Treasury Secretary Tim Geithner today announced a new plan that will allegedly help stabilize the financial markets, restore institutions’ balance sheets, and thus ease the credit crunch with all its attendant ripple effects. It’s an unwieldy construct with multiple parts, but ultimately a lot of it comes down to using taxpayer money to help purchase “toxic assets.” (E.g., CDOs backed by MBSs, the stuff hedged by all those CDSs. Isn’t it fun to play with the new lingo we’ve all learned these last few months?)
The stock market seems to love the plan, seeing as how it surged several hundred points today. But does that mean it’s a good thing?
Paul Krugman certainly doesn’t think so, and wasted no time explaining why in today’s New York Times.
Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.
It’s as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street.
…The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.
…But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.
One of the underlying premises of the Summers/Geithner approach to things (continued, as Krugman accurately notes, from Paulson) is that the biggest institutions aren’t “really” insolvent, appearances to the contrary notwithstanding, because the assets underlying their CDOs and whatnot have a “hold to maturity” value that’s higher than the currently very low “mark to market” value per current accounting. (In metaphorical terms: the banks aren’t really zombies, they’re just malnourished.) The concept here, therefore, is that facilitating liquidity will encourage investors to take a (subsidized) risk on those assets, and everyone will come out fine once the “real” value has a chance to shine through.
I’ve been at best cautiously skeptical about this line of thinking since September —it’s been a learning process—but what it comes down to is that it’s just not very credible any more. (Nor does the investing class believe it, obviously… or the MTM value wouldn’t be so low in the first place. Besides, there’s just something hypocritical about saying MTM was a perfectly fine basis for everyone’s balance sheets when things were on the upswing, but it’s not reliable now that they’re on the downswing.)
It’s been six months. To the extent that there’s been actual forensic investigation into the underlying value of some of these assets, the results have not been encouraging: they really are mostly “trash.” (As should have been obvious two years ago to those paying attention.) Meanwhile, the crashing Main Street economy (job losses, business closings, foreclosures, etc.) makes it even less likely that the remaining pools of assets (i.e., other people’s debts, remember!) will actually turn out to be valuable, since fewer debtors are in a position to repay them.
This plan, like the many variants that have come before, relies on the crucial assumptions that we need to buy time; that when everything comes out in the wash, there’s real underlying value here; and that meantime, the people in charge of these institutions have meaningful expertise and should be kept in place. (That’s certainly a big part of what the AIG bailout was all about, as Matt Taibbi described in detail in his recent no-holds-barred, names-named Rolling Stone piece: pumping capital in so that AIG could make good on its CDS obligations to places like Goldman, who had used those CDSs to hedge what it knew were risky holdings… thus helping Goldman keeps its own books balanced. Of course, this implicitly validates the whole highly overleveraged business model in which both sides were engaged, which isn’t really especially sane.)
What Krugman, James Galbraith and other critics are saying (and have been) is that these premises aren’t sound. The emperor has no clothes. The people atop these institutions didn’t know what they were doing, and didn’t properly account for risk, and don’t actually hold anything that retains enough value (even long-term) to consider them solvent… and thus that they need not to be patched up and kept intact, as is clearly the plan here, but instead put into receivership, restructured, broken up, and sold off, making the old shareholders and management bear the burden of their recklessness, and letting new ones start over with clean slates. To reiterate a metaphor I’ve used elsewhere, a quick amputation beats a long, slow wasting disease.
Most importantly, there’s a strong case that this plan just won’t work. It’s clearly an attempt at market-making and price discovery, which in ordinary times (or if this were merely a liquidity crisis) would make sense… but as the Telegraph (UK) notes,
…wade through the pages and pages of press releases, fact sheets and frequently asked question guides released by the US Treasury today, and on not one will you find any reference to how these assets will be valued.
Since the core problem to date in removing assets from bank’s balance sheets has been valuation, you’d think the plan might address that? …
In reality, the private investors who get involved in the [plan] will want not to want pay top-dollar for these assets, far from it. If banks, which have already been forced to heavily write down the value of these assets due to strict mark-to-market accountancy rules, are not offered decent bids when it comes to auctioning assets, they will withdraw, for fear of being forced to take further multi-billion dollar write-downs, and the scheme will fail.
For the sake of fairness and thoroughness, though, it’s worth pointing out that this isn’t a universally held view. That Wall Street likes it is no surprise; its players benefit directly regardless of larger effects. But UC Berkeley economist Brad DeLong (no right-wing market fundamentalist!) has also posted a detailed argument today on why he thinks this plan is a good thing, for both the economy and the taxpayers. Even he acknowledges that it’s more of a stopgap measure than a full solution… but he does agree with the premise that the “risk discounts” on the assets in question are excessive right now, and proceeds from there.
DeLong makes an interesting case, but not an entirely persuasive one. Obama’s approach to short-term stimulus and long-term budget priorities have been smart and admirable, but his approach to the financial sector, specifically, risks becoming a real problem. This was predictable right from the start with Larry Summers, obviously (hell, he helped shred Glass-Steagal back in the ’90s), but I’d harbored higher hopes for Geithner. Those hopes have been disappointed.
And finding out who’s right is not merely an academic exercise: as Krugman observes, “by the time Mr. Obama realizes that he needs to change course, his political capital may be gone.” This is not an outcome any of us should want to see. There are more worthwhile projects on deck which need that political capital.Tags: bailout, banking, economy, financial crisis, mark-to-market, Obama, Paul Krugman, Timothy Geithner