Obama's Biggest Mistake

President Obama made a huge mistake during the transition period leading up to his assuming the presidencey of the United States, and it was naming Tim Geithner as the Treasurey Secretary. Geithner just is not the right man to be head of the US Treasurey as the world slips towards a second Great Depression.

Tim Geithner just does not seem to have the creativity to deal with the economic mess that this nation is facing. He seems committed to the view that banks should never be saved by the government, and no matter what they should stay private even if they’re bankrupt, because — well because. Geithner seems incapable of envisioning a government run solution, which is okay, except he is one of the men in charge of developing the government's solution. I believe that Geithner has tunnel vision which prevents him from trying to devise a policy which assumes that the many of the assets in the banking system are “bad,” and need to be removed from the system.

My question is how long does President Obama stick with Tim Geithner as the Treasurey Secretary? Can Geithner turn it around at Treasurey? How long can we wait to find out?

Why Geithner's Plan was a Dud

You might remember that last week Treasury Secretary Tim Geithner delivered a much anticipated speech on the next steps Treasury would be taking to bring stability back to the financial and banking sectors.

It bombed.

The question was why?

There were many who thought maybe President Obama had erred in selecting Geithner for this role, and to be honest I wondered it myself.

Geithner's plan as he presented in a live speech and press conference lacked details, and the Secretary looked scared. He made pronouncements about elements of the plan, but then said that we'd learn about the details eventually. Investors were not impressed, and the markets fell hard and quickly.

The question again was why? It turns out that Geithner decided late in the process that the plan he'd been working on was not going to work. So at the last moment he scrapped it entirely. Once the Treasury secretary and his team realized they would need a different approach, they had to decide how to present a plan that was still coming together. As they saw it, the Bush administration had a habit of presenting plans with details they had no intention of sticking to, which didn't exactly inspire confidence. Geithner preferred to "disappoint the markets with vagueness than lay out a lot of details they might have to change later."

At the same time the Treasurey Department has a shortage of personnel. To date, President Obama has not nominated any assistant secretaries or undersecretaries at Treasury, and the handful of mid-level staffers who have started work are still finding their offices and getting their building passes and BlackBerrys.

In addition Geithner and his team made a strategic decision to limit input from the financial industry and other outsiders, aiming to prevent leaks and avoid a perception they were designing the plan for the benefit of big banks. But that also meant they were unable to vet their plan with the companies involved or set realistic expectations of what would be announced.

All this combined to lead to the flop last week. Lets hope the extra time helps them to get a better plan, which can actually succeed.

Geithner's Plan Falls Flat

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.

Geithner to Announce New Plan

Treasury Secretary Timothy Geithner is scheduled to unveil a plan to handle the government's second half of the $700 billion financial rescue program today. The plan as it is being leaked is to impose tough new standards on future payments to banks. It also calls for greatly expanding an effort to unclog credit markets to provide loans to consumers and businesses. The administration also announced that the program would be expanded beyond consumer and small business loans to provide aid to the troubled commercial real estate sector.


The administration's new plan will include a government-private sector partnership aimed at removing toxic assets from banks' balance sheets, although the details on how this program would operate were still being worked out.

The Obama administration is promising an aggressive effort to combat the worst financial crisis in seven decades, unveiling a program that could mobilize well over $1 trillion in public and private support to get the frozen credit markets functioning again.

The new plan would greatly expand an effort to unclog credit markets that provide loans to consumers and businesses. Funding for this effort would see a huge increase — from $20 billion up to $100 billion.

Anatomy of a Meltdown

Read this first draft of history from the New Yorker called "The Anatomy of a Meltdown" by John Cassidy. Be sure you're sitting down.

Ben Bernanke and the financial crisis.

At Princeton, where Bernanke taught economics for many years, he was known for his retiring manner and his statistics-laden research on the Great Depression. For more than a year after he was appointed by President George W. Bush to chair the Fed, in February, 2006, he faithfully upheld the policies of his immediate redecessor, the charismatic free-market conservative Alan Greenspan, and he adhered to the central bank’s formal mandates: controlling inflation and maintaining employment. But since the market for subprime mortgages collapsed, in the summer of 2007, the growing financial crisis has forced Bernanke to intervene on Wall Street in ways never before contemplated by the Fed. He has slashed interest rates, established new lending programs, extended hundreds of billions of dollars to troubled financial firms, bought debt issued by industrial corporations such as General Electric, and even taken distressed mortgage assets onto the Fed’s books. (In March, to facilitate the takeover by J. P. Morgan of Bear Stearns, a Wall Street investment bank that was facing bankruptcy, the Fed acquired twenty-nine billion dollars’ worth of Bear Stearns’s bad mortgage assets.) These moves hardly amount to a Marxist revolution, but, in the eyes of many economists, including supporters and opponents of the measures, they represent a watershed in American economic and political history.

