sanctity of the capital structure and to treat differently stakeholders with similar legal rights

TO BE NOTED: From the FT:

"Bank tests we should get stressed about

By Mohamed El-Erian

Published: April 21 2009 20:46 | Last updated: April 21 2009 20:46

With the banking system still under stress, financial markets are waiting with great anticipation for the release by Washington of the results of stress tests for major US banks. Some believe the tests, scheduled to be released in early May, are excessively hyped. They are wrong.

The stress tests will accelerate the redefinition of the financial landscape, with a meaningful impact on future economic growth and welfare. However, whether the impact is for good or ill depends on how the results of the tests, and policies that flow from them, are pursued.

Rightly or wrongly, the February stress-test announcement was interpreted by markets as signalling a comprehensive process through which the government would evaluate the soundness of banks and decide on sustainable solutions for the sector – a sector critical to the economy’s prospects.

In particular, the tests suggested a concrete way to differentiate between the solid institutions that can raise private capital, and those that will (and must) feel a heavy government hand. They could also lead to a way to reconcile the multiple initiatives designed to stabilise a highly disrupted sector that is contaminating many sources of job creation, nationally and internationally.

The US government now has to deliver on those expectations; and it will not be easy. The outcome will be decided by more than the design and execution of the stress tests for the 19 selected institutions. It also depends critically on the announcement, context and follow-up.

To maximise the prospects for a good outcome, or at least minimise the risk of damage, it would be prudent for US policymakers to take seriously the following five factors:

First, transparency is key. Whether the government likes it or not, hundreds of analysts around the world will reverse engineer the stress tests. The government would be well advised to assist the process through clarity. Obfuscation would result in damaging market noise and further derail the real economy. At the minimum, policymakers need to provide credible details on the methodology, the underlying assumptions and scenario analyses.

Second, the results of the stress tests must be part of a comprehensive, forward-looking package to resolve problems at banks. Out-performing banks should be provided with exit mechanisms from the exceptional government support that they have been receiving and, presumably, no longer need. At the other end, there must be clarity as to how capital-deficient banks that no longer have access to private capital will be handled.

Third, the banks’ recovery and rehabilitation efforts must be co-ordinated closely with other efforts to put the banking system back on a viable road. In particular, they need to work together with the implementation of initiatives aimed at lowering funding costs (such as federally-guaranteed borrowings and Federal Reserve facilities), and facilitating the removal of the overhang of toxic assets. This will require a level of co-operation among US agencies that, historically, has not come easily or effectively.

Fourth, the government should arrest and counter the recent erosion in key parameters of the market system. Specifically, it must work hard to resist the temptation to override contracts, to undermine the sanctity of the capital structure and to treat differently stakeholders with similar legal rights. Indeed, seemingly attractive and politically expedient financial engineering, such as that used in the third Citigroup bail-out, risks undermining long-standing principles that have served the US well for years.

Finally, the US must never lose sight of the international dimensions of its policies. Its response must be consistent with efforts to upgrade a deeply challenged infrastructure for cross-border harmonisation of regulation and bank capital. The aim is to ensure a degree of global consistency that clarifies accountability and responsibility.

These are stringent requirements. Yet there is really no alternative. The US is already embarked on a journey to a “new normal” that includes reduced private credit intermediation and lower capacity for sustained, non-inflationary growth. Adherence to these five principles would help to ensure that the damage caused by past market failures is not compounded further by stress-test policy failures.

The writer is chief executive of Pimco and author of ‘When Markets Collide: Investment Strategies for the Age of Global Economic Change’, winner of the 2008 FT/Goldman Sachs Business Book of the Year

Copyright The Financial Times Limited 2009"

both plans involve Treasury twisting the banks’ arms to force them to do what is ultimately in their own best interest

From Reuters:

"The Geithner plan vs the Brady plan

Post a comment (3)

Posted by: Felix Salmon

Tags: bailouts, bonds and loans

Mohamed El-Erian is interviewed over at FT.com, and at the beginning of the first interview, at about 1:45, he says this:

I think you’re going to need a little bit of moral suasion. This is very similar to what we saw with the Brady plan at the end of the 80s. You had the overhang of the developing country debt, and you had a mechanism to lift it, but at the end of the day, you also need some moral suasion to get the banks to participate, and to clean up their balance sheet.

It’s an interesting analogy. But in one important respect there’s a huge difference. In the Brady plan, the banks had illiquid loans on their balance sheet which they swore up and down they were holding to maturity (because if they sold them they’d take a loss they couldn’t afford). The solution was to turn those illiquid loans into liquid bonds, add a few sweeteners in the form of zero-coupon Treasuries, and create a mechanism for allowing the banks to slowly let those toxic assets trickle off their balance sheets by selling them in the liquid secondary market as and when they could afford to.

The PPIP, by contrast — or at least the Legacy Securities Program — works the other way around. The banks have liquid bonds on their balance sheet, which they can sell in the secondary market if they want, but only at very low prices. Under the Geithner plan, those liquid bonds will be transformed into highly-illiquid public-private investment funds, with both the ability and the intention to hold the bonds to maturity.

And, of course, the fiscal cost of the Brady plan was wholly transparent and up-front. Under the Geithner plan, no one has a clue what the cost to the government is going to end up being.

But El-Erian is right that both plans involve Treasury twisting the banks’ arms to force them to do what is ultimately in their own best interest. But in one way the Geithner plan can’t ever be as successful as the Brady plan. Under the Brady plan, the main indicator of success was that the developing-country governments in question regained access to private-sector capital. Under the Geithner plan, the plight of the borrowers is not really part of the problem, since most of the debts in question were issued by some kind of special-purpose vehicle. Maybe the resuscitation of the securitization market as a whole is one of the objectives of the plan. But it’s not at the top of the list."

Me:

“with both the ability and the intention to hold the bonds to maturity.”

Yes, and that’s a part of the plan. The point is to have the TAs be seen as investments. If hedge fund buyers, Pimco,etc., do buy these TAs, since they’re well know investors, it will help the government transform the TAs into long term investments in the eyes of the public. It’s a forward looking plan, showing confidence in our future, intended to attack the fear and aversion to risk. In that sense, it’s like infrastructure investment in the stimulus. It shows confidence in the future, and helps attack the notion of toxicity. That’s also why it’s going to be offered to average investors through mutual funds. By the way, if John Paulson is buying them, then they are investments. It’s simply a question of whether they are good or bad investments.

Also, the subsidy part of the PPIP, which is inherent in any hybrid plan, is inflationary, and will also help with QE, since the government will be perceived as having to print money if this all goes sideways.

Since I’m saying a lot of crap to most people, and partly to myself as well, I think that the FDIC is saying that the banks are going to have to pay for the PPIP in the end. They’ll raise their fees, and seize them, just to piss of Hempton, proactively, if they have to going forward. Since the PPIP is intended to save the banking system, as Caballero seems to believe, then they banks are going to have to pay for the plan in the end. It’s starting to sound damned clever.

- Posted by Don the libertarian Democrat