"The Government's Plan to Subsidize the Purchase of So-Called "Toxic" Bank Assets--Posner
Major banks have large quantities of mortgage-backed securities (actually slices of those securities, but I can disregard that detail) and also of mortgage loans that have not been securitized. (The banks have other securitized and nonsecuritized debt as well, but for the sake of simplicity I confine my discussion to mortgages and mortgage-backed securities.) The banks are required to mark securities to market--that is, to carry them on their books at market value rather than at book value--and they have done that with respect to the MBS's. They have not done that with respect to many of their nonsecuritized loans (those that are still "performing"--that are not yet in default, though they may soon be). They are believed to have overstated the value of both the MBS's and the nonsecuritized loans in order to avoid acknowledging that their capital has been impaired to the point at which the bank regulators, if they insisted on current market values, might require the banks to raise more capital from private investors, or to accept a government bailout--or else be closed by the regulators.
Because the banks have overstated, or at least are believed (though with good reason) to have overstated, the value of these mortgage-related assets and are unwilling to acknowledge what they have done by selling the assets at a price below their valuation of them, there is essentially no market activity in the assets. No one will buy them at the price demanded by the banks. As a result, the true value of the assets is difficult to ascertain, though the low bid price is probably the best evidence of their true value.
In a regrettable, because misleading, bit of business and political jargon, these overvalued (by the banks) mortgage-related assets have been dubbed "toxic assets." What makes the phrase misleading is the implication that these assets poison the bank's balance sheet and as a result paralyze bank lending. That doesn't make sense to me, though it was the premise of the original TARP program enacted last October and may have made some sense then, when the entire financial-intermediation sector was in a state of panic.
Because of the losses that the banks have taken, they are undercapitalized, and it is thought that existence of these overvalued assets on their books is making it difficult for the banks to attract private capital. This is implausible. A person who wants to do business with a bank--say, buy its bonds--and is concerned about its solvency will examine the bank's balance sheet and notice some assets that are accurately valued, such as cash and Treasury bonds, and others that appear to be overvalued judging from the lack of demand for them priced at the bank's valuation. So in deciding whether the bank is solvent, the prospective investor will write down the value of the overvalued assets to their market value, of which probably as I have said the best estimate is what buyers would be willing to pay for them. There is no contamination of other assets and hence of the balance sheet, any more than in any other company that has some assets that are difficult to value.
Suppose the government wants the banks to have more cash, in the hope that they will lend more--more precisely, wants them to reduce their requirements for extending credit and to lower their interest rates--and is not optimistic that the banks can raise the cash in the private market. Whether the banks will lend much more if they have more cash is uncertain, because in a depression (and in my opinion, as I explain in my book A Failure of Capitalism: The Crisis of '08 and the Descent into Depression, to be published shortly, we're in a depression, not a mere recession), demand for loans falls. People want to save, not borrow. Especially in this depression, because the mismanagement of the economy by the Bush Administration and the Federal Reserve in the first half of the decade produced a dramatic fall in the personal savings rate and a movement of savings from safe forms to investments in houses and common stocks, so that when housing and stock prices fell, people's savings plummeted and they are trying to rebuild them--the personal savings rate has soared since the financial crisis of last September. The more income that is saved, the less that is used to buy goods and services--especially when people's incomes are shrinking--so output falls and with it the demand for borrowing by businesses.
But suppose it's true that banks would lend more if they had more cash, and probably it is true to some extent, given the huge spread between the riskless Treasury bill interest rate and the interest rates being charged by banks even to good customers. Then the government could continue doing what it has been doing--giving banks cash in exchange for preferred stock. That form of bailout increases the banks' lendable capital because preferred stock has no maturity date, so that the banks don't have to worry that the government will snatch the money away from them. There is no need to remove the overvalued assets from the banks' balance sheets, if as I believe the market is not deceived by them.
A problem with that approach, however--a political rather than an economic problem, if politics can be separated from economics in a depression (I don't think it can be)--is that the government doesn't want to ask Congress for more money to lend to banks because "Wall Street" has been thoroughly demonized by an ignorant (or demagogic) Congress and the ignorant media. The Federal Reserve, it is true, could infuse cash into the banks, without having to go to Congress, just by buying the overvalued assets. But that approach has two problems. First, if the Fed just pays the actual value of the assets, it isn't doing much for the banks--it is not expanding their balance sheet--but if it overpays, it will be fiercely criticized as being in the pocket of Wall Street. Second, if the Federal Reserve buys debt, especially long-term debt, and especially debt worth less than it is paying for the debt, it increases the risk of a future inflation. If it buys a security from a bank for $1, and two years later can sell it for only 40 cents, then even if it retires the cash that it receives from the sale, the money supply will have grown by 60 cents. Moreover, for the Fed to suck large amounts of cash out of the economy by aggressive sale of debt owned by the Fed would push up interest rates and cause a recession, as happened in the early 1980s when the Fed under Paul Volker decided to break inflation. Inflation is not a current concern--indeed, the inflation rate is so low that there is a worry about deflation--but it may quickly become one as the economy starts to recover.
