Monday, March 30, 2009

The missing link

Among the barrage of Treasury releases last week, there was one that gave me a reason to cheer. And no, it was not the details on the PPIP… it was rather Geithner’s legislative proposal to grant the US government authority to take over systemically important financial institutions at the brink of default.

The legislation would allow the government to place an institution into conservatorship or receivership, and then administering its reorganization or wind-down in an orderly manner. It would, for example, enable the government “to sell or transfer the assets or liabilities of the institution in question, to renegotiate or repudiate the institution's contracts (including with its employees), and to address the derivatives portfolio, thus reducing the potential for further disruption.”

This is good stuff… It could be the “missing link” in the strategy to deal with the toxic assets—a strategy that should involve a healthy process of creative destruction in the name of capitalism and, yes, the taxpayer.

Another way to put this is that the current strategy to deal with the toxic assets leaves a lot to be desired, not least an endgame… We still have no sense of how much taxpayer money we will be throwing into this; how big a leverage the Administration sees as desirable for the financial sector and the economy as a whole; or, even, whether they see inflation as a foe or friend in dealing with excessive leverage.

The PPIP hasn’t provided an answer to any of these, partly because it fails to reveal the answer to the root question: How big is the hole in the US financial system?

Instead, the PPIP’s voluntary nature (in letter at least) means that the banks selling the toxic assets can say “no thanks” if the bid prices don’t suit them. In other words, in the absence of appropriate “encouragement” (in carrot or stick form) by the government, banks would be left with quite a bit of toxic stuff banks in their books.

This is more so the case since the PPIP will only impact the prices of assets covered by the program. Assets that are not covered would be unlikely to see any form of (so-called) “price discovery”, given that investors’ cost of funding would no longer be subsidized (see here why the prices bid would be inextricably linked to an investor’s cost of funding).

Yet, the identification of the “hole” in banks’ capital is the critical first step before we can answer the second key question: Should we pay for (all of) it?

That’s a big one, and one that begs for the Administration’s vision on two others: How large a leverage can the financial system sustain? And what’s the best use for private and public capital?

The questions are more than brunch material. They way in which we choose to address them have implications for the future stability of the financial sector and for the efficient (or not) channeling of domestic savings into productive investments.

But again, the PPIP throws no clarity to neither. When it comes to leverage, the program simply facilitates the deleveraging of US banks by leveraging up the public (and segments of private) sector. In other words, it shifts leverage around rather than dealing with the tougher choice of setting a desirable target.

I should note here that Geithner & friends have already given half an answer to the leverage issue: They want it lower (via stricter capital requirements)! What they haven’t explained is the other half: Would that be achieved through higher capital (i.e. taxpayer money, printed money or Martian money) or through downsizing?

Then there is the question of credit allocation. In its current form, the PPIP places greater emphasis on real estate-related loans and securities. Is that a desirable objective (esp. given the support the sector is already getting)?! Sure, you could argue that money is fungible—that is, if banks can get relief, they could start lending again to other economic sectors. But this would bring us once again to the question of desirable leverage (i.e. how much should banks be allowed to lend, given their capital)?

The new resolution authority would help deal with these issues by allowing the government to downsize the financial sector as needed, through write-downs and wind-downs in an orderly fashion (for those allergic to the concept of “conservatorship”, I recommend you to repeat the word twenty times or until it sinks in).

It would also help provide the necessary “stick” for those banks that are inclined to ride through the storm undercapitalized, in the hope of future asset inflation. For example, the government could mark any remaining “toxic” stuff either to “market” or in line with the methodologies of the “Third Party Valuation Firm"--which is the entity they will be using under the PPIP to assign preliminary prices for the pools of assets banks put for sale. It could then offer to provide partial recapitalization, provided the bank can match that with private capital…. Or else--

As such, I see this legislation as a critical tool in helping us emerge from this crisis with a leaner and stronger financial sector, a more efficient credit allocation process. The only thing I’m left to wonder is whether Geithner & co. have seen it as such themselves.

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