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Financial Stability Plan:  Too Much Downside Risk

Remember that saying “don’t assume, because when you do it makes an ass out of u and me.”  Taxpayers are assuming too much downside risk with the Financial Stability Plan as presented by Treasury Secretary Geithner this morning.  So, are we the asses on this latest bailout plan?  Taxpayers are on the hook for more capital injections into banks and potential purchase guarantees of toxic assets by private investors.  The plan does offer some improvements such as requiring a ‘stress test’ of bank balance sheets and more transparency and disclosure of toxic assets but this only a start.  Time is of the essence and relying on a market system that is not functioning properly is a waste of time and money.

First, we have heard over and over again since September of last year, this economic crisis is generational unprecedented and the amount of money at stake is mind numbing.  We are truly in unchartered waters.  Any action taken is essentially a real life experiment.  But, that should not preclude us from debating and criticizing any policy decisions made by the Obama Administration.

The Financial Stability Plan, as presented yesterday by Treasury Secretary Geithner, is the wrong approach to a extremely critical situation.  This plan is wrong because:

• Moral/accountability - nothing changes for the financial institutions that created this mess.  These financial institutions used “risk capital” to an extreme which jeopardized their balance sheets and are basically being rewarded for this risky behavior.  Bankers are happy.
• Risk - The taxpayers are assuming to much downside risk with additional capital injections and guaranteeing a price on the purchase of toxic assets.  In the worst case scenario, banks that received capital injections fail and private investors exercise their guarantees (meaning prices are below what the assets were purchased for), we are talking trillions of dollars wasted and we still would have to do something about a very weakened banking system.
• Cost - estimates are at least $2.5 trillion and this is on top of the several trillions of dollars already used by the Treasury Department and Federal Reserve Bank.

There are positive aspects to the Financial Stability Plan but the details will be important and how certain portions of program are implemented will determine if the optimism is warranted.

“Financial Stability Trust: A key aspect of the Financial Stability Plan is an effort to strengthen our financial institutions so that they have the ability to support recovery.” This Financial Stability Trust includes additional disclosure and transparency but uses the words “forward looking” more than once.  A very important aspect to this portion of the plan is the “Forward Looking Assessment - Stress Test”.  The stress test “requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected.”

Issues:  A stress test that requires a rigorous disclosure and analysis of banks balance sheets is a very good thing.  However, the standards for the stress test and the implementation of the test is what will be important.

• Who develops the ‘stress test’?  What are the standards of the ‘stress test’?  Will it favor, intentionally or unintentionally, financial conglomerates?
• Will the financial conglomerates or big banks be absolutely (no loop holes) required to submit to a ‘stress test’?
• What happens if the a bank fails the ‘stress test’ - will we continue to pump capital into it or will it be forced to liquidate?

These are just a few issues that the Financial Stability Trust provisions of the overall plan should address.  There is no question that in order to restore confidence, trust and financial stability in the markets there has to be more transparency and disclosure.  The overriding concern is that the people leading the implementation of this plan, mainly the Treasury Secretary Geithner, have the will and desire to demand that these financial conglomerates achieve the necessary level of transparency and disclosure to satisfy the concerns of the overall market.

There are two important money aspects of the Financial Stability Plan: 1) The Public-Private Invest Fund; and 2) Consumer & Business Lending Initiative.  These two programs alone may cost up to $2 trillion.  The Public-Private Invest Fund concept is flawed and the Consumer & Business Lending Initiative may show some promise but the concerns are a one of timing and cost.

Public-Private Invest Fund - the details of this important aspect of the overall plan are still being worked on.  Based on news reports, it seems that this Fund will provide some sort of price guarantee to private investors in order to encourage them to purchase the toxic assets from the banks.  If a private investor purchases the toxic assets at say $.75 on the $1.00 but it turns out that actually price/value is $.05 on the $1.00, taxpayers via the Treasury will pay the private investor the difference ($.70 on the $1.00).  Now, this is still very theoretical since the details of the plan are still being developed but it sounds like that is the approach that the Treasury Department is going to adopt. 

Issues/Problems:There is a huge gap in how buyers (private investors) value these toxic assets and how sellers (banks) value this toxic assets.  The problem all long with these toxic assets is that no one, including many the owners, know what these assets are worth.  Banks are going to be very careful with the price of these assets because if they don’t receive enough money for them they could be insolvent (asset worth less than liabilities).

• A private investor is going to require a big incentive from the taxpayers/Treasurer to buy these toxic assets because these assets are extremely risky.
• What if private investors and banks cannot agree on a price - are we going to force banks to sell assets (I doubt it)?
• What happens when a bank sell assets and as a result of the sale of toxic assets is deemed insolvent?
• Where is the ceiling for taxpayers, meaning is this $1 trillions it (no more money), regardless of the actually losses incurred by private investors?

Consumer & Business Lending Initiative:  This is from the Financial Stability Plan:

Addressing our credit crisis on all fronts means going beyond simply dealing with banks. While the intricacies of secondary markets and securitization – the bundling together and selling of loans – may be complex, they account for almost half of the credit going to Main Street as well as Wall Street. When banks making loans for small businesses, commercial real estate or autos are able to bundle and sell those loans into a vibrant and liquid secondary market, it instantly recycles money back to financial institutions to make additional loans to other worthy borrowers. When those markets freeze up, the impact on lending for consumers and businesses – small and large – can be devastating. Unable to sell loans into secondary markets, lenders freeze up, leading those seeking credit like car loans to face exorbitant rates. Between 2006 and 2008, there was a net $1.2 trillion decline in securitized lending (outside of the GSEs) in these markets.

Issue/Problem:This may work but the problem is that the economy has deteriorated to the point that consumers are reluctant to purchase any big ticketed item including houses and lenders are being extremely conservative with lending practices.  The liquidity in the secondary market, while important, should not be the priority and given any additional taxpayer money.  It is kind of a “chicken and egg” scenario.  We need to put people back to work so they gain the confidence to make purchases again and President Obama’s recovery and reinvestment plan is step in that direction.  But a financially stable banking system is important to that implementation of the reinvestment plan.

Time is of the essence.  The longer we wait the worse the problem will become.  President Obama said that in his press conference this past Monday and it is true.  However, we will be wasting time and money pursuing a plan that depends on a market system that is currently not working.  Private investors don’t trust the banks.  They don’t know what is on the balance sheets.  So, we are suppose to have confidence that they can agree on some price for these toxic assets.  Banks are concerned about consumers so they are not going to lend despite all the liquidity/taxpayer money that is poured into the “secondary market”.

We need to press reset on the banking system.  The ‘stress test’ is a good start and requiring additional transparency and disclosure must be a system-wide priority.  This includes very specific standards (not guidance) on how to value these assets.  There is some standard or method to valuing these asset - it just might not be the one that the banks like but to bad for them.  The objective of the ‘stress test’ should be to determine whether a bank is insolvent.  If the bank is insolvent then it must be financially and managerially reorganized regardless of size.  Treasury should either be “the bank” in terms of lending to consumers and small businesses or either provide capital to those banks and credit unions that are relatively healthy so that they can provide credit to consumers and small businesses. 

Some people are saying that such drastic measures are not politically feasible.  However, all the arguments that President Obama made regarding the importance of stimulus package also apply to addressing the other part of this economic crisis.  Remember, “When the town is burning, you don’t check party labels.  Everybody needs to grab a hose.”  Everybody must share in the sacrifice and pain of this crisis especially executives and shareholders of these financial conglomerates.