Commentary

Timmy’s Big Week

U.S. Treasury secretary Timothy Geithner had a very big week. In February, the panicked American public and their clueless representatives in Congress saw a timid and overwhelmed Geithner fumbling and bumbling his way through a vaguely defined plan to rescue the banking system from all of the toxic securities purchased – with borrowed funds – during the crazy days of the now extinct credit bubble.

In contrast to February, March seems to have brought out the lion in Geithner. Early this week he laid out a much clearer plan to bring in private investors to help the government mop up the rotting piles of mortgage-related “assets” infecting the financial system, and yesterday he announced plans to grab the reins of troubled, yet systemically essential non-bank institutions – such as A.I.G. – so that the government will be better able to manage any possible future implosions. In the paragraphs below, I will discuss both what I consider to be the merits and pitfalls of Mr. Geithner’s new initiatives.

First, I will address Geithner’s proposal to rid the banking system of bad assets. The problem with the jumble of mainly real estate-related securities sitting on bank balance sheets is that they are illiquid and tied to an asset class that is still losing value. Therefore, there is no market for them, and they just end up getting marked ever lower each quarter in lockstep with sinking home prices. This forces banks to seek more capital or face costly credit downgrades, which will bring them closer to insolvency – and into the arms of the U.S. Treasury or the FDIC.

To solve the problem of liquidity and establishing fair value for these troubled assets, a legitimate market needs to be established. This means private investors need to be brought in to the process. But they will only get involved if their downside risk is limited, meaning they want cheap funding and government guarantees. Well, when this plan moves forward, they’ll get both in spades.

The Treasury’s latest scheme, dubbed the Public-Private Investment Program, will offer up $500 billion in financing to buy toxic assets – the program could swell to $1 trillion if credit conditions deteriorate further. The NY Times reported that $75 billion to $100 billion would come from TARP, set up in the initial financial bailout plan last fall. Private investors will put down up to 6 percent of the equity required to buy troubled assets, which will be matched by U.S. Treasury funds. The FDIC will then lend money at a six-to-one ratio for each dollar put forward by private investors and the Treasury. (By the way, the Times also noted that the FDIC would borrow the money to buy the toxic securities from the Treasury – how convenient.)

The merits of this plan are quite simple: the establishment of a transparent and liquid market for toxic assets could, with luck and favorable winds, help restore banks to fiscal health by removing rotting assets from their balance sheets. This, it is hoped, will supercharge lending (which I believe is a bad idea) and restore confidence among bank creditors.

The problem, as I see it, lies in the fact that private investors are asked to contribute such a small percentage of the cost of purchasing these assets. For those private entities who choose to get involved, it will be very similar to purchasing an option – they only stand to lose their small initial investment, yet they – and the Treasury – stand to gain handsomely if the securities rise in value.

The FDIC, which ponies up the bulk of the money in these new investment funds, will absorb the losses if the value of these securities falls. Since the FDIC is borrowing money from the Treasury, the taxpayer will be forced to cover potential losses. In addition, private investors may overbid for these securities due to the leverage at their disposal – just as homebuyers, putting virtually no money down, paid way too much for real estate during the housing bubble. This could cause a distortion of asset values, which could help banks restore capital levels, but harm taxpayers by exposing them (you and I) to substantial losses if the economy continues to deteriorate.

Another potential problem lies in the size of the program. Even if it is expanded to $1 trillion, it may prove to be too small given that, by some estimates, up to $4 trillion worth of toxic assets are stewing on balance sheets across the American financial system. This, unfortunately, mirrors the approach taken with A.I.G. Instead of either declaring the patient dead or administering an adequate remedy, the government decided to keep this pitiful entity on life support, at a tremendous cost to the taxpayer. The same could happen here; the Treasury’s efforts could prove too timid, resulting in only slowing an inevitable process that will end up costing trillions of dollars over the next few years. Better to make a bold stand now, or step aside prepared to clean up the pieces as these toxic assets and the institutions holding them crumble to the ground.

Geithner’s second act, performed before Congress yesterday, centered on revamping the government’s financial regulatory framework. During the halcyon days of the credit bubble, some of the biggest players in the financial markets, such as insurance companies, private equity companies and hedge funds, operated without proper government scrutiny. (The result of this lack of oversight is the basket case known as A.I.G.) The Times reported that entities deemed to large to fail by the Treasury would be subject to more stringent capital requirements.

According to the Times, the most striking part of Geithner’s proposal is the regulation of private pools of capital (hedge funds and private equity funds) and the markets for credit derivatives, such as credit default swaps, which brought A.I.G. to the edge of the abyss. Many of these private, lush ponds of money currently navigate without interference from the Securities and Exchange Commission (S.E.C.), or the Federal Reserve. (By the way, both commercial and investment banks were operating under the scrutiny of either one, or both of the entities mentioned above, yet many still managed to get into enormous trouble.)

Geithner’s plan, as explained by the Times, calls for these mysterious investment outfits to register with the S.E.C., forcing them to disclose leverage ratios and information about investors and those with whom they trade. The new report cards would be shared with a “systemic risk regulator,” which, I suppose, would be given authority to intervene under the banner of financial disaster prevention.

As for the over-the-counter market for credit derivatives, they would be traded through a federally regulated clearinghouse. This would force the disclosure of collateral posted and funds borrowed in each transaction. The Times also noted that participants in the credit derivatives markets would have to meet eligibility requirements. Standards would also be set for trading and settling these securities.

Geithner’s plan to monitor leverage at large hedge funds and private equity funds is on the surface a good idea, as is bringing credit derivatives under the regulatory umbrella, just as options and futures markets are. Both will reduce the buildup of excessive leverage by large pools of private capital.

The problem is that large hedge funds and private equity groups may splinter into smaller entities to avoid federal interference. This could easily introduce systemic risk to the financial system, with thousands of newly minted, smaller investment funds engaging in the same activities, under the radar of the regulatory system. (This is what caused the mess the government is now cleaning up; hundreds of financial institutions were all engaging in the same irresponsible practices – alone they posed no threat, but taken together they brought the global credit markets to a virtual halt.)

In sum, it was a momentous week for Mr. Geithner. It’s heartening to see a more detailed plan for ridding the banking system of toxic assets. Equally, it is essential to regulate the market for credit derivatives. But his plan to tackle bad assets in the banking system may prove too timid given the Treasury’s commitment of funds relative to the size of the market for these toxic securities. And, given the limited risk private investors would have to assume to buy them, over-bidding could result, costing the taxpayer more money up front and, of course down the road if these securities prove worthless. And regulating private pools of money once they reach critical mass will only force those running these funds to spread their assets out into smaller entities to avoid scrutiny – leaving the financial system vulnerable to another shock in the years ahead. I certainly hope that Tim Geithner – and President Obama – realize that they are running out of time; ill-conceived measures and half-steps born of timidity will only lead to a costlier disaster down the road.

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