umarsaeed

Toxic Plan

In Criticism, Financial on March 28, 2009 at 5:29 PM

Last week, Tim Geithner unveiled his Public-Private Partnership Investment Program to remove toxic assets from the American banking system. The markets reacted like kids in a candy shop – so it’s best to ignore them right now. The New York Times has dedicated this blog page for the greatest economists in the America to explain to us how this plan won’t work.

Personally, I feel bad for Geithner. Wall Street is never going to be his friend because he was never one of them. Meanwhile, economists acting as watchdogs of his every move are extremely critical, rarely offering alternative solutions. What is particularly annoying is that it’s a well known fact that Geithner has absolutely no help as the Treasury Secretary right now. If I were a renowned economist in tune with the complexities of today’s market, had a blog on the NY Times, or was a professor at Princeton – I might give Tim a call and see if he needs help.

My father and I watched both Tim Geithner, and Paul Krugman (the self-declared nemesis of Tim Geithner) on This Week with George Stephanopolous. Geithner made it clear that this was a small part of a bigger plan. The other thing that stuck with me was that despite the state of emergency, this administration has very little power to takeover these banks and deal directly with its problems, and Geithner is actively working on getting those powers.

The example that was given to the media to describe the mechanics of how this re-purchase plan will work is as follows:

  • The US government will partner up with private investors to purchase these “toxic” assets;
  • To purchase $100 of “toxic” assets, the government will pitch in $7 and the private investor will pitch in $7 (50/50 equity ownership of the asset);
  • The remaining $86 will be funded by a loan issued by the Federal reserve

To a private investor, like a hedge fund, the government is funding 93% of the venture, so the incentive to get involved in the purchase of these assets has been well-established. Following our example above, if a hedge fund and the government purchased $100 of mortgaged backed securities from an American bank in need of liquidity, and 5 years from now it turns out that the asset they bought could be sold for $200 – the proceeds would be divided as follows:

  • $200 cash received on the sale
  • Subtract from that the loan that we owe the feds $86 + interest on that loan we’ve been paying the Feds all along, which would be something like $4, so a total of $90 goes to the Feds
  • The remaining $110 is split, 50/50 between the government and the hedge fund
  • The hedge fund could boast a return of 785% on the initial investment

And now, I’ll present an excerpt from a conversation I had with Tim Geithner in my head:

————————————————–

Umar: Hi Tim. I’m a big fan of America in general. I’m wondering, by introducing this plan, you’re allowing investors like hedge funds to profit while the American people bear most of the risk – aren’t you worried about a public backlash? Hedge funds aren’t exactly popular among the public to begin with.

Secretary Geithner: I’m a big fan of yours too, Umar. Like, I follow you on twitter and everything. The problem is I don’t have a choice. The market for these mortgage backed securities (MBS) is currently non-existent. These banks are heavily invested in MBS, and because there is no market for them, their money is essentially stuck. When our banks have this much money locked up in illiquid securities, they lack the ability to lend, which is the most fundamental economic action a bank can do in order to help stimulate the economy.

Also, we actually want private investors involved. As you already know, if the government was to offer to buy these assets from the bank, we would end up overpaying.

Umar: Yeah, that’s true. I remember when Paulson first suggested that the government would have to purchase these assets from the banks to create liquidity, we were laughing at my office. It was clearly a bad idea. There was no doubt in my mind that if the government offered to pay for these toxic assets, you guys were going to overpay. That’s simply how private banks deal with the government.

Secretary Geithner: That’s right. I think your very first blog post was very appropriate given what you are writing about – people seem to think that corporations will do the right things simply because it’s an emergency, but that’s not the case. You can’t trust them in the negotiation process. By partnering up with private investors, which can be anyone from the investment community, not just hedge funds, we’re creating a market for these investments. Because the private investor is financially vested in the transaction, the government is far less likely to overpay. It also protects the government from participating in completely worthless assets. Sure, the hedge funds might be leveraging Fed loans to enter the transaction, but the government is leveraging hedge fund expertise and resources to ensure that the transaction is profitable.

Umar: But Tim, based on what I know about the Mortgaged Back Securities market, the spreads are huge. How do you respond to all the experts out there saying that this scheme won’t work? If the private partnership wants to purchase something for $0.20 on the dollar, but sellers are adamant that $0.80 is a good price – your plan doesn’t actually resolve that basic discrepancy.

Secretary Geithner: No – the plan simply lays the infrastructure for market forces to resolve this issue, it doesn’t directly force transactions. The reality is that because there currently is no market for these securities, accounting guidelines require you to write them off (remove them from your balance sheets). When the banks go to borrow money, other banks look at the value of their assets in order to assess how much credit will be extended. When you have hundreds of billions of dollars invested in MBS that you are forced to write down to zero – your balance sheets do not look good, and other banks can’t lend you money. The first step is to create a market for these securities, so that we have some basis to value these assets. It’s not necessary to sell all of these assets – that’s only part of the objective. Those banks that desperately need cash will accept lower offers. However, by accepting offers the market will slowly grow, and entice more buyers. The more private investors get involved, the better we can reflect the true value of these MBS using real market transactions. This means banks that don’t end up selling these MBS assets to anyone still benefit from revaluing them on their balance sheets at a value other than zero.

Just to put things into perspective, these assets having a market value of zero is like saying every single American just defaulted on their loan. That’s simply not the case. The market is currently being choked by fear and overexposure, and I’m just trying to loosen the grip.

Umar: Okay, let’s assume that in a month or two, investors start bidding for these assets. Explain to me how this will create liquidity? How does it loosen the grip?

Secretary Geithner: Sometimes I wish you were American, you know that? You have to understand, the problem with these banks very closely resembles the problem that everyday Americans are having – they’ve maxed out their credit. Just like ordinary people, banks are extended credit based on the assets they own, and their liquidity ratios which tell us how easily they will be able to pay their interest payments.

Despite all the money we seem to be spending and lending, the fact that the banks are not lending to each other is single-handedly stopping any progress. Once a market is created, the banks will now have the option to increase their liquidity and reserve ratios by selling these MBS assets in exchange for cash. In addition to this, there will be a benchmark to value these assets, which will help some banks because they will be able to write up those assets that are currently valued at zero. For these banks, they can now borrow against the value of these assets.

Once the financial health of the banks improves, banks will not be hesitant to lend to one another, because there will be enough cash on hand to pay interest and the loan back. Once the troubled banks are able to borrow from the healthier banks, then they can lend to the American people, which ultimately stimulates the economy. But make no mistake about it – we can not grow unless the banks lend. It’s as simple as that. It’s how our system works.

Umar: Look. I just have to ask you this because I might not have the chance again. Don’t you find it the least bit disturbing that in order to get American people and corporations out of their debt problems, you’re offering a solution that gets investors into more debt

Secretary Geithner: Yeah, I know. It’s weird, eh?

————————————————–

If we view the plan for the specific objectives Geithner is trying to fulfill, it’s not as disastrous as the economists are speculating. It obviously isn’t enough to resolve this crisis, but it’s a necessary step to spread the MBS risk which is currently concentrated with the banks in order to unclog the financial system. The government is taking virtually all of the risk on the proposed transactions, but I urge economists to describe an alternative where the government doesn’t take on risk? Finding a flaw in any proposed plan during a time of turmoil and crisis is not exactly rocket science. There is never going to be a single all-encompassing perfect plan to solve the crisis. Also, don’t overestimate how much the government can actually do besides throwing money at people or corporations. This is America – they are a nation staunchly against any form of government control over corporations.

Geithner has to get America walking before She can run again. All he can do is clear the path and hope She follows.

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