Hope amid Bailout Blues

January 23, 2009

By Chidem Kurdas

 

It is hard to find another example in history of so much taxpayer money spent with so little understanding as has been the case with the Treasury’s Troubled Asset Relief Fund—though the new stimulus package may involve even more money and less  understanding, as Mario’s posting on the Macroeconomic Knowledge Problem suggests. A few questions posed by Anna Schwartz offer remarkably lucid insight to the TARP mess.

 

TARP was originally supposed to relieve bank balance sheets by buying financial paper for which the demand has disappeared. Instead, the first installment was used to buy the equity of financial companies, making the federal government a big shareholder. Then the automakers went to Washington with their hands out and got a piece of TARP. It is not clear how the Obama administration will spend the rest of the money, but they’re speaking about channeling it to households that are defaulting on mortgages. Meanwhile, toxic debt continues to weigh down bank balance sheets.

 

Anna Schwartz, of course, is the co-author with Milton Friedman of A Monetary History of the United States, 1867 to 1960. In a recent NYT op-ed column posing questions to  Treasury secretary-nominee Timothy Geithner, she raised three issues. Her first query – why he did not deal with Citigroup’s problems as the head of the NY Fed, the primary supervisor of the bank – should make Mr. Geithner squirm. Click for column

 

The other two questions highlight the Achilles’ heel of TARP policy. She asks what criteria was used to pick the companies that receive taxpayer largess and suggests an alternative. The Resolution Trust Corporation, which bought and eventually sold off the assets of savings and loans in the 1980s, can be revived to do the same with financial paper. Ms. Schwartz wants to know if Mr. Geithner would request Congress to revive this institution, “so you would not have to decide which companies to save and which not to save?”

 

By buying equity or otherwise intervening in certain cases but not in others, the Fed and the Treasury have not revived the banking system even after spending hundreds of billions of dollars. The policy has instead sowed further confusion. So this approach was a bad mistake. The right thing to do is to specify the assets that are at the root of the financial malaise and take them over. That does not require picking companies. It directly addresses the cause of the bank freeze.

 

We’re lucky about one thing—that Ms. Schwartz is around to shed light on murky policies.

14 Responses to “Hope amid Bailout Blues”

  1. Joe Calhoun Says:

    Schwarz also said in a WSJ editorial that Bernanke was attacking the wrong problem. This is not a liquidity problem, but a solvency problem. She said that companies need to be allowed to fail, something that Bernanke seems unwilling to do. I suspect that in applying a liquidity solution to a solvency problem, Bernanke has made the problem worse by introducing regime uncertainty into the equation. I also suspect that in applying this liquidity solution to a solvency problem, Bernanke will be successful in avoiding a lengthy deflation which was his goal (remember his apology to Friedman). Unfortunately, reaching his goal doesn’t solve the problem.

    It seems significant that RTC received assets from failed S&Ls. RTC did not have to determine a price for the assets as TARP will. If the plan is to let the banks fail and then fold the assets into an aggregator, that would be a good plan. If the plan is the same as the original idea for TARP, the same problem exists now that existed when it first passed – what do you pay for the assets? I suspect the reason Paulson ditched the original plan is because he realized that if he paid a competitive price for the assets, it would just further impair the balance sheet of the banking industry and cause more failures.

    The way I see it, we have two choices. Either we let them fail and aggregate the bad assets in an RTC type institution and sell them off over a number of years. Or we suspend mark to market and let the banks carry this stuff at their current mark like we did with the Latin American loans in the 80s.

  2. chidemkurdas Says:

    I agree that pricing the assets was and is the obstacle. However, avoiding that issue has meant that the problem is not solved and additional uncertainty is created by the government arbitrarily picking beneficiaries–such as the choice of backing Bear but letting Lehman go bankrupt.

    There are methods to value non-trading securities. While suspending mark-to-market pricing for banks is too dangerous as a precedent, an RTC could use model-based values. The rules that apply to banks need not apply to a special institution set up to deal with this specific problem. In any event, investors that have illiquid assets in their portfolios are allowed to use models under certain circumstances and an RTC certainly could.

    THis is far from ideal, but at least would get the toxic stuff out of the way. And there’s a reasonable chance it will no longer be toxic once the market start to move.

