Today Treasury Secretary Geithner prescribed tough medicine for restoring confidence in the financial system. The stock market responded by vomiting up its recent gains. One could ask why, but one’s time might be more fruitfully spent tackling easier problems, such as rediscovering the lost art of alchemy or devising the Napoleon Dynamite algorithm that wins the Netflix prize.
The fact is nobody really knows the answer. Chalk it up to the market’s buy-on-the-rumour/sell-on-the-news mentality, low volumes, day traders, short-sellers, profit-taking of recent gains or last night’s full moon. Each is as reasonably plausible and likely to be right (or wrong) as the other.
But some of it might have been the vague details of Geithner’s ambitious financial stability plan, which consists of three big steps:
(1) Financial Stability Trust: The Treasury will stress test financial institutions and make direct injections of government capital to insolvent banks; the capital would act as a bridge to private sector investment down the road.
(2) Public-Private Fund: A public-private partnership to buy between $500 billion and $1 trillion in illiquid assets from financial institutions.
(3) Consumer Lending Facility: Providing relief to consumers, homeowners and small businesses by getting credit markets to lend again; the government would accomplish this by purchasing $1 trillion of new securitized debt products for auto, student and mortgage loans.
Number (1) basically amounts to a de facto nationalization of weak financial institutions without actually saying so. Why? Nationalization is the intervention that dare not speak its name. But while the measure itself may not be a bad idea, the double-speak and lack of detail have left many scratching their heads as to the real motivations and consequences. (When, for example, would the government sell off its stakes in these banks?)
Similarly, Number (2) is effectively setting up a “bad” bank without actually saying so. There are two concerns with a government-run “bad” bank. The first is that the government runs the risk of over-paying for troubled assets (thus handing banks a windfall at the expense of taxpayers) or under-paying for them (which would require the government to contribute more capital to these institutions down the road, also at taxpayer expense). The second problem is that the government is not set up to manage the assets it would buy under such a program.
By calling for a public-private partnership, Geithner has answered the second challenge of a “bad” bank initiative–he’ll get the private sector to manage the assets and also buy some of them (though which private sector funds would do so is not clear). But he hasn’t addressed the valuation problem, which is equally important and more difficult.
So far, somewhat okay. Many economists believe that some form of nationalization and “bad” bank approach will be needed to make up the approximately $1.5 trillion shortfall U.S. financial institutions currently have. It’s the third initiative, however, that may be the most ambitious and controversial part of Geithner’s plan.
Banks are so far in the hole they can’t make new loans. But if they could securitize loans and sell them off to investors (as they did in the good old days of easy credit), they might start lending again.
It’s important to realize here that securitization is not, by itself, a bad thing. It only becomes troublesome when the loans securitized are worth less than the collective droppings of New York City’s pigeon population. When that happens, and the entire multi-trillion dollar securitization market collapses, investors understandably become reluctant to buy securitized bonds at any price.
Geithner’s solution would require banks to make only “good” loans, which would be securitized. Then the U.S. government would buy them all.
In terms of creativity, Geithner gets an A+. Nothing else would get banks lending faster than the knowledge that they wouldn’t have to hold any of the loans they make. This would also would be more effective than any stimulus package to get consumers, homeowner and small businesses purchasing and avoiding foreclosure/bankruptcy soon. But in every other sense, it’s a doozy.
Geithner is proposing nothing less than replacing the global capital markets with… the U.S. government (for a limited time, to be sure–but he’s given no indication of how long that would be).
This is the mother of all interventions.
If you hate big government, it doesn’t get any worse than this. And he hasn’t told us how he would ensure the banks would make good loans.
To be fair, Geithner is hoping the Consumer Lending Facility, along with the other steps, will restore confidence in the capital markets to invest again in banks and securitized products. It could just work. Or it could fail spectacularly. Geithner hasn’t given us enough details to really know, and that’s one of the big reasons why people don’t like what he’s proposed.
Short of a massive intervention like this, however, it’s not clear how anyone can get the credit markets unglued anytime soon. Furthermore, both the Great Depression and Japan’s Lost Decade-and-a-Half demonstrate the danger of too little action too late.
Geithner needs to give the country–and, indeed, the world–more details on how he plans to implement these steps. More importantly, he needs to do so sooner rather than later. If not, the stock market won’t be the only one vomiting up his medicine.
