Last week, Treasury Secretary Timothy Geithner finally released more details about the government’s plan to fix the credit markets. The plan, it seems, involves the creation of funds to buy troubled assets from banks that will be backed by public and private sector equity and financed by the public sector. These funds will be allowed to lever up so that the relevant bank assets will be purchased at prices well above what they are currently trading for in the markets.
Detractors immediately panned the plan, claiming that it was merely a subsidy to hedge funds and other Wall Street denizens who helped cause the crisis in the first place. Buying the troubled assets would do nothing to help spur bank lending, and Geithner, they argued, appeared to have been captured by Wall Street. In attacking the government’s plan, many of these detractors continued to indiscriminately throw out terms like “insolvency” and “toxic assets” to give the impression that the majority of the big commercial banks were doomed to either fail or become so-called “zombie banks.” These commentators also ably ridiculed Treasury for its pitiful attempt to rebrand the loans and asset-backed securities on the banks’ books as “legacy loans” and “legacy securities,” terms that sound like government doublespeak designed to confuse or deceive the public.
The government has received no credit for what appears to be steps in the right direction to get the credit markets functioning again, with the proposed plan hopefully freeing up bank capital for new loan issuances and restarting the securitization markets. The problem is that the administration has failed to communicate with the public about the plan in an understandable way and has even dodged important issues that must be clarified in order to inspire confidence that the government is doing the right thing. Critics like Paul Krugman and Nouriel Roubini have made superficially compelling arguments that, while having genuine substance behind them, have not been presented to the public in a substantive manner, and the government has made no real rejoinders to these arguments. The risk is that this failure to communicate will result in a lack of political will necessary to pull the economy out of recession.
The administration seems to be aware of this communications problem. On Sunday, Secretary Geithner appeared on “Meet the Press” and “This Nation” to explain the government’s rationale behind its plan. Geithner explained the importance of the credit markets to the economy and the necessity of unfreezing them in order to maintain any chance whatsoever of climbing out of this recession. He pointed out that, until recently, close to half of the lending capacity in our economy was provided by non-bank lenders and so it was very important to restart the securitization market and have new bond issuances. Most importantly, Geithner indicated – somewhat obliquely – that the government’s Public-Private Investment Program (PPIP) was designed to take assets off the balance sheets of banks not to save them all from failing due to insolvency but rather to free up capital to enable banks to originate new, productive loans (and lines of credit) and to make it easier to put money into banks that need to be recapitalized. In other words, the new program will help the government and private sector recapitalize banks that fail the government’s stress tests in a more surgical manner and will also help restart the securitization markets at the same time.
While Geithner’s appearance on the Sunday morning news circuit was a good start, it is not at all sufficient for making people understand the importance of the new program. Geithner, though clearly a smart and devoted public servant, simply does not have the teaching skills or charisma needed to present what we’re facing in a way that most citizens will understand, and unfortunately, he also lacks credibility in that he is considered by many (wrongly, in my opinion) to be a regulator who has been captured by Wall Street. Thus, it is imperative that President Obama himself take the time to explain what has happened to the financial system thus far and what the government is doing about it, perhaps using visuals and the new communications technologies it is said he is so fond of.
When President Obama talks to the nation about the financial crisis, he must address several of the issues that critics have raised against the government’s plans in a genuine and non-evasive manner. The most important of these issues are: (1) the solvency of the banking system; (2) the unintended consequences of nationalization as an alternative solution; and (3) the rationale behind creating funds where private investors share in both the upside and downside risk of purchasing troubled assets.
The Solvency of the Banking System. Paul Krugman and Nouriel Roubini suggest that if a bank is “insolvent,” it will either fail or refuse to lend in an appropriate manner. Though there is substance behind their argument, this substance has not really been presented to the public, and most reporters and commentators merely cite Krugman and Roubini for the proposition that “insolvency” equals “bank failure” or “zombie bank.” The administration must add nuance to the policy debate by explaining the relevance of bank insolvency and by detailing the government’s plans to mitigate the detrimental effects that bank insolvency might be having on the extension of credit.
