Geithner's gamble

How does the US Treasury Secretary's plan to repair the banking system work? Stephen Foley reports
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The Independent Online

The US stock market went up as much yesterday as it went down last time Tim Geithner, the Treasury Secretary, announced a plan to repair the battered banking system. The difference this time was that this was a fully fleshed-out plan to cleanse banks of their toxic assets, assets that have shot confidence in banks' solvency and forced them to row back on the lending to businesses and consumers that keeps the economy humming.

What needs to be done?

At the kernel of the credit crisis are hundreds of billions of dollars of unsuitable mortgages handed out to subprime borrowers in 2005, 2006 and 2007. These loans, parcelled up into mortgage-backed securities and derivatives called collateralised debt obligations, are already going sour in large numbers, as borrowers default and their foreclosed homes are dumped on the market at low prices.

Investors have shunned these securities and derivatives for more than 18 months now, fearful that the US housing market will keep getting worse. When these assets do sell, it is at depressed prices, far below face value. Banks, believing that the housing market will eventually stabilise and most borrowers will not default, do not want to sell in these circumstances.

A similar stalemate has been reached in the market for commercial mortgages and other types of credit derivatives, such as parcels of credit card loans. In all, perhaps $2 trillion of impaired assets is sitting on bank balance sheets. The government hopes that offering taxpayer money to buy them will kickstart the frozen markets and restore confidence more widely.

What is the plan?

The Obama administration is proposing to create scores of "public-private investment funds" (PPIFs) with private investors such as hedge funds and pension fund managers. These vehicles, which will be funded on a 50-50 basis by the taxpayer and the private investor, will buy some of the loans and credit derivatives currently held by banks or trading occasionally in the secondary market at depressed prices.

In order to magnify any profits – and make it worth the private sector's while – the funds will also borrow money, perhaps up to six times the original pot. That debt will be guaranteed by the US government. In total, adding together the private sector's investment, the government's stake and all the debt, $1trn could be available to buy toxic assets.

Why has it taken so long?

The Treasury first hatched a plan to use taxpayer money to buy toxic assets last September, at the height of the financial panic, but the last Treasury Secretary, Hank Paulson, dropped it in favour of injecting capital directly into the banks. That was faster, and the Obama administration is promising still more capital injections if needed. The toxic asset purchase plan is back as one part of a much wider set of measures to aid the banking system.

The detail is devilish. Last year's plan would have not involved any private sector participation at all, but that was rejected because there seemed no way for the government to set an accurate price for the assets it was buying. Now, by involving the private sector in auctions, a market price of sorts will be set. However, it has taken a long time to balance the interests of private investors, the selling banks and the taxpayer.

Is it a fair deal for the taxpayer?

Not only does this have to be a fair deal for the taxpayer, but it has to be seen to be a fair deal. There is too much public anger at Wall Street for the Obama administration to risk something that looks like another no-strings handout to the finance industry. At first glance it looks to pass that test.

There are no restrictions on executive pay or bonuses for participants, but the government will be paid for making the loan guarantees. Most importantly, by matching private investor equity dollar for dollar, the current plan means that the taxpayer, too, will make the same profit or loss as the private investor – at least unless there is another, unexpected lurch downward by the economy.

In those circumstances, if the underlying mortgages and other loans perform much worse than expected, the value of the assets can be expected to collapse, too. Once the decline is so large that the equity in the PPIF is wiped out, the government debt guarantee will kick in, and the taxpayer will have to eat any additional losses.

Is it too complicated?

It certainly is complicated. The amount of debt that these PPIFs will take on, and where it comes from, depends on what type of assets they are buying. For purchasing parcels of loans, the government will guarantee debt of up to six times the PPIF's equity. For securities backed by mortgages, commercial real estate and credit card loans, the Treasury will lend up to 50 per cent of the equity, but the vehicle can borrow more under the Federal Reserve's Term Asset-backed securities Loan Facility, the Talf, on terms to be determined.

Its complexity is of a piece, however, with all the other acronymic schemes devised to restore liquidity to what are, after all, complex credit markets. It is not the complexity that could kill it, but something much more simple: will anyone take part?

Do private investors like the plan?

Bill Gross, the chief investment manager at Pimco, the biggest bond fund manager in the US, calls it a "win/win/win" scheme and says he will participate. BlackRock, another big fund management group, has also expressed interest. Both think they can even launch "toxic asset mutual funds" the public can invest in.

Especially because PPIFs can leverage returns using cheap government-backed debt, the upside could be substantial if the recession is short and the assets surge in value. Their downside is capped at the level of their equity investment.

But the public furore over bonuses paid to AIG executives, and Congressional plans to confiscate them through a retrospective tax, has made the private sector even more nervous about dealing with the government.

And what about the banks?

Depends on the price. This is the $64,000 question, and it always has been. Banks have not been willing sellers of any of these assets for more than 18 months. They do not like the prices the private sector is offering, and many might be forced to recognise big losses if the auction process sets a value below where the assets have been valued on the banks' books. Financial firms have already recognised more than $500bn in losses on these assets, and some might be pushed into insolvency if they have to recognise more. In contrast to the fund managers, there was no public comment from any of the nation's big banks yesterday.

Does anyone think this is a silver bullet to end the credit crisis?

No, but it will help with aiming the gun. If even a few auctions go ahead, we will at least get a market price for assets and that will help with some of the questions about the likely solvency of the biggest banks in the US.

The global equity strategy team at Credit Suisse puts it most succinctly. "The key question remains the one about the true nature of the crisis. Is this just a crisis of confidence and liquidity (ie fear has led the markets to underestimate the true economic value of banks' assets) or a solvency problem (that is, the true economic value of banks' assets is not sufficient to cover their liabilities and regulatory capital)?" Credit Suisse votes for the latter. The Obama administration is neutral. If the prices the auctions generate are high, that could prove to be a windfall for the nation's battered banks. If they are low, at least it creates some certainty about how bad things are, which in turn might tempt private investors to recapitalise the salvageable banks. As for the rest, then nationalisation will be back on the agenda in a few months.