Yesterday Treasury Secretary Timothy Geithner presented the Obama’s administration’s Financial Stability Plan to deal with the financial system’s toxic asset overhang and ease, if not reverse, the ongoing decline in bank lending to households and corporations.
To say that it went over like a lead balloon would be an understatement.
Out of the three broad strategies that most economists say are available - nationalization, ‘good / bad bank’, backstop guarantee on ring-fenced toxic assets - the administration plan offers elements of all three.
I am always wary of a plan that offers a little bit of everything.
Geithner’s first program involves a mandatory ‘stress test’ for all banks with $100bn-plus assets which should also shed some clarity on the individual banks exposures and valuations of toxic assets. This I like because there is still too much we do not know about the financial crisis. A major part of this whole economic meltdown has been fear of the unknown. Safe investments and secure loans have been damaged by fear of toxic assets.
According to the plan Geithner laid out yesterday, after the stress test the Treasury’s Capital Assistance Program would stand ready with preferred shares / warrants injections where needed, only this time with clear lending requirements and strict limits on dividends, stock repurchases and acquisitions next to a $500,000 compensation cap. This solves some of the problems with the original $350 billion that Paulson injected into the financial markets late last year.
Geithner claims that any capital investments made by Treasury under the CAP would be placed in the Financial Stability Trust. However, Geithner left unclear what other options are there for institutions that are severely undercapitalized or fail to attract public capital on a recurring basis (Bank of America and Citigroup are two examples) Yes the program aims at ensuring that there is full transparency disclosing all relevant information on capital recipients at www.FinancialStability.gov; but is that enough to give Geithner our trust?
The second program Geithner spoke about was the Public-Private Investment Fund (PPP). This program aims at setting up a new lending/guarantee facility (the so called Bad Bank solution). This program would work by leveraging an initial private capital commitment with government funds to an initial scale of up to $500 billion (and if you look at the fine print it can be expanded to a maximum of $1 trillion.) The aim of this idea is to involve private capital on a large scale that sits currently on the sidelines while also allowing private market forces to determine the price for currently troubled and illiquid assets.
Personally I think yesterday’s tanking of the Dow was because Geithner mentioned using private capitol in his plan.
A similar experiment was tried before with the private sector sponsored M-LEC vehicle that ultimately proved unviable due to asymmetric toxic asset exposures of participating banks and due to still unresolved asset valuation issues. Commentators agree that for a similar plan to work this time, the government will have to assume a potentially substantial downside in order to induce otherwise unwilling investors to participate in view of the size of potential losses.
Renowned distressed debt experts such as Edward Altman and Martin Fridson note that the best time to invest in distressed debt is when default rates peak. Mind that high-yield default rates are set to rise to 15-20% sometime in 2010 from currently 4-5% due to very bad credit quality at the outset of the cycle.
Yet this again is putting all the risk on the public and all the reward for those who got us in this message.
The third program put forth by Secretary Geithner is an expanded version of the previously $200bn Federal Reserve Term Asset Backed Securities Loan Facility (TALF) program aimed at unclogging the markets for auto, student and other consumer loans. That initiative may expand to as much as $1 trillion, using $100 billion from the Treasury's rescue funds, and include aid for commercial real estate markets.
Geithner points out that securitization created about 40% of the demand for new loans extended to consumers, students, and auto buyers. The decline of securitized lending to the tune of $1.2 trillion between 2006 and 2008 leaves a hole that needs to be filled if a severe lending contraction should be prevented.
Economist Nouriel Roubini in his latest writing It Is Time to Nationalize Insolvent Banking Systems argues that, ultimately, nationalization may be a more market friendly solution of a banking crisis: 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. Moreover, it bypasses the asset valuation issue as any overpayment goes back into taxpayers pockets. “With the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC the administration is putting in place the steps for the eventual and necessary takeover of the insolvent banks.” This might well explain some of the negative market reaction.