The government must show that it is not so much a question of whether a bank is technically insolvent – where the bank’s tangible assets are determined to be less than its liabilities – but whether the bank’s balance sheet is so impaired that it will refuse to lend in order to maintain capital adequacy ratios or to prop up related non-bank affiliate companies. Consider this: if a bank is truly insolvent, the best way for the bank to climb out of the hole in an environment with very low interest rates is to borrow more money or take in more deposits and lend this money at relatively high interest rates. Why, then, would the banks hoard money rather than lend it out? There are only two reasons I can think of.
One is that banks are afraid that if their troubled assets are required to be marked down any further, they will have to keep cash in the bank to remain adequately capitalized as per regulatory requirements or face having to shop for cash infusions. In this market environment, many companies (not just banks) have only been able to raise cash by borrowing money at punitive interest rates (think about the preferred deal that Buffett struck with Goldman) or by raising equity at extremely depressed market prices, which has severely diluted existing shareholders’ stakes. This is why banks lobbied for and successfully obtained a relaxation of the mark-to-market accounting rules. The theory goes that if banks are not forced to mark down their troubled assets to market values, they will not have to raise money to stay adequately capitalized and so they will be more than willing to lend out what cash they do have in order to climb out of insolvency.
The second reason why banks may be hoarding capital is that banks controlled by financial conglomerates like Citigroup and the ilk may be using bank capital to shore up their more troubled affiliate companies. For example, the Citibank subsidiary of Citigroup is probably adequately capitalized at this time, but the other non-banking subsidiaries of Citigroup – say, the division that wrote credit default swaps – could very well be bleeding money right now. This hemorrhaging of capital could potentially result in liquidity issues that would force the holding company into bankruptcy court. Thus, before the government got involved with Citigroup, the holding company was incentivized to take bank capital and profits and send it over to its more troubled subsidiaries rather than using that money to issue new loans. This focus on shoring up non-banking subsidiaries would also explain why there have been recent reports indicating that the big financial conglomerates are interested in participating in the PPIP, which could result in the non-banking subsidiaries earning juicy profits in the short term.
The ultimate takeaway is that the government has decided to take the time to make qualitative decisions about which banks are likely to act badly rather than just nationalizing them all. This is not that unusual. After all, the FDIC takes into account several factors when deciding whether a bank should be put into receivership, including risk management controls, profitability of operations, quality of assets on the books, capital levels, and the bank’s ability to meet obligations such as withdrawals by depositors, rental payments, and labor costs (i.e., the bank’s liquidity). However, in order for the government and private investors to determine how much capital the banking system really needs, the government must remove the troubled assets that are clouding everyone’s view of how much money will be necessary. Once these assets are removed, the government will “stress test” the banks in a way that will prevent the banks from using their capital for unhelpful purposes such as paying dividends and that will help the government and the private sector recapitalize the banks in a manner that will be least costly to the taxpayers.
But before the government can proceed, it will need to make this case to the public in a way that will get most of Congress behind the plan.
The Unintended Consequences of Nationalization. Krugman and Roubini disagree with the government’s approach to recapitalizing the banking sector and believe that using the blunt instrument of nationalization is the only way to solve the problem of banks that refuse to lend. When Secretary Geithner appeared on Meet the Press, he didn’t address the issue of nationalization, either with respect to FDIC takeovers of banks or the effective nationalization of financial services conglomerates through 80% government ownership. On the contrary, he quite misleadingly presented the choice the government faces as binary, with the government buying troubled assets from the public sector either by itself or with the help of private investors.
President Obama must explain why the government has taken the nationalization solution off the table with respect to the big banks. Nationalizing the bank and financial holding companies will probably cost the government much more money than the proposed program. One of the lessons learned from the AIG debacle is that the government won’t be able to easily sell off the assets or subsidiaries of complex financial organizations that have been nationalized. While the government searches for buyers, the taxpayers will have to pay the cost of running these companies while at the same time watching the value of these companies diminish due to the stigma of government ownership and the corrosive way in which politicians will use public outrage to their own benefit. If the government does find private buyers for the subsidiaries of the big banks, these buyers will demand that the taxpayers sell these off at fire sale prices since there will be so many more attractive investments available to the potential buyers.
