- Overview: Geithner aims to add private funding as a new component of proposals to address the toxic debt clogging banks’ balance sheets next to government guarantees of ring-fenced toxic assets. Aspects of the plan that have been settled include a new round of injections of taxpayer funds into banks, targeted at those identified by regulators as most in need of new capital. Previously, the comprehensive solution that aimed at keeping banks in private hands as outlined in Tim Geithner's confirmation hearing was the set-up of an 'aggregator bank' that buys toxic assets. The main sticking point is the toxic asset valuation issue--> markets gain on prospect of easing mark-to-market accounting rules. Major headache is systemic impact of too-big-to-fail banks. Treasury will outline action plan on February 10.
- Amount of toxic assets: WSJ says combination of guarantee and aggegator bank likely, with the latter buying about $2 trillion in toxic assets. Compare with size of U.S. originated shadow banking system pushing for re-intermediation and access to central bank liquidity is $10 trillion (see Geithner speech June 9). Of these, about $6T in U.S., $4t abroad according to Fed research based on flow of funds data (compare with Goldman estimates (not online) that amount of toxic assets in U.S. is at $5.7T). Moreover, IMF notes in October GFSR that $10T is the likely amount of asset deleveraging at global banks. Simon Johnson estimates U.S. bank rescue will cost $3-4T with net cost to taxpayer of about $1-2T or range of 5-10% of GDP as in past banking crises (via Fortune).
- RGE: for U.S. banks: $1.1T in total loan losses, $600-700bn in current mark-to-market losses based on derivatives and cash bond prices. Compare with Chris Whalen (IRA) estimate for accumulated bank charge offs for 2009 in the neighborhood of $1 trillion vs. $1.5 trillion in Tier 1 Risk Based Capital at all US banks. "The good news, though, is that 2/3 to 3/4 of that loss number comes from the top 4 - Citigroup, Bank of America, JPMorganChase and Wells Fargo, in that order of risk profile."
- Industry proposal with private sector involvement (via Fortune): The idea, as drafted and as articulated by Citigroup's Flexner, is for the government to create a massive new fund to lend money at a fair price to professional investors -- pension funds, hedge funds, private equity funds and endowment funds -- for the sole purpose of providing reliable long-term financing to allow these investors to buy the various "toxic assets" in the secondary market that are now frozen on the balance sheets of financial institutions the world over--> The bet would be that these securities would increase in value over time
- similarly Michael Jaliman 'MBS Economic Freedom Bonds' (without temporary nationalization) and Luigi Spaventa's Brady Bond proposal to clear toxic asset overhang and sever market and funding liquidity negative feedback loop.
- Jeffrey Sachs: The bank can be recapitalized at fair value to taxpayers and without inducing a squeeze on bank capital and lending. The government can swap 20 in government bonds for the 20 in toxic assets plus contingent warrants on bank capital, the value of which depends on the eventual sale price of the toxic assets. The government would then dispose of the 20 in toxic assets at a market price over the course of the next year or two and exercise its contingent warrants at that time. During the period of liquidating the toxic assets, the government would exercise a kind of receivership over the banks in order to prevent asset stripping or 'Hail-Mary' incentives on the part of managers --> In this process, there are no taxpayer bailouts, and there is also no squeeze on bank capital resulting from the exchange of toxic assets at less than face value.
- Nouriel Roubini: in the bad bank model the government may overpay for the bad assets as the true value of them is uncertain; even in the guarantee model there can be such implicit over-payment (or over-guarantee that is not properly priced). Thus, paradoxically nationalization may be a more market friendly solution: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and – possibly – even the unsecured creditors in case the bank insolvency is too large; it provides a fair upside to the tax-payer; it can resolve the problem of government managing the bad assets by reselling most of the assets and liabilities of the bank to new private shareholders after a clean-up of the bank.
- Robert Pozen: Here's a practical solution to the valuation issue: suppose the Treasury estimates that a toxic asset is worth $700,000. It would pay the bank $560,000 in cash (=80%) plus a capital certificate for $140,000 (=20%). If the government later sold that security for $660,000, the bank would receive an additional cash payment of $80,000 (80% of $100,000, the excess of $660,000 over $560,000). The Treasury would receive the remaining $20,000 of the excess. On the other hand, if the government later sold the security for $550,000, the bank would receive nothing more. The Treasury would absorb a loss of $10,000.
- Willem Buiter (similar arguments by Stiglitz/Romer/Soros): Government should finance and run temporarily one or more good banks, i.e. buy the good assets for which there IS a price by definition and leave the bad assets with the old legacy banks and its shareholders, creditors. Latter will most likely fail and at that point Chapter 7 and 11 are ready--> the state meets its three key objectives: first, its short-run economic stabilisation and crisis-fighting objective; second, its medium and long-term banking sector incentive-enhancing, moral-hazard-minimising objective; and third, its fairness objectives: the polluter pays or, you break it, you own it.
- Paul Krugman: The only way to make effectively insolvent banks viable again without explicit but temporary government takeover and restructuring is if the government pays much more for toxic assets than private buyers are willing to offer. There is no guarantee that paying near fair value prices will make banks solvent again which would require additional capital injections. A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.
- Luigi Zingales: Avoid putting any further taxpayer money at risk at all and mandate a sizable debt to equity swap and adjust distributional issues with equity warrants (change in legislation needed).
- Nationalization (Swedish Model):
Pro: write down toxic assets to market value, then nationalize insolvent banks (receivership) in order to align institution's and taxpayer incentives (Zombie banks are likely to engage in gambling), wipe out equity holders (maybe also debt restructuring needed) instead of subsidizing them with taxpayer money, dismiss management, dispose of them via a new RTC (or bad bank), wind down unviable banks, refinance viable ones, start afresh.
Con: Government is not in the business of running a commercial bank; potentially large upfront government outlays, what do you do with debt holders?, stigma.
- Backstop guarantee of ring-fenced assets on banks' balance sheets of Citi and BoA:
Pro: Little upfront outlays for the government
Con: Open-end government commitment, question of asset valuation unresolved; assets that are good today may turn bad tomorrow (coming loan losses) which may need additional capital, persistent lack of transparency on who holds what, ongoing subsidization of existing share- and debt holders by taxpayers, banks might need additional capital injections.
- Bad Bank or Aggregator Bank (to be run by FDIC):
Pro: Government purchase of toxic assets off banks' balance sheets contributes to price discovery and helps deleverage balance sheets.
Con: Big question is at what price should toxic assets be bought? If government buys at market values, many banks will be insolvent anyway as they have to mark down asset values to new price. If price is too high, taxpayer is once again subsidizing eqyity and debt holders. Bernanke advocates 'hold-to-maturity' prices above current market prices.
- 'Bad bank' without nationalization and full writedown of toxic assets to market value is reminiscent of super-SIV that industry did not want to back itself due to asymmetric exposures.
- IMF: Fair value accounting has its problems but it is still the best option available.
p/s photos: Kim Ok Bin