Thursday, March 26, 2009

Geithner Plan as the second-best solution?

The critical issue in any banking system bailout is to get toxic assets off bank balance sheets and thereby remove the uncertainty about counterparty risks, recapitalize banks and get them to resume their normal borrowing and lending activities, and thereby break the de-leveraging feedback loop, restore confidence and normalcy in the credit markets.

The original Paulson Plan sought to buy up illiquid mortgage backed securities by conducting direct auctions. Then came a series of course corrections (and here) which led to equity injections with varying scope (to include other types of assets) and conditionalities.

The latest version of bank bailout plan, part of the Financial Stability Plan of the Obama administration, the Geithner Plan (simple explanation here), seeks to rope in private investors, both individually and through institutional funds, to participate in purchases of toxic assets with the incentive of dominant government stakes (both equity and debt) and non-recourse loans.

Paul Krugman has argued that the fundamental issue at hand, that is driving the debate on bailout plans, is a choice between two contrasting assessments of the health of the banking system. The Paulson Plan and now the Geithner Plan rest on the assumption that there’s nothing fundamentally wrong with the financial system, there are only misunderstood assets (as opposed to bad assets), and if investors were somehow made to share this belief, the banking system would get back to normalcy.

In contrast, if the assets are bad, and cannot be restored back to their old values, then all bailout money will only go down the drain. If this is the case (as it increasingly appears so since the underlying real estate values are unlikely to get back to their old inflated values any time soon), it is argued that nationalization is the most effective and optimal solution, with the least cost for tax-payers. In other words, the choice of options appears to boil down to one between a liquidity and solvency crisis, a result of a self-fulfilling panic or fundamentally bad investments.

Mark Thoma triggered off a debate (and here and here) on the bank bailout plans in the blogosphere by his posts comparing the markets for distressed assets with that for toxic cars. In either case, there are three choices - government to directly purchase the illiquid assets; government to subsidize and incentivize private investors to buy up these assets; and government to take over the institutions selling these products after wiping off their shareholders, stress test the purchases, write off the bad ones, and sell the rest back to the public.

The first two options come up against the uncertainty about price of the underlying asset and the extent of the problem. How much to pay or subsidize and for how many assets? The danger is two-fold - overpaying (more than what could be recovered by selling it after normalcy is restored) for the assets causing loss to the tax payer, and/or underpaying so that the cash injection is inadequate to repair the bank balance sheet and a turnaround. Supporters would however argue that if somehow the price paid is reasonable and normalcy is restored in the credit markets once liquidity is established, the government can recover its investments and even make handsome profits. The third solution, while suffering from all the same problems has the advantage of minimizing the costs to tax payer and providing a dose of certainty as to what will be the climax.

Mark Thoma again put the debate in proper perspective in an excellent post here, and argues that there is no definitively good plan and all the three, with "proper tweaks", could work. He also draws attention to the political difficulty in pushing through a nationalization solution. He writes about sticking with Geithner Plan, despite his preference for nationalization, "Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work." Brad De Long (and here) too takes much the same view.

Calculated Risk, as always is excellent, in describing the Geithner Plan as "sub-optimal, but... probably the best we can get in the current environment" and a "European style put option". It zeroes in on the problem with the Geithner plan as "that it incentivizes investors to pay more than market value for toxic assets by providing a non-recourse loan and with below market interest rates. The investors do not receive this incentive, the banks do. And the taxpayers pay it, so this is a transfer of wealth from taxpayers to the shareholders of the banks. This can be thought of as a European style put option - it can only be exercised at expiration. The taxpayers will pay the price of the option in the future, the investors receive any future benefit, and the banks receive the current value of the option in cash. Geithner apparently believes the future value will be zero, and that is a possibility. If so, this is a great plan - if not, the taxpayers will pay that future value."

Paul Krugman, Simon Johnson (and here), William Buiter, Steve Waldman, and Matt Yglesias have blogged about the Geithner Plan. NYT carries a debate among some of the aforementioned here. Nouriel Roubini finds some promise in the Geithner Plan.

It is now well established that the perverse incentives for agents within the financial sector and poor system design in the financial sector played a central role in bringing about the crisis. As the aforementioned economists and others point out, the problem with the second best solution like the Geithner Plan is that it leaves all the incentives and the institutional framework that caused the problem in the first place intact and risks losing a great opportunity, with the political momentum going, to reform the financial system. It also leaves intact the big banking behemoths, now ever larger thanks to the forced mergers, whose size carry inherent conflicts of interests and perverse incentives.

It is clear that if the present momentum is not seized to fundamentally restructure the banking system, we may have missed a historic opportunity. Even if the Geithner Plan were to engineer the miracle and stage a recovery, absent these fundamental reforms, it would leave the seeds for a more pernicious variant of moral hazard and set the stage for an even more devastating crisis in the future.

On a note of caution, as Calculated Risk pointed out, the Geithner Plan is vulnerable to being gamed or arbitraged by the participating banks. Naked Capitalism provides the ways in which this can be done.

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