Toxic banks or toxic assets?

Two weeks ago, George Soros memorably framed the core choice the US now faces as a choice between buying toxic assets or taking over toxic banks.

“The hard choice facing the Obama administration is between partially nationalising the banks, or leaving them in private hands but nationalising their toxic assets.”

There is perhaps a third option: handing the toxic assets over to the banks’ existing equity investors and the banks long-term unsecured creditors, assigning the deposits to the remaining "good" bank and recapitalizing the new bank with public funds.

Judging from this week’s press reports, Treasury Secretary Geithner didn’t like these options.

If Floyd Norris is right, the US Treasury will propose a fourth option: providing credit to private investors that are willing to buy the banks toxic assets.

Private investors then would have to figure out the right value of the banks existing toxic assets. In return, they would get all of the upside. They would also take some of the downside. But perhaps not all the downside.

If the government provided credit to private investors who put up cash to buy toxic asses, the private investors would take the first loss. That discourages overpayment. But with a non-recourse loan the government on the hook if the value of the toxic assets fell by too much. The private investors could extinguish its debt by handing the toxic assets it bought over to the government.

This seems like a transaction that requires the government take on additional risk. But that probably isn’t totally accurate, as the government already in some sense has most of this risk.

So long as the government is committed to protecting the banking system’s creditors – depositors, money market funds and bondholders – from losses, the government already has most of the downside risk on these toxic assets. There isn’t much bank equity left. As a result the government is already on the hook it the banks’ end up taking additional losses on their toxic assets. If the government provided financing to other actors willing to buy the banks bad assets, the government would have more exposure to those players’ toxic assets, but less to the banks’ toxic assets.

The plan Norris describes sounds a bit like the ideas some in the market were circulating a few days ago. The resulting “Geithner plan” also has some similarities to the Brady plan that helped to resolve the Latin debt crisis (really a banking crisis stemming from the banks’ overexposure to some large sovereign borrowers). Both Brady and Geithner seem to want to move bad assets from bank balance sheets to the market. And in both cases the government likely will facilitate the transaction in part by limiting the risks born by private investors. Brady bonds were collateralized by long-term Treasuries, assuring that investors would get their principal back.*

But it isn’t completely clear that Floyd Norris’ story has all the details right. The Wall Street Journal’s reporting suggests a somewhat different potential structure, one based on a public-private partnership. The FT suggests both approaches are under consideration. Krishna Guha:

"The exact details of how the private-public partnership will work are not known. One option discussed by policymakers is for the authorities to co-invest alongside private investors in a “bad bank” or “aggregator bank” that would purchase the toxic assets. Another version would involve the government sector providing non-recourse financing on a large scale for private buyers of toxic assets, possibly in conjunction with guarantees that explicitly limit loss on these assets. "

We will know later today.

The Treasury seems to have concluded that it was impossible for the government to figure out what price it should pay the banks – really the banks existing owners – for their toxic assets. There is a reason why bad bank – like the RTC-- generally were created after a bank had already failed and their equity investors have been wiped out. If the government already owns the banks assets (as a result of its guarantee of the banks’ liabilities) it doesn’t really matter what price it pays the “good” bank for the assets of the “bad” bank.

But providing other parts of the financial system – including parts of the shadow financial system -- with credit to help it buy the banks bad assets isn’t a perfect solution either.

Implicitly, Geithner and his colleagues seem to have concluded that the “great unwind” has limited the private sector’s ability to absorb the banks troubled assets. Key players no longer can borrow the funds needed to make large bets on troubled mortgage-backed securities. By providing credit to those willing to buy bad assets, the US government hopes to push up their market price up, and in the process induce the banks now holding these assets to sell. The US government in effect is providing the financial system with leverage to facilitate – one hopes – a transition to a less leveraged financial system. The amount that private investors have to put down – relative to the amount they are spending – is a key detail.

And it is quite possible that the market by be suffering as much from a sellers’ strike as much as a shortage of credit. Yves Smith is characteristically direct:

“The elephant in the room is how do we solve the heretofore insurmountable problem that the market price of the bad assets is well below what the banks are willing to sell them for”

So long as a bank can rely on the government to prevent a run (thanks to the government’s guarantee that creditors of large banks won’t take losses; i.e. “no more Lehman’s”) the banks current owners may prefer to sit on its toxic assets and hope the market recovers.