Ben Bernanke, who seemed to have been selected as much for his predictability as for his economic expertise, is now engaged in the boldest use of the Fed’s authority since its inception, in 1913.

Bernanke, working closely with Henry (Hank) Paulson, the Treasury Secretary, a voluble former investment banker, was determined to keep the financial sector operating long enough so that it could repair itself—a policy that he and his Fed colleagues referred to as the “finger-in-the-dike” strategy. As recently as Labor Day, he believed that the strategy was working. The credit markets remained open; the economy was still expanding, if slowly; oil prices were dropping; and there were tentative signs that house prices were stabilizing. “A lot can still go wrong, but at least I can see a path that will bring us out of this entire episode relatively intact,” he told a visitor to his office in August.

By mid-September, however, the outlook was much grimmer. On Monday, September 15th, Lehman Brothers, another Wall Street investment bank that had made bad bets on subprime mortgage securities, filed for bankruptcy protection, after Bernanke, Paulson, and the bank’s senior executives failed to find a way to save it or to sell it to a healthier firm. During the next forty-eight hours, the Dow Jones Industrial Average fell nearly four hundred points; Bank of America announced its purchase of Merrill Lynch; and American International Group, the country’s biggest insurance company, began talks with the New York Fed about a possible rescue. Goldman Sachs and Morgan Stanley, the two wealthiest investment banks on Wall Street, were also in trouble. Their stock prices tumbled as rumors circulated that they were having difficulty borrowing money. “Both Goldman and Morgan were having a run on the bank,” a senior Wall Street executive told me. “People started withdrawing their balances. Counterparties started insisting that they post more collateral.”

The Fed talked with Wall Street executives about creating a “lifeline” for Goldman Sachs and Morgan Stanley, which would have given the firms greater access to central-bank funds. But Bernanke decided that even more drastic action was needed. On Wednesday, September 17th, a day after the Fed agreed to inject eighty-five billion dollars of taxpayers’ money into A.I.G., Bernanke asked Paulson to accompany him to Capitol Hill and make the case for a congressional bailout of the entire banking industry. “We can’t keep doing this,” Bernanke told Paulson. “Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation.”

Paulson agreed. A bailout ran counter to the Bush Administration’s free-market principles and to his own belief that reckless behavior should not be rewarded, but he had worked on Wall Street for thirty-two years, most recently as the C.E.O. of Goldman Sachs, and had never seen a financial crisis of this magnitude. He had come to respect Bernanke’s judgment, and he shared his conviction that, in an emergency, pragmatism trumps ideology. The next day, the men decided, they would go see President Bush.

On October 3rd, Congress passed an amended bailout bill, giving the Secretary of the Treasury broad authority to purchase from banks up to seven hundred billion dollars in mortgage assets, but the turmoil on Wall Street continued. Between October 6th and October 10th, the Dow suffered its worst week in a hundred years, falling eighteen per cent. As the selling spread to overseas markets, the Fed’s failure to save Lehman Brothers was roundly condemned. Christine Lagarde, the French finance minister, described it as a “horrendous” error that threatened the global financial system. Richard Portes, an economist at the London Business School, wrote in the Financial Times, “The U.S. authorities’ decision to let Lehman Brothers fail will be severely criticised by financial historians—the next generation of Bernankes.” Even Alan Blinder, an old friend and former colleague of Bernanke’s in the economics department at Princeton, who served as vice-chairman of the Fed from 1994 to 1996, was critical. “Maybe there were arguments on either side before the decision,” he told me. “After the fact, it is extremely clear that everything fell apart on the day Lehman went under.”

The most serious charge against Bernanke and Paulson is that their response to the crisis has been ad hoc and contradictory: they rescued Bear Stearns but allowed Lehman Brothers to fail; for months, they dismissed the danger from the subprime crisis and then suddenly announced that it was grave enough to justify a huge bailout; they said they needed seven hundred billion dollars to buy up distressed mortgage securities and then, in October, used the money to purchase stock in banks instead. Summing up the widespread frustration with Bernanke, Dean Baker, the co-director of the Center for Economic and Policy Research, a liberal think tank in Washington, told me, “He was behind the curve at every stage of the story. He didn’t see the housing bubble until after it burst. Until as late as this summer, he downplayed all the risks involved. In terms of policy, he has not presented a clear view. On a number of occasions, he has pointed in one direction and then turned around and acted differently. I would be surprised if Obama wanted to reappoint him when his term ends”—in January, 2010.

