. . . and certainly not dead on arrival, despite what Krugman says
Yesterday Treasury secretary Geithner finally fleshed out the government’s plan to create more liquidity for the toxic (sorry, now they’re called “legacy”) loans and securities on banks’ balance sheets. The program is complicated, and important details have yet to be filled in. But from what I can see, the plan should help close, if not eliminate, the gap between the assets’ lowball “market” values and their carrying values on banks’ books. That’s a good thing—but it may not be the panacea that many people think.
I’ll spare you the details of the plan, called the Public-Private Investment Fund, PPIF. (If you can’t help yourself, they are here.) Let me say up front, though, that while I’m not a huge fan of the program, I do believe it will accelerate the clean-up of some banks’ balance sheets.
No one can tell how big a success the plan will be until its final details emerge, of course. But it will almost certainly help liquidity, since the government will provide ample low-cost financing to private-sector buyers. And it will help pricing, as well, since buyers will be able to use leverage that would otherwise be unavailable.
A big question, though is whether banks will be willing to sell at the prices prospective buyers will want to pay. Take Bank of New York Mellon, for example. Last year, after marking its securities to market per FAS 157, the company took $1.6 billion pre-tax charge on its on mortgage-related securities. Management says the expected credit-related loss on the paper comes to just $535 million; the remainder, $1.1 billion, was due to spread-widening, and has nothing to do with the credit quality of the underlying mortgages.
Perhaps Bank of New York will simply want to get this part of the cycle behind it, and will be willing to sells the MBS into the PPIF at its carrying price. But if the company really believes the paper’s true impairment is just $535 million, rather than $1.6 billion, should it really consider giving up an extra $1 billion in value? I would be very hesitant to do that, and I expect many bank managements in similar situations would be, as well.
So even if under the PPIF, an investor’s required return would be equal to a selling bank’s carrying value, will the bank sell? I’m not sure. I hope not, in many cases.
I believe it’s fairly obvious the assets most likely to be sold via the PPIF are those (be they loans or securities) that banks are carrying at “market” rather than the assets they’re carrying at accrual values. This means, in particular, assets that were acquired and marked to market in the past year, such as the Wachovia assets acquired by Wells Fargo, Washington Mutual assets acquired by JPMorgan Chase, and National City assets acquired by PNC.
So, in my view, the PPIF can do no harm. Potential investors will be in a position to make fair (but I assume not generous) offers for bank assets, which banks will be able to either to accept or decline. That is a good thing, but it won’t cleanse bank balance sheets in a single stroke.
Still, economist and New York Times columnist Paul Krugman declared the Treasury program dead on arrival yesterday morning; as you might guess, Krugman, a Roubini-ite, believes the assets to be “toxic.” If the banks marked them down to their true value, he believes, the system would be insolvent. All PPIF will do is exacerbate the banking industry’s ongoing vicious cycle: banks will continue mark down their assets, the markdowns will exacerbate losses, capital will then continue to shrink, so lending will keep on contracting, and the recession will thus never, ever end. Krugman’s solution: nationalize the banks, and the sooner, the better, to get credit creation started again.
As Krugman writes in his column“The common element to the Paulson and Geithner plan is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that, if properly priced, banks wouldn’t be in trouble.”
He goes on to say that, because of the government subsidy on financing, the PPIF might lead to transaction prices that might be higher than “real” market prices. But he doesn’t believe that’s the real problem.
“The real problem with this plan," he writes, "is that it won’t work. Yes, troubled assets may be somewhat undervalued.” [Emphasis added]
I doubt it, professor! In the very same column you say a) that these assets are so toxic that, if their true values were recognized, the banking system would be insolvent, and b) these same assets “somewhat undervalued” on banks’ balance sheets? You can choose one or the other. But you can’t choose both!
As I see it, the PPIF can only be a positive to create a more liquid market for banks’ “toxic” assets and, in turn, to move us to the day when Cassandras like Krugman have to stop calling the banks insolvent and urging that they be nationalized.
What do you think? Let me know!