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Testing Time for a Young Administration

Author: Roger M. Kubarych
February 12, 2009
Nikkei

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The new Obama administration was probably apprehensive about an early "test" of its resolve by Islamic extremists or North Korean hard-liners. Instead, the test came at home: from the stock market and Congress. The stock market endured one of the worst Januarys ever, and February has not been much better. Investors do have a lot to worry about: a worsening recession, a fragile banking system, and uncertainty over economic policies. Congress has its own concerns: retaining its authority, responding to shifting public opinion, and comforting contributors.

The Obama presidency starts out with formidable advantages --a big majority in Congress, a high approval rate in the opinion polls, and an eloquent commander-in-chief. But the congressional majority is not quite enough to pass anything the majority Democrats want. Popularity can erode quickly. And eloquence alone does not ensure support for specific programs, especially in Congress.

Pushing through an economic stimulus plan in the face of the worst recession in decades--with 600,000 people being laid off every week, house prices sinking, businesses facing bankruptcy, crippled banks, and a struggling stock market--ought to have been easy. It wasn't. The ideological gulf between Democrats and Republicans is too wide. The core philosophy of economists associated with the Democratic Party is Keynesian. They believe that the fastest and most reliable stimulus to overcome the recession comes from more government spending. The Republican members of Congress who survived last November's sweeping defeat dismiss that judgment and push for tax cuts, instead.

President Obama, the pragmatist and a conciliator by temperament, promised tax cuts while he was campaigning last year. So he was willing to do some of each. Polls showed the public consistently leaned more toward tax cuts than increased spending as the best way to combat recession. But the final compromise tilted toward the Democratic position. About 65% of the $789 bn program comes from increased spending programs, the rest from tax relief. Not everyone is overjoyed, but most will learn to like the stimulus program if it works as well the Obama economics team predicts.

The views of experts, politicians, and the public are even more divided over what may be the thorniest issue: what to do next to solve the financial crisis. Nobody really knows. The Paulson plan was not really a plan, but a series of hastily devised (and hugely unpopular) band-aids to stop the bleeding. So everyone in financial markets across the globe looked forward with great expectations to hear what the new Treasury Secretary Tim Geithner would unveil on February 10, especially after President Obama's ringing endorsement the day before.

Probably no speech could live up to the hype, but it was startling how badly the US stock market reacted to his proposals. They include further recapitalization of banks using appropriated funds, but with tougher conditions; a major extension of an existing Treasury-Federal Reserve facility, not yet in operation, to support securitization of consumer and small business loans; a new Public-Private Investment Fund of up to $1 trillion to buy troubled assets from financial institutions; and a home foreclosure prevention initiative.

Much was not new, but basically enlarged programs established by the Paulson Treasury. What was new did not offer fully-developed plans but essentially amounted to a "work in progress." Disappointed investors decided to sell, rather than wait a few weeks for elaboration.

Especially hard hit were the stock prices of banks, in particular large regional banks. The Geithner plan contemplates a formal "stress test" to determine bank eligibility for future capital infusions. Those stress tests are very likely to uncover sizable gaps between balance sheet valuations and market prices of many so-called "legacy loans and assets." That's because some big regional banks treat large portions of mortgage-related and other illiquid assets as "held to maturity" and do not mark them to market regularly. A tough-minded stress test, designed to test for solvency, not capital adequacy or liquidity, would logically treat everything a bank owns as available for sale. As investors weighed the consequences of such a regime, they rushed to sell shares. Within hours a number of the biggest regional banks had lost between 25% and 30% of their market values.

The lesson is that what's needed to erect a regulatory system that will keep banks from repeating the mistakes that led to the crisis may conflict with the immediate need to restore investor confidence and make it possible for banks to raise additional equity capital in the marketplace, rather than going back to the US Government. The ugly stock market response to the Geithner plan will make it all the harder to recapitalize the US financial system without taxpayers footing the bill--not a happy prospect.

This article appears in full on CFR.org by permission of its original publisher. It was originally available here (Subscription required).

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