It is against this background that one can understand Secretary of the Treasury Geithner's complex plan of subsidizing hedge funds, pension funds, and other large investors to buy overvalued assets from the banks. If an investor would not pay more than 30 cents for an asset that the bank values at $1 (the price at which it acquired the asset), but the bank would be willing to sell the asset for 40 cents, the government has to pay the difference to the investor to make the transaction happen. (The bank might want to hold out for more, but the regulators can probably coerce it to sell for less than it wants.) And that is what the government plans to do. According to Jeffrey Sachs, the government's subsidy will induce buyers to pay almost twice as much for the assets they buy as the current market value of those assets, though conceivably that value is too low, since the absence of an active market makes valuation difficult. But the government plans to disguise what it is doing by casting the subsidy in forms difficult to monetize, such as guaranteeing the investor against loss, and by drawing on the existing funds of the Federal Deposit Insurance Corporation. The essential point is that whatever form the subsidy takes, the difference between the valuation that the market places on the asset and the price paid for the asset will be paid for, albeit indirectly, by the government, as otherwise there will be no transaction.
It might seem a plus that, in my example, three-fourths of the money comes from the private sector rather than from the government (in fact, under the plan, the private buyers will be putting up only 50 percent of the equity capital for the purchase, and will be borrowing the rest in the form of loans guaranteed by the government). But in the larger economic picture, this turns out to be a minus rather than a plus. If instead of subsidizing a hedge fund to buy securitized debt, the government lends the bank the money that it thinks the bank needs in order to be encouraged to do more lending, then the hedge fund in my example has 30 more cents with which to do its own lending or other investing. Hedge funds are nonbank banks. That is, like banks they are financial intermediaries (meaning that their business is to lend or otherwise invest capital that is itself largely borrowed). If hedge funds give banks cash in exchange for assets, banks have more cash but hedge funds less, which means that financial intermediaries as a group have no more money than before, whereas they would have more if the source of the money to buy the bank's asset had been the government rather than another financial intermediary.
The government's plan envisages complex, three-party transactions--bank, hedge fund (or other private investor that buys an asset from the bank), and the government. It presents a host of difficult tax issues that have yet to be resolved. See http://gibsondunn.com/Publications/Pages/DetailsofPublic-PrivateInvestmentFundReleased.aspx. A government loan to an undercapitalized bank (with the asset lent against being treated as collateral for the loan) would be simpler, and therefore faster and more effective. But I assume that the Administration considers the political obstacles to a further explicit bank bailout to be insurmountable.
Although my guess is that the political factor is the major driver of Gaithner's complex plan, the plan does have other advantages, so that on balance, despite its higher transaction costs and likely longer delay in implementation, it may conceivably be the superior approach quite apart from the political imperative. It will simplify the banks' balance sheets by removing assets of uncertain value and replacing them with cash, and it will draw on private-sector expertise in valuing assets and in negotiating transactions. The government could of course hire a Wall Street firm to advise it on the purchase of assets from banks, but both the carrot of profit and the stick of competition are likely to be stronger motivators to efficient transacting, and this argues for making private firms buyers rather than just advisers.
Posted by Richard Posner at 6:24 PM | Comments (2) | TrackBack (0)
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"Second, if the Federal Reserve buys debt, especially long-term debt, and especially debt worth less than it is paying for the debt, it increases the risk of a future inflation"
I backed such a plan in order to combat Debt-Deflation through QE. My only objection at first was political backlash.
"The essential point is that whatever form the subsidy takes, the difference between the valuation that the market places on the asset and the price paid for the asset will be paid for, albeit indirectly, by the government, as otherwise there will be no transaction."
Once the government bailed out AIG, a subsidy to the buyer became necessary. That's because the owner's of the TAs have been betting on government intervention. As well, they've received money to avoid fire sales of assets. In other words, the government has subsidized and given an incentive to the owners, which necessitates a subsidy and incentive to the buyers to compensate or equalize the exchange. Because of this and the need to transfer some of the banks debts to the taxpayers, a subsidy is a necessary part of any hybrid plan.
"The government could of course hire a Wall Street firm to advise it on the purchase of assets from banks"
This was William Gross's plan. It suffers from inherent conflict of interest. In truth, any hybrid plan will suffer from this, as PPIP shows. Even though Geithner is not from Wall Street, he's a Wall Street tool. Conflict of interest is inherent in a hybrid plan.
The reason that hedge funds are involved is simple. They are designed to buy risky assets, and are currently buying them. Who else will? If the government were to do this, it would be portrayed as the government investing in risky assets like a hedge fund.
"(The bank might want to hold out for more, but the regulators can probably coerce it to sell for less than it wants.) And that is what the government plans to do."
This seems to be the plan.
"Although my guess is that the political factor is the major driver of Gaithner's complex plan, the plan does have other advantages, so that on balance, despite its higher transaction costs and likely longer delay in implementation, it may conceivably be the superior approach quite apart from the political imperative."
I disagree somewhat. I think that this is simply the best hybrid plan that can be fashioned in the current situation. Down the road, the FDIC might be able to seize these behemoths, but, as of now, that's hard to see working, although I believe that they are trying to put themselves in a position to do this.
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