The Obama-Geithner Plan will fail
UPDATE 26 Mar 2009: You should note that I have reluctantly gotten onboard with this plan. My motivation is simple: too much time has passed and this is the plan we have to work with. It is a workable albeit unfair plan and there is no time to craft another. So, let’s keep our fingers crossed.
The original post is below.
The title of this post is fairly provocative and categorical. This is by design. For I see Obama’s banking plan as more of the same — not ‘change we can believe in.’ And we all need to be clear about the need for Obama and his team to correct their course of action. Whilst there may be plenty of other reasons to support the President, this is not one of them.
Now, late last year, I