Tuesday, March 24, 2009

Felix Salmon misrepresents me...

Felix Salmon mischaracterises my views… 

In particular he says

The status quo, absent any Treasury proposal, is basically the Hempton plan: let profitable-but-insolvent banks work their way slowly back to solvency by making large operating profits and not paying dividends. But the problem with the Hempton plan is that it only works on a kind of don't-ask-don't-tell basis: the banks can't be publicly insolvent, since then they need to be taken over by the government.

No.  My view is that we should have nationalisation after DUE PROCESS.  My view is that very few things will be nationalised – but I could be wrong.

What I like about the Geithner plan is that it provides PRICE DISCOVERY.

The price discovery gives regulators a process for marking the banks' books.  The bank “stress test” is no longer a “self assessed exam in which the punishment for failure is death” but an externally assessed exam, assessed by (admittedly subsidized) private money.

Once you have the true bank capital position determined you can allow the banks with adequate capital to muddle through (possibly with government liquidity support) and force the insolvent banks to raise capital.  If they can’t raise the capital you nationalise them.

As the exam is now objective – not self assessed – a lower capital standard (say a third normal) should be allowed.  High capital standards are really required in part because banks lie.  If they can’t lie a lower standard should be acceptable.  Moreover you suspend dividends whilst they muddle through.

Now the Geithner plan – done on a larger scale – can also support another policy objective.  If a bank comes to the Treasury and says “we are illiquid – help” the Treasury can now say “sell some assets”.  The bank cannot any longer claim there is no market for those assets – they can sell them to the Geithner plan fund(s).  

When they are forced to sell them the difference between illiquidity and insolvency will become clear.  If the assets sell near their book value then the bank really is just illiquid.  If large haircuts are required the bank is insolvent.  The government response can be dictated by a market price.

I never advocated that muddle through is the right policy.  I just happen to think that muddle through will work for most banks because most banks are not that insolvent.

But – after this process – I could be found to be wrong.  Very wrong.

And we will have nationalisations.  And they will not appear as theft because markets determined who was solvent and who was not.



John

8 comments:

Andy said...

I think Galbraith has the best take on what the real problems with the Geithner Plan are, including the fact that our financial system remains too large a part of our economy with the same dunderheads running it, after all is said and done.

http://econvideo.blogspot.com/2009/03/galbraith-on-geithner-plan.html

Chris said...

John,
Thanks v. much for the clarity and modesty of your blog. It has really helped me wade through the shrill commentary from very smart but highly charged bloggers. For some time, I thought Geithner was too close to Wall St and was concerned he was shelving nationalization for political/state capture reasons. Having tried hard to think about nationalization in practice however, I understand why he, and you suggest it as a last resort. Surely the economic risks, and the challenges it carries are so high that it can only be done following a predictable, exhaustive, methodical PROCESS.
My two concerns are that
(i) the politics are going to kill Geithner before the economics so Krugman's shrillness is a real problem cos it might,sooner rather than later, flip the Dems in Congress against Geithner without whose support he is buried. The problem is that ALOT of people, be it the public, the chattering class, and the markets have heightened Attention Deficit Disorder and want something fast and brutal one way or another, even if it's wrong. I think Geithner needs someone credible, maybe Volcker, maybe Buffet to get on TV and explain this to people and the markets.Again and again and again. When really smart people like PK, Felix Salmon miss this basic point, then there is somehting wrong with the debate. Obama can't do it because if the plan fails, he (rightly) doesn't want to fail with it.

(ii) If the politics don't get him first, does Geithner really plan on following through with the implications of the price discovery that follows form his toxic asset plan if banks are not willing to sell at hte market price? Will he really play hardball and say, sell your assets, get private capital or we take you over in 6 months - that is where you and PK,Simon Johnson etc disagree. They don't think Geithner will follow through, and so the banks won't have any incentive to sell.
Any thoughts on this?

cdo-cubed said...

Hi John

These aren't going to be real market prices though are they? The buyers get low interest rate leverage from the Tsy and either the FDIC or the Fed (TALF). They can pay more than expected value because they get to put them back to US Govt in a bad scenario. See here:
https://self-evident.org/?p=502

jb said...

I really don't understand how this Geithner plan amounts to price discovery. The FDIC is giving 6-1 Debt to equity loans, so they give investors a (free?) 16.66% initial margin above debt loan with no margin calls plus free put options to boot (since no recourse) if only they buy an asset. Won't this make it more likely for investors to overpay? This leads to 3 problems 1) as asset prices are inflated from the FDIC subsidy, balance sheets will continue to be unrealistic pictures of the future when measured on a mark to market basis 2) Treasury loses on its half of equity for price drops of more than 7% from the winning bid (not current prices), 3) FDIC loses on its loan for prices drops of more than 14%. Are these price drops unlikely? Your mention of price discovery implies that current prices are not market prices? Perhaps you mean current prices reflect a wait and see attitude? Seems like it is time for bond holders to realize the risk they took in lending to these banks.

Richard Smith said...

Bond holders, yes. How does the gearing work? If I was a major holder of bonds of a probably bust bank, could I bid up for the toxic assets, keep my bank out of bankruptcy, and thus avoid taking a haircut on my bonds? I'd have to accept a relatively small hit on my holdings of toxic assets, but it might be worth it. If those 40 cent prices are actually right, the taxpayer could end up with most of the hit, eventually.

Depends on the numbers but there might be an incentive for some investors to overpay quite handsomely.

septizoniom2 said...

you say the geither plan will lead to price discovery. i think you are assuming away all of the conflicted party issues.

Anonymous said...

John,

I think your analysis is absolutely correct with one notable exception.

Widespread insolvency of banks.

Our regulated banking system was not designed to operate at 1. greater than 20x leverage and 2. with very risky assets (i.e. grossly mispriced mortgages).

for instance, when the first Basel Accord was adopted in 1988 (or so) there was a reasonable basis to apply a 50% risk based capital requirement discount for mortgages. But they never envisioned banks holding the poor quality of mortgage assets that banks hold today. This is a specific example to explain the problem more generally, we are using historical guidelines of solvency that are not applicable to our regulated(sic) banking system today.

If you look at tangible equity ratios (historically low) and the volatility(and uncertainty) of asset prices on bank balance sheets (historically high by orders of magnitude), I don't see how anyone can argue that a great many of the banks, including some of the money center banks are insolvent.

Philip said...

John,

Thank you so much for your blog. Assuming that you are right that the virtue of the Geithner plan is that it will provide price discovery (and I agree with some of the reservations expressed by other commenters), couldn't we get the same benefits with far less commitment of public money by requiring the banks to select and sell a small sample of their assets on a statistically valid sampling basis? But I suspect that unlike you, Mr. Geithner isn't really looking for price discovery, he is looking for a mechanism to increase prices of toxic assets above current market levels.

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. Mr. Hempton may hold either long or short positions in securities of various companies discussed in the blog based upon Mr. Hempton's recommendations. The commentary in this blog in no way constitutes a solicitation of business or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author.  In particular this blog is not directed for investment purposes at US Persons.