The Treasury has stressed that while the ongoing price correction will stimulate home demand, there is a need to reduce foreclosures, which otherwise adding to the excess overhang of homes pose the risk of price over-correction, pushing more homeowners into negative equity. The Treasury plans to announce a Housing Program in the next few weeks to help refinance mortgages and contain foreclosures by reducing monthly payments for homeowners. The program will be financed by using $50 billion from the remaining TARP funds. To increase lender participation, the plan makes it compulsory for banks using government funds under the Financial Stability Plan to participate in foreclosure mitigation. In order to stimulate home demand and help the current homeowners refinance, the Treasury and Fed will continue with their November 2008 plans use $600 billion to buy MBSs and debt of the GSEs using and reduce mortgage rates to the 4-4.5% range. More importantly, the plan will increase flexibility to modify loans under the Hope Now and FHA Programs started in 2007-08 to help increase participation and foreclosure prevention.
Efforts to stimulate demand reducing mortgage rates and offering tax incentives will be largely ineffective as they are a small factor in determining home demand relative to factors such as tighter lending standards, changing dynamics for households - job and income loss, wealth erosion, rising savings rate, and low expectations of income or asset appreciation. These factors will constrain home demand in the short run while potential buyers await further price correction and banks don’t see the viability in offering mortgage for a house whose value is expected to fall.
As a result, the government needs to focus on the supply side of the market by refinancing at-risk mortgages and preventing foreclosures that will only add to the existing overhang of houses. Moreover, government’s loan modification program should reduce mortgage principal rather than just reducing the mortgage rate or extending the loan maturity, which has been the case in past government programs. Unless the problem of insolvency among a large number of households is addressed, default on modified mortgages will also continue. Also, given the large number of homeowners with negative home equity, the program will need much larger funds - over $600 billion to $1 trillion though the actual cost might be much less, since the government will receive a share from future home appreciation. Monetary incentives for servicers are also low and ineffective. Even the number of homeowners the program plans to target, 1.5-2 million is a very small fraction of the over 12 million homeowners with negative equity. In fact, several Democrats are pushing a legislation to allow bankruptcy judges to change mortgage terms that would allow lenders to reduce the mortgage principal for primary homes and bring down monthly payments. To increase participation, they support offering monetary incentives for servicers while lenders will be entitled to a share if the homeowner sells the house and also have the government share any losses on the modified mortgage.
Looking at the shortcomings of past government programs such as the Hope Now, Housing Retention and FDIC programs, the new program should be mandatory for lenders in order to increase participation.
The government will also need to share the cost of modifying the loan, by matching the principal or the interest rate cut in a proportionate or less than proportionate amount. By guaranteeing the loans, the government will be the senior debt holder. The new interest rate should be based on the risk assessment of the borrower and all three parties – homeowner, lenders and servicers, and the government should share the cost of modification. However, determining the extent of principal reduction based on the true value of the house, and dealing with second lien mortgages and the diverging interests of mortgage servicers will be challenging.
Under the new guidelines for compensation issued by the Treasury, firms receiving federal aid will be subject to shareholder say on pay and will be required to cap executive compensation at $500,000 with any additional compensation given out in restricted stocks which can be cashed only after the government has been repaid or the bank has satisfied repayment obligations, and met lending and stability standards. Moreover, bonuses and compensation for other top executives will also be reduced. At the very least the Treasury is going to require disclosure of the compensation structure and strategy, and expenditure on luxury items. Still, while the government's intervention is warranted, the compensation reform being put forward does little to align risks with rewards. Sadly reports are that Geithner fought for real compensation reform.
A large share of the compensation can and will be given out in restricted stocks including compensation for several traders and funds managers who are not under the lenses of the current plan. These measures also give a green light to those who have already received large compensation and severance packages at the troubled banks. More importantly, the measures might act a disincentive in attracting credible executive talent to these troubled institutions in the future who can help deal with the bank losses and overhaul. Wall Street compensation is determined in a competitive market with CEOs joining a firm offering the most attractive pay packages and perks. Many banks are already reluctant to seek capital injection from the Treasury or are contemplating to payback past borrowings in order to avoid government scrutiny over their compensation packages. There is too much voluntary action on the part of the banks. The government needs to be much more forceful. These companies caused the financial crisis, and should not have the luxery of choosing to take part in this package.
To reduce excessive risk-taking in the short-run, compensation, bonuses and even severance packages should be based on the long-term performance of the employee relative to the risk undertaken with large part of the payments given out in restricted stocks that can be redeemed over a longer period of time.