Warren Drops A Bomb on Geithner

While she speaks in a mild-mannered tone, make no mistake: Elizabeth Warren TKOs Tim Geithner. In a measured tone, she lays out the three approaches to dealing with financial crises:

1. Liquidation, i.e. Chapter 11
2. Receivership. FDIC seizes the insolvent banks, separates the good and bad assets, recapitalizes the banks/gets bondholders to perform debt-for-equity swaps, and sell back the good bank to private investors
3. Subsidies. These can either be direct, in the form of capital infusions, or indirect, such as buying toxic assets at inflated prices.

Then Warren examines Treasury's policy of subsidization to date, before concluding

Treasury's overall approach seems based on the premise that the banking problem is temporary - and look, we all hope that's the case. If it is, more aggressive steps may never be needed. It is possible, however, that Treasury's approach fails to acknowledge the depth of the current crisis. The economy may not come roaring back. And the big profits that propped up the banks during the housing boom may not return. For some, that means it is necessary to consider alternate approaches.

Translation: this is not a liquidity crisis, and we're going to have to put insolvent banks into receivership. Hopefully Congress is paying attention.

Stiglitz: Wall Street Wins, Taxpayers Lose

This is now two Nobel prize-winning liberal economists vociferously opposed to Geithner's PPIP. A week after Paul Krugman announced that the leaked reports of Geithner's plan "fills me with a sense of despair," Columbia professor Joseph Stiglitz takes to the New York Tims to voice his own displeasure over the huge taxpayer giveaway the Geithner plan represents for banks and private investors. From the New York Times:

In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. Since the private investors are spared most losses, then they primarily “value” their potential gains. This is exactly the same as being given an option.

Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Stiglitz goes on to attack the claim that the current crisis is simply the result of a lack of liquidity - i.e. panic is driving down asset prices beyond the fundamentals. Again from the New York Times:

The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time....

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.

Has the Obama economic team rebutted these arguments, aside from saying calls for putting insolvent banks into receivership are "deeply impractical"? If Obama is seen as in Wall Street's pocket, there will be no political will for further bailouts, which will inevitably be necessary. Putting off the day of reckoning, and playing nice with the bakers is a very, very dangerous course.

Samuelson: Assets Just Need Some Love-erage

Count Robert Samuelson among those who insist that "there are no bad assets; only misunderstood assets". Per Samuelson:

"Deleveraging" has caused prices to plunge to lows that may be as unrealistic as previous highs.

Grasping this, you can understand the idea behind Geithner's hedge fund. It is to inject more leverage into the economy -- not to previous giddy levels but enough to reverse the panic-driven price collapse.

But has the collapse in assets prices been the result of panic or fundamentals? One study has shown that some CDOs are actually worth even less than what many pessimists thought. To counter the notion that the fundamentals justify the current depressed prices, Samuelson cites

one mortgage bond whose market value has dropped by roughly 40 percent even though all promised payments have been made and, based on the performance of the underlying mortgage borrowers, seem likely to continue.

Unfortunately, this description omits two key details: are the borrowers underwater on their mortgages, and do the mortgages reset in the near future? If borrowers owe substantially more than their homes are worth, then they have a powerful incentive to post jingle mail, and walk away from their mortgages, even if they could afford to pay it. And as the real economy continues to deteriorate, with unemployment rising and wages lowering, increasing numbers of underwater borrowers will likely be under greater financial strain; paying off a mortgage that dwarfs the value of one's house will make less and less sense. Likewise, if these are option ARM mortgages, then they will likely reset within the next year. Borrowers who can make their payments today may not be able to make the higher, reset rates. If either of these scenarios is the case, then discounting this particular mortgage bond 40% seems fairly reasonable.

Samuelson does hedge a bit, admitting that these current lows "may be as unrealistic as previous highs." Perhaps he realizes that losses in mortgages, in commercial real estate, and in credit card debt are all real. There is nothing panic-driven about these losses. And unfortunately, the wizards of Wall Street multiplied these losses several times over with synthetic CDOs and CDS bets. No, our major banks are very insolvent. And no amount of financial engineering - no matter how clever - will change that.

Friedman: Toxic Assets Just Need Some Love

Another day, another gem from Thomas Friedman. While Friedman correctly identifies fixing the banking crisis as fundamental to turning the economy around, he seems to have embraced the "toxic assets are not bad; they are simply misunderstood" fallacy. From the New York Times:

we need to get a market going that would bring fair value and clarity to the "toxic assets" crippling the balance sheets of our major banks. This will likely require some degree of government subsidy to private equity groups and hedge funds to get them to make the first bids for these toxic assets by guaranteeing they will not lose.

Who told Friedman this was a good plan? Could it have been...private equity guys and hedge fund managers? And what is "fair value" for the so-called toxic assets? Is it the price at which selling them will make banks solvent? Friedman has adopted the transparently untrue belief that toxic assets still have some fundamental value, but are being artificially depressed because of panic. Unfortunately, our Treasury Secretary seems to believe this as well. But facts are stubborn things. And the facts indicate that toxic assets are worth even less than what pessimists have projected. This is a solvency crisis. Insolvent, too-big-to-fail institutions need to be put into receivership, broken up into smaller pieces, and sold back to private investors. This will pose numerous technical challenges. It is not a free lunch. But it's the most cost effective way to create public trust that the financial system is healthy.

Repeat After Me: It's A Solvency, Not A Liquidity, Crisis

Give Russell Roberts and Arnold Kling credit for at least being able to identity the current crisis as one of solvency rather than one of liquidity.

A liquidity crisis means assets lose value because of panic and distressed selling. The assets themselves are still inherently valuable, and given enough capital to tide the banks over, they should be able to survive and sell off the assets at something close to full value once the "market dislocation" ends. A solvency crisis means assets are actually worthless, or close to it. Insolvent banks become black holes (see Citi and AIG, which is a quasi-bank), as they pour capital into the gaping holes in their balance sheets. FDIC receivership is the best option for insolvent banks.

This is a distinction our government officials have apparently been unable to make. Bernanke and Geithner have both publicly stated that our financial system is suffering from a lack of liquidity. If this were true, the unprecedented liquidity the Fed and Treasury have injected into the system over the last six months would have ended the crisis.

I see three possible explanations for Bernanke and Geithner's apparent disconnect from other informed observers when it comes to assessing the banks: 1) they have honestly misdiagnosed this as a liquidity crisis, 2) they are afraid of the politics of nationalization, or 3) they wish to extinguish all alternatives before turning to nationalization because of the technical challeneges it poses. If the first explanation is true, they should both be replaced. If the second is the case, then David Axelrod should explain that given that conservatives from Alan Greenspan to Lindsey Graham have endorsed some form of temporary nationalization, there is more than enough political cover. And if the third is true, then I have two questions: why will the TALF work better than the TARP, and how much more expensive will nationalization be in six months time than it is now?