 2008 after the market for securities backed by consumer debt froze . Like its sister program, the original TARP, it was never implemented. Now, like the WHO song says, “Meet the new boss, same as the old boss.” TALF is being re-floated by Secretary Geithner, and just like the resurrection of TARP, the TALF is expected to need $1 trillion to bring moribund credit facilities back from the dead.
The basic idea is that the government will lend private investors money to buy new “AAA”-rated security pools of consumer debt. If banks know that - after they make car loans, student loans or issue credit cards - they can package those loans and sell them to waiting investors with cash-in-hand, those financial institutions will start to make consumer credit available again. When the financial institutions sell the securitized pools, they get money from the buyers and can make more loans with fresh capital.
Amazingly, the TALF program is designed to allow private capital to borrow cheaply from the U.S. Federal Reserve and incorporate 20:1 leverage to buy new “AAA”-rated securitized debt instruments from distressed banks - with government guarantees that limit losses to the cash invested, and not the money borrowed. The initial capital will be provided by private investors - namely hedge funds and private equity firms - that will be only-too-happy to partner with government in the TALF investment fund.
New Investors, Same Old Story
While the public may be skeptical as to how - or if - this program will work, Blue Mountain Capital Management LLC, a multi-billion-dollar hedge fund anxious to participate in the program, probably spoke for its industry brethren when Chief Executive Officer Andrew Feldstein said: “This is exactly what the financial system needs.”
Already, several of the biggest names in “private capital” are gearing up to participate in this new TALF giveaway program; they include: Pacific Investment Management Co., BlackRock Financial Inc. ( BLK ), Citadel Investment Group LLC and D.E. Shaw & Co. LP .
In the face of all that is uncertain or unknown surrounding this new rescue plan, one thing is virtually certain: These private-capital players wouldn't be so anxious to play ball if they weren't almost absolutely sure that there was a chance to make windfall-level profits from this program.
There's still no formula as to how troubled assets are to be valued. In fact, there's not even a real definition as to what a troubled asset actually is. And that's not all: Troubled assets are actually a moving target.
While asset-backed securities of subprime residential mortgage debt were once considered “ground zero” in the financial crisis, now bankers, Congress and Obama Administration officials are including for consideration securitized pools of Alt-A residential mortgages, commercial mortgages, credit card receivables, car loans, student loans, and just about every other category of securitized debt whose values continue to sink as unemployment rises and the U.S. recession seems to deepen.
That's why it is so difficult, if not impossible, to value these securities; as unemployment spikes and the economy sinks, the underlying assets that determine the value of the securities (meaning the prices of homes, commercial buildings, offices and malls, automobiles, and the ability of borrowers to pay off their credit cards and student loans) are eroding on a daily basis.
There's an additional problem, too: As we discovered the first time around, the so-called “ratings” placed on this debt has a limited shelf life, and are not to be trusted. The worsening economy makes those ratings a moving target, too.
Like a dog chasing its tail, the Treasury's plan is going nowhere but in circles. Increasingly, it appears that Secretary Geithner's new plan isn't markedly different from the original plan proposed by Secretary Paulson, his predecessor. What's actually needed is an entirely new plan.
The Route to Follow
There are other plans that make more sense and don't facilitate the rich getting richer on the backs of taxpayers. The government should not be wasting taxpayer money several times over by infusing capital into banks while they bleed capital out of their balance sheets from mark-to-market accounting on toxic assets - only to then use that taxpayer money to pay for toxic assets to be put into a highly leveraged bad bank that will likely fail and require another bailout, a cycle that seems destined to perpetuate itself.
Here's a simple plan that will work.
- Leave troubled assets on the balance sheets of banks.
- Identify what truly is “troubled,” and cordon off those assets in a separate accounting category. Don't make banks use mark-to-market accounting on those assets.
- Make all banks, hedge funds, and other financial institutions of all types, formally disclose to the Fed (on a strictly confidential basis), a report that details every asset on their balance sheets, and to formally identify which of those holdings are in the “newly created, troubled-asset” category. That will enable the central bank to carefully track the problem.
- Have the Fed establish transparent, openly disseminated pricing models for every category of troubled assets.
- Don't allow any derivatives trading of any benchmark or troubled asset index, or pricing-model matrix.
- Allow investors to buy, on a reverse-auction basis, through a “blind-brokerage” facility, the troubled assets from banks.
- Eliminate brokered deposits to help ascertain which banks don't actually possess solid deposit bases.
- Close banks that are too weak to compete, merge those that can be merged and protect all depositors. Give that process a year to work itself out.
- Create a bank-rating agency to openly rate banks on the basis of capital adequacy, reserve requirements, matched books and debt and investment spreads.
- When banks get too big, based on a national model, make them spin off smaller regional units to reduce systemic risk and to better serve smaller markets.
- As for investors buying troubled assets, create a facility for the public to buy into mutual-fund-like pools to invest in this asset class.
- Allow 100% write-offs of all depreciation on these investments for anyone willing to take the risk of owning them, and modify the capital-gains assessment on possible gains - both moves will make these investments more attractive.
There's no reason that the Obama Administration can't create the transparency for this rescue plan that's been promised. If taxpayer money is going to be used to save the financial system, taxpayers should have the same (or better) opportunities than hedge fund and other “private capital” pools to profit from the mess that they're being asked to pay for fixing.
It's high time that attendant to all the stimulus spending on the table, sensible tax policies be addressed as a more-comprehensive and longer-term solution to a flea-ridden system that keeps us chasing our tails with no end in sight.
[ Editor's Note : Money Morning Contributing Editor Shah Gilani is a retired hedge fund manager and an internationally recognized expert on credit and financial crises that continue to sweep the globe. More than 2 million readers have perused his analyses of deregulation, problems with the debt-rating process, and the bailout and stimulus plans put forth by the Bush and Obama administrations. Indeed, just last month, in an open letter to President Barack Obama , Gilani detailed a regulatory plan that he believes would go a long way toward restoring the investor confidence that most experts say is needed if the crisis is to be brought to a close. Gilani is also the editor of The Trigger Event Strategist , which identifies profit plays that continue to be created by "aftershocks" from the financial crisis.]
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