It is also likely that the equity and credit markets will go haywire once again in the event of large scale nationalizations. The government needs private capital to participate in the recapitalization of the banking system, and there is no guarantee that private capital will be able to raise funds to purchase financial assets if the government crosses that line. Like it or not, the performance of the equity and credit markets matter when it comes to raising capital from investors.
The government has a hammer in its tool belt called nationalization. The problem is that many commentators are claiming that everything in the financial system looks like a nail.
The Use of Private Investors to Purchase Troubled Assets. The President must also explain to the public why the government has chosen to recruit private capital for the purchase of troubled assets from the bank. Secretary Geithner stated on Sunday that the government wishes to use the expertise of private investors determine the appropriate price to pay for banks’ assets so that taxpayers will not overpay for these assets. This makes perfect sense since it will take lots of legwork to value these assets given their complexity, and the government simply does not have the workforce required to undertake this task.
But Secretary Geithner did not adequately address the criticisms leveled at the plan by commentators like Krugman who claim that this is merely a subsidy to private investors who will naturally overpay for the assets they make bids on given the use of leverage. This is perhaps one of the most foolish criticisms of the plan, as it completely ignores investors’ aversion to downside risk. Leverage always amplifies the results of an investment decision. Low returns on an unleveraged basis can be transformed into very high returns when leverage is used. However, losses can also be amplified with leverage, and no investor in their right mind would be willing to risk the complete loss of their capital by making the expected value calculations that Krugman does, particularly in an environment where almost everyone has lost a great deal of money on their investments.
Note that it is highly unlikely that the troubled assets to be purchased will be worth nothing, and if the private investors walk away from the government loans because the assets are worth less than what they paid, it will be because their equity has been wiped out. This is not unlike the homeowner who walks away from an underwater mortgage, thereby losing all of his down payment, the interest he paid, and the house. Investors concerned with downside risk are incentivized to purchase these assets at prices that will allow for a margin of safety for their equity. It is true that the asset managers who will be running these funds might be willing to bet the farm if their fees are bumped up for outsized performance with no regards to risk, but the government will almost certainly structure the funds in a way that will not incentivize this type of bad behavior.
How to Communicate These Issues to the Public. Geithner’s appearances on Sunday were a good start for communicating with the public about the government’s plans to fix the financial system, but his failure to address certain issues has continued to give fodder to the administration’s critics and to members of Congress who wish to exploit the deep antipathy (rightly deserved) that the public has towards Wall Street at this time. Citizens are getting angrier and angrier about government action that they perceive as at best ill-conceived and at worst corrupt. And they simply don’t trust that the Treasury or the government, in general, is being honest with them about what’s really going on behind the scenes. When the time comes for the administration to ask for more money from Congress to recapitalize banks that have failed the stress test, if the citizens are not on the administration’s side, Congress may very well take actions that result in a far worse economic situation than could otherwise have been.
This is why the President himself must expend some political capital to get the people on the side of the government. The President currently enjoys outstanding approval ratings that indicate that the American people trust him far more than they do the rest of the government. This is primarily because everything he has said about the financial crisis has been in the form of platitudes and hopeful rhetoric. All the substance of the government’s plans has been released through channels that simply don’t get the attention of most Americans. Op-eds written by unknown government officials in the Wall Street Journal, appearances on news shows by these officials, press releases, and the creation of new websites such as financialstability.gov just won’t cut it.
President Obama himself must give the country a true fireside chat on the topic of the banks, just as FDR did over 75 years ago. Because the problems with the financial system are so much more complex now, the President will have to take the time to figure out the way to best present the government’s views to the people, and he must do this in an honest and non-partisan manner. Whether President Obama will use his pulpit to counter criticisms of the government’s plan will not only be a test of this administration’s willingness to do what it takes to ensure economic recovery, but also a test of the government’s willingness to communicate and be transparent with the citizens of this country.
