Guarded Optimism On Geithner's Plan
The under-pressure Tim Geithner, in probably his last ditch effort to save his career, will bring out his toxic asset plan today. From available information, I am optimistic and I believe markets will see it that way as well. This could sustain the rally for another couple of weeks. What is important is that the plan will start to "move" the toxic assets. Questions over the pricing will be secondary in my view as once things get transacted, it will eventually find a proper pricing level. The fact that reputable outside managers will be involved is a good start.
Brad de Long did a quick FAQ on the new Geithner plan to be unveiled today. The plan will be buying as much as $1 trillion in troubled mortgages and related assets from financial institutions. The plan is likely to offer generous subsidies, in the form of low-interest loans, to coax investors to form partnerships with the government to buy toxic assets from banks. To help protect taxpayers, who would pay for the bulk of the purchases, the plan calls for auctioning assets to the highest bidders. Industry analysts estimate that the nation’s banks are holding at least $2 trillion in troubled assets, mostly residential and commercial mortgages.
Q: What is the Geithner Plan?
A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.
Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?
A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.
Q: Where does the trillion dollars come from?
A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.
Q: Why is the government making hedge and pension fund managers kick in $30 billion?
A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.
Q: Why then should hedge and pension fund managers agree to run this?
A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.
Q: Why isn't this just a massive giveaway to yet another set of financiers?
A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.
Q: Why do we think that the government will get value from its hiring these hedge and pension fund managers to operate this program?
A: They do get 17% of the equity return. 17% of the return on equity on a $1 trillion portfolio that is leveraged 5-1 is incentive.
Q: So the Treasury is doing this to make money?
A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.
Q: How does having the U.S. government invest $1 trillion in the world's largest hedge fund operations reduce unemployment?
A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lazy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.
A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.
Q: And firms that ought to be expanding can then get financing on good terms again, and so they hire, and unemployment drops?
A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.
A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.
Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.
Q: This sounds very different from the headline of the Andrews, Dash, and Bowley article in the New York Times this morning: "Toxic Asset Plan Foresees Big Subsidies for Investors."
A: You are surprised, after the past decade, to see a New York Times story with a misleading headline?
A: The plan I have just described to you is the plan that was described to Andrews, Dash, and Bowley. They write of "coax[ing] investors to form partnerships with the government" and "taxpayers... would pay for the bulk of the purchases..."--that's the $30 billion from the private managers and the $150 billion from the TARP that makes up the equity tranche of the program. They write of "the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money..."--that's the debt slice of the program. They write that "the government will provide the overwhelming bulk of the money — possibly more than 95 percent..."--that is true, but they don't say that the government gets 80% of the equity profits and what it is owed the FDIC on the debt tranche. That what Andrews, Dash, and Bowley say sounds different is a big problem: they did not explain the plan very well. Deborah Solomon in the Wall Street Journal does, I think, much better. David Cho in tomorrow morning's Washington Post is in the middle.