Bernanke and Paulson’s reversals have been deeply unsettling, perhaps especially so for the millions of Americans who have lost jobs or defaulted on mortgages so far this year. And yet, for the past year and a half, the government has confronted a financial debacle of unprecedented size and complexity. “Everyone knew there were issues and potential problems,” John Mack, the chairman and chief executive of Morgan Stanley, told me. “Nobody knew the enormity of it, how global it was and how deep it was.” In responding to the crisis, Bernanke has effectively transformed the Fed into an Atlas for the financial sector, extending more than $1.5 trillion in loans to troubled banks and investment firms, and providing financial guarantees worth roughly another $1.5 trillion, making it global capitalism’s lender of first and last (and sometimes only) resort.

“Under Ben’s leadership, we have felt compelled to create a new playbook for the Fed,” Kevin Warsh, a Fed governor who has worked closely with Bernanke, told me. “The circumstances of the last year caused us to cross more lines than this institution has crossed in the previous seventy years.” Paul Krugman, the Times columnist, a former colleague of Bernanke’s at Princeton, and the winner of this year’s Nobel Prize in Economics, said, “I don’t think any other central banker in the world would have done as much by way of expanding credit, putting the Fed into unconventional assets, and so on. Now, you might say that it all hasn’t been enough. But I guess I think that’s more a reflection of the limits to the Fed’s power than of Bernanke getting it wrong. And things could have been much worse.”

Read more here.

Dow Soars After News of Obama's New Treasury Secretary

After eight years of the George Bush/GOP economic policy, news of President-elect Barack Obama's pick of Timothy F. Geithner, the president of the New York Federal Reserve, for Treasury Secretary set off a huge rally on Wall Street.

The markets are apparently "applauding the change":

After two days of punishing losses, Wall Street surged on Friday afternoon after news reports said that President-elect Barack Obama had tapped Timothy F. Geithner, the president of the New York Federal Reserve, to be secretary of the Treasury.

Skittish financial markets closed dramatically higher following the reports, recouping some of the slide that brought them to 11-year lows. The Dow Jones industrial average soared 494.13 points or 6.5 percent, closing at 8,046.42. The broader Standard & Poor’s 500-stock index swung 6.3 percent higher, or 47.59 points to 800.03. The Nasdaq composite was up 5.2 percent.

“It was almost a Geithner relief rally,” said Steve Neimeth, portfolio manager at AIG SunAmerica Asset Management.Bits of news have swung financial markets widely
in recent weeks, and on Friday afternoon, traders seemed to rally behind unconfirmed reports that the country’s next president had picked his chief financial officer. The markets were not applauding the choice specifically, said Ryan Larson, senior equity trader at Voyageur Asset Management, but any choice at all.

“What you’re seeing is a rally off the headlines,” Mr. Larson said. “The markets are applauding change. It’s a hope that change will bring some sort of effectiveness to these plans and ultimately make a road map to come out of it.”

Obama Said to Pick Geithner as Treasury Secretary

President-elect Barack Obama picked Timothy Geithner, head of the Federal Reserve Bank of New York, to be his Treasury secretary. Geithner has helped lead U.S. efforts to combat the deepest financial crisis in seven decades, helping oversee the decisions this year to take over American International Group Inc., rescue Bear Stearns Cos. and leave Lehman Brothers Holdings Inc. to fail. Geithner, 47, served as an undersecretary for international affairs under Larry Summers, and has been at the helm of the New York Fed since November 2003.

As head of the New York Fed, Geithner has served as the central bank’s top liaison with Wall Street. Geithner oversaw meetings at his bank to attempt to head off Lehman’s failure in September, later hosting gatherings on how to resolve AIG.

Geithner is no stranger to Washington or the Treasury. Before taking over the New York Fed in 2003, he spent most of the previous 18 years working in the nation’s capital, first at Kissinger Associates, then at the Treasury and finally at the International Monetary Fund.
During that time, Geithner earned what his one-time mentor Summers called a “doctorate in financial policy.” He also developed a skill-set his supporters say makes him well suited for his new job: calmness under pressure, an ability to see many sides of a problem and a sense of the politically possible.

Wall Street Closes Up More Than 400

The roller coaster ride that is the stock market this week took a turn for the better today. It was a stunning late-session turnaround Thursday, with the Dow Jones industrials up more than 400 points after a report that the federal government might create an entity that will take over banks' bad debt. The rumor, first reported on CNBC, said Treasury Secretary Henry Paulson was considering an old idea to battle the economic problems this nation is facing. Paulson's idea is to form an entity very similar to the Resolution Trust Corp. This entity was set up after the failure of savings and loan banks in the 1980s, and was fairly succesful in dealng with that economic crisis.

If an RTC was to be created it would be set-up to acquire the bad or risky real estate debt that has hobbled financial institutions and led to the intense volatility in the markets this week. Personally I think this is a good idea, and I have to wonder what would this nation be like if Bush had hired competent people from the beginning.

Seriously, look at Bush's second term hires compared to his first. Gates, Paulson, Bernanke, they actually are competent, and may help this nation sail through the mess that the Republicans gave us.