  3. Bill Stepp Says:

    Without defending the Helicopter Pilot, AJS’s emphasis on the solvency problem (and downplaying the liquidity issue) overlooked the lessons of finance 101, namely that if a company has a solvency issue, it’s usually because if has a liquidity problem. The former is viewing the problem from the angle of its balance sheet; the latter focuses on its cash flow and earnings. If a bank’s earnings and cash flow deteriorate by enough, it will become insolvent.
    As The Economist has been pointing out, the banks had a solvency crisis because they had a liquidity crisis.
    Schwartz is an economist, so just like a builder who thinks everything is a nail, she thinks every bank problem is a solvency problem. Yes, but that’s only half the story.

    I’ve said it before, and I’ll repeat it here: economists need to learn accounting and finance for their economic implications, if for no other reason. That’s why they should be part of the undergraduate economics curriculum.

  4. Bill Stepp Says:

    Correction: the banks had a liquidity problem before they had a solvency problem, as mentioned by The Economist.

  5. chidemkurdas Says:

    Absolutely right. The concepts of accounting and arguments accountants make are ignored in policy discussions, yet these are essential to understanding what’s going on. I should say that the best discussion I ever encountered about how to value non-trading assets was at a panel held by the New York State Society of CPAs. The accountants at the panel disagreed on the best exact method, but were many steps ahead of the bailout debate in explaining issues and possible resolutions.

  6. Joe Calhoun Says:

    Just so no one misunderstands, when I said we had two options, I didn’t mean that I favored them both. I’m in the let them fail and sort it out later camp.

    As for the liquidity versus solvency problem, I don’t agree with the Economist that the banks had a liquidity problem first. Is it a liquidity issue if the value of your collateral falls? It seems to me that the issue we are all dancing around here is that some of these securities are indeed worthless. And while there is some issue with determining which of the assets is worthless, it isn’t as hard as the banks would have us believe.

    There are willing buyers for most of these assets. That the prices offered aren’t what the holders believe is their long term value is, in my mind, irrelevant. The price today reflects the uncertainty surrounding the real estate market that didn’t exist a few years ago. It is their lack of capital that makes it impossible for the current holders to carry these securities to maturity. That isn’t a liquidity issue. There is plenty of liqudity out there to buy these assets at market prices but not enough to pay face value or what the banks would like to sell for. So what? Banks should have been more careful with their capital and not overextended themselves with short term financing.

    A market takes two, a willing buyer and a willing seller. I’m in the markets and I can tell you there are willing buyers at a certain price. There are no willing sellers at those prices because the banks believe the government will relieve them of these securities at a higher price. If they knew that Uncle Sam wasn’t coming to the rescue, the market would start to work and some of these guys would end up where they belong – in bankruptcy. The securities would be bought from the bankrutpcy estate and if the buyers are savvy they would make money. But that isn’t because the securities are worth more today. Any buyer today is paying a price that includes a huge risk premium due to the uncertainty surrounding the real estate market. That the current holders can’t afford that risk premium is not a liquidity problem – its a capital problem, ie solvency.

  7. Bill Stepp Says:

    If the value of a borrower’s collateral falls, it is a liquidity issue to the extent that the drop in its value reflects the market’s (lowered) expectations of its earnings and cash flow.
    A good book that discusses some of these issues is _Creating Shareholder Value_, 2nd ed.
    Normally, the liquidity problem is the flipside of the solvency problem. They are two different lenses on the same problem. It is a mistake to assume an issue in one of them doesn’t imply an issue in the other, as one might think from the AJS interview, and from some loose talk in the financial press and the blogosphere.

  8. Joe Calhoun Says:

    It seems to me that to call a drop in value for the collateral a liquidity problem one has to assume that the drop in value is temporary. If the drop in value is permanent, I would call that a solvency problem. I don’t think there is any doubt that many of these securities have suffered a permanent impairment of their value.

    I actually think there are two problems at work here. There is the regime uncertainty introduced by the government intervention and there is a solvency/liquidity problem. We won’t know if it is a solvency problem or a liquidity problem until after the fact. If the prices for these securities ultimately recover, then I guess it was a liquidity problem. If the values don’t recover, then it was a solvency problem. What should we do in the meantime? I say remove the uncertainty by declaring that there will be no more bailouts and let the market clear.

  9. Bill Stepp Says:

    Of course a permanent drop in liquidity implies a solvency problem, which is a logical extension of my point.
    I agree that markets should be allowed to clear and that assets should be priced to reflect information in the unimpeded market. Ironically, this would probably spur the repair of the markets a lot faster than will occur with government intervention and the attendant regime uncertainly, with all that implies for asset values and balance sheets, not to mention larger issues such as employment of resources both capital and labor.

    But, hey, a helicopter pilot has to do what a helicopter pilot has to do….

  10. chidemkurdas Says:

    Banks did not expect to hold this stuff–they ‘d been selling it with no trouble for years, so the presumption was that it’d be sold. Once the primary buyers — pensions and sovereign wealth funds– withdrew, most of the market disappeared. There was never a very active secondary market in, say, mortgage-backed CDOs. So there’s a solvency problem for banks, which causes liquidity problems in the financial sector. It will get worse as the separate solvency problem for homeowners shows up in full force with mortgage defaults. But there’s also a political problem: demands for the government to do something, anything. So as a practical matter, it’s a question of what’s the lesser evil of policy options. The government buying equity has not resolved the problem, it means the government favoring some companies over others, and of course it is a move toward de factor nationalization. It’s hard to think of worse policy.

  11. Joe Calhoun Says:

    I’m not sure how much of this stuff the banks and brokers intended to sell. Real estate loans (and all the derivatives) were rising as a percentage of total assets. They were definitely eating home cooking. Obviously, they didn’t intend to hold all they get left holding the bag for, but that’s what happens when you play musical chairs with riskly assets. Somebody’s not gonna get a seat.

    Demand for the government to do something I think is not as great as you might think. I’m an investment advisor and I talk to a lot of people. The vast majority of them are not happy about what the government is doing and would prefer the bad banks to fail. I think the politicians are the ones who are afraid to let the market work. They are in an interesting situation. If they do nothing and the economy recovers relatively quickly (and I agree with you that would be the case), that might put a lot of doubts in people’s heads about the need for future government intervention. Politicians can’t let that happen. On the other hand, no matter what they do (well almost), the economy will eventually recover and you can believe they’ll be lining up to take credit.

  12. chidemkurdas Says:

    Who wants what is an interesting question. A large part of the population might not want bailouts for banks, but industries are lobbying, companies are lobbying, unions are lobbying, everybody who can is lobbying. And there is a media campaign whipping up panic. It is certainly a great opportunity for politicians to say, here, we gave some medicine and see, the patient is doing better. I agree with you that with the cyclical nature of economic-financial activity, politicians can hope to take credit for recovery. And if the uncertainty they create makes matters worse, they can propose more drastic action. It’s a win-win situation for politicians. Fact is they already have the remaining TARP money, can get more and are certainly going to do things. Great time for lobbyists, too.

  13. Bill Woolsey Says:

    The assets of the largest three banks make up slightly less than half of the assets of the banking system.

    Each one holds more than 10% of the total assets of the banking system.

    About 10% of the total assets of the banking system are mortgage backed securities.

    There are some reports that the current market price is of mortgage backed securitiees is pennies on the dollar.

    Suppose that if the banks mark these to market as they are legally required to do, they are insovlent. Is that 15%, 30%? 45% of the banking system?

    After the S&L crisis regulators were limited in their ability to use forbearance.

    And so the panicky situation. A few money center banks fail, it is a large portion of the banking system.

    Anyway, if TARP buys the assets at market value, this just makes things clearer–banks that are insolvent make up a large portion of the total assets of the banking system.

    Of course, if TARP pays enough, the banks that are insolvent because of mortgage backed securities are solvent. Their stockholders and management are saved.

    But that costs too much. The banking system (not including the shadow system) is 13 trillion. TARP would need to buy more than a trillion worth of mortage backed securities.

    So, they go for equity injections. Drips and drabs and the bad assets are written down as the banks can afford them.

    My view is that FDIC should take over banks holding Mortage backed securites more than their capital. They should take over those securites and then should swap 10% of the debt of the failed banks for equity. The reorganized banks then would have new stockholders, 10% capital, and no mortgage backed securities. All debt holders and depostors are bailed out (a problem.) And FDIC is stuck with 1.2 tillion of mortgage backed secuties that can only be sold for a pittance. My guess, howver is that 2/3 will be collected so the final cost is about $400 billion.

    The is no moral hazard for equity investors in banks. But ample for those purchasing the debt of banks.

  14. chidemkurdas Says:

    Why is no logic to TARP buying at market price since market players are — by definition — willing to buy mortgage securities at that price. Because the market is frozen, current market price is much below the value indicated by rising mortgage default rates. After all, most homeowners will continue to pay their mortgages. The idea is for TARP to buy at higher, model-derived prices that approximate the long term values of the securities, taking into account the expected defaults.

    The point is the Fed government is already spending well over $1 trillion, what with $700 billion TARP and other separately funded expenditures, for various bailouts. But it’s doing so in a way that does not address the root cause of the financial paralysis.


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