Sunday, June 14, 2009

What's good for Goldman Sachs...

So that’s how it all ends.. The Treasury has finally decided to allow a select group of banks to pay back the TARP money—a decision served to the public as a great win-win outcome for both the taxpayers and the banks.

I beg to diagree. The decision is a major setback in the efforts to re-establish transparency and health in the financial system. The reason is loss of leverage: For good or for worse, the TARP money was the strongest lever that policymakers had to exert influence on banks.

I’m not talking about influence on executive pay, by the way—indeed, that was the very policy blunder that led banks to rush to repay the TARP capital in the first place. I’m talking about influence over banks’ willingness to clean up their books from their toxic assets and recognize any associated losses.

As we all know, banks were already reluctant to sell toxic stuff in a very unfriendly market. The absence of the government’s stick means that they’ll prefer instead to ride through the storm, which is ongoing, and sell once market conditions become more propitious.

And if anyone though they would still go ahead out of recognition that balance sheet clean up is good for the country, just recall what happened last year:

In the aftermath of the Bear Stearns failure, policymakers, including the Fed, kept bugging banks to raise capital and build up a cushion for worse times to come. But bugging was clearly not enough—the Fed’s pleas were met with resistance, due to what were perceived at the time as unfavorable market conditions(!).

So the government has lost the stick… but maybe a carrot is enough? Like, the PPIP? After all, the PPIP (Public Private Investment Partnership) was designed to encourage sellers to sell by inflating the prices of toxic assets, through government subsidies to potential buyers.

I don’t think so. First of all, the very same reason that made banks rush to repay the TARP money will deter them from participating in the PPIP—government meddling.

Secondly, even for those banks that do participate (because they’re still on the government’s leash and have no choice) the PPIP does little to restore balance sheet transparency—on the contrary:

Banks will now be able to mark up all their junk at the PPIP-inflated prices, just because they sold some of it under the government scheme. Kind of a cheat, if you ask me, given that this will not exactly be a market. Nor will the scheme catalyze market activity in the securities that are not covered by the program.

Ok, no carrot, no stick either. But does cleaning up the banks’ balance sheets really matter? I mean, is it good for the country?!

Arguably, the stress tests should have made toxic assets sales irrelevant—by forcing banks raise sufficient capital to withstand even an extremely adverse scenario, the presence of toxic assets in banks’ books shouldn’t matter.

In practice, however, there are two caveats: First, the stress tests were arguably lenient: Not only because the adverse scenario is already becoming close to materializing; but also because they address capital adequacy and solvency in the strict sense of the term without capturing potential capital holes arising from the adverse feedback loops that materialize when market conditions turn sour, or when liquidity dries up.

Secondly, the whole point of the clean up was to pass on the toxic assets to healthier hands (or to hands with better distressed-debt expertise) and preserve banks’ capital for what they can do best: Lend to the productive sector and get the economy going again. So even if banks have, in principle, sufficient capital to withstand the storm, they will (justifiably) hang on to it, until the horizon brightens.

Finally, let me throw in nother reason why the TARP payback is a setback: Leverage. Not policy leverage but financial sector leverage. To the extent that this was a crisis of over-indebtedness, both at the household and the financial sector level, the increase in banks’ equity (including the government equity) wa a positive development: It helped reduce leverage in the financial sector and, indirectly, help the deleveraging of the household sector, as households walked out of their homes and their debts, passing them on to the banks.

The TARP payback is thus a step backwards. For all the new capital the banks have raised, the TARP repayment means that we’re now back to the leverage levels of 2007 (with leverage measured as the ratio of total assets to tangible common equity).

True, the banks selected to repay actually have a lower leverage than the industry average. But still: Absent reform on regulation governing how much leverage is appropriate and how that leverage should be managed across the business cycle, any green light on TARP repayments looks premature. Particularly when key macro data, from unemployment to mortgage delinquencies, are turning from bad to worse.

Ultimately, the point here is that the TARP capital was actually good for Goldman Sachs (and the rest of them) and good for the country. It provided a boost in banks’ capital position while the macroeconomic and financial outlook continues to remain shaky, while providing a stick to the government to force banks to raise more capital and clean up their book.

But in the meantime, the government screwed up by stigmatizing TARP recipients and inciting them to get out of it as soon as possible.

With TARP repaid, what’s good for Goldmans is good for Goldmans. Maybe if we're lucky, it might turn out to be good for the country.

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