Finding private buyers doesn’t solve this problem. No bank has much incentive to sell its toxic assets at a price that would leave the bank bankrupt. Not selling is one way of gambling for redemption.

Breaking this logjam presumably is the purpose of another reported component of the reported Financial Stability Plan: a review of the balance sheets of large banks and, if needed, additional injections of equity capital into troubled banks. Here the Treasury seems to be moving away from former Secretary Paulson’s desire to put equity into all the banks, even relatively healthy banks, to avoid stigmatizing individual banks.

If the estimates of the banks’ total losses from Nouriel Roubini and Elisa Parisis-Capone are close to right – their estimated losses top those of the IMF, but the IMF’s estimates continue to be revised up – a lot of banks though won’t have any choice. Roubini and Parisi-Capone estimate that the US financial sector’s losses are close to its equity capital, something that no amount of regulatory forebearance can hide. …

It is consequently is likely that the government will end up with a large stake in some banks, even if key banks aren’t formally nationalized. That is fully appropriate. It is clear that the taxpayer is already on the hook for most of the banking sector’s downside. There simply isn’t enough equity left to offer the taxpayers much of a cushion against further losses (in world where the banks’ creditors are protected). If the taxpayer puts in new equity to allow the bank to remain adequately capitalized after the existing private equity is written down to cover past losses, the taxpayer should get a large share of the upside.

Will the Geithner plan work? I certainly don’t know.

Based on what I have read over the past two days, I have two main concerns.

The first is that the desire to avoid “nationalizing” key banks will soften the review of the banks balance sheet. I understand the desire to avoid nationalization. Once major banks are publicly owned, there would be pressure to lend for less-than-commercial purposes. But in some sense the substantive argument isn’t the crucial one. I testified before the Senate Budget Committee two weeks ago, along with Simon Johnson (if you aren’t reading the Baseline Scenario http://baselinescenario.com/, you should be) and Tim Adams. I got the sense that there isn’t currently political support for a step as significant as nationalizing the key banks. Economics bloggers – and Martin Wolf - aren’t in quite the same place as America’s elected representatives. The Senate wants the banks (meaning their equity investors and management) to pay a price for their mistakes and it wants the banks to remain in private hands. Alas, those two objectives are in tension …

The second is that need to stretch the $300 billion or so available under the existing TARP out may have triggered the push for options that have a limited upfront cost but ultimately pose large risks. The FT’s Guha reports:

"Rather than seek to solve all the problems by pouring vast amounts of public capital into the banking system, the plan hopes to crowd in private capital through guarantees and financing. This reflects financial and political constraints – the administration is having to work, at least for now, within the $350bn (€273bn, £238bn) second tranche of the troubled asset relief programme – as well as a desire not to expand government ownership of the financial sector any more than is absolutely necessary."

David Brooks reports that the Treasury is shying away from guaranteeing a lot of the assets on the banks’ balance sheet for this reason.

There had been some talk about setting up an insurance program, with the government guaranteeing a low-end price on toxic assets. But Geithner doesn’t think that can work. “If you’re pricing a guarantee or pricing a purchase, you have the same basic problem: the absence of a market price,” he said. It’s better to create a market so prices can be set normally, not by fiat.

That is good.

But the reported plan does seem to involve rather extensive use of the Fed’s balance sheet.

Ultimately, the financial sector’s losses are bigger than can be absorbed by the portion of the $700 billion in TARP funds that has been injected into the banks and the banks pre-existing equity. Goldman estimated that there at least $3 to $4 trillion of “troubled” assets on the books of US banks. That is the stock of troubled, assets – not the losses. But even if the banks existing equity investors take a large share of the losses on these assets, I suspect that the US will be lucky if can escape from the current mess with a net cost (meaning the net loss once toxic assets and toxic banks have been sold off) to the taxpayer of less than 5% of GDP …

Systemic crises tend to be costly.

UPDATE: Geithner’s plan

* The Brady plan guaranteed full payment of principal on the bonds of troubled Latin borrowers, as the principal of Brady bonds was fully collateralized by Treasury bonds. Countries that participated in the Brady bond bought this collateral with loans made available from the IMF. In return for the government’s support for the restructuring process, the banks agreed to restructure (lower interest rates, reduced principal) their original loans. The overall effect was to take bank loans to troubled sovereign borrowers off the books of the banks and put them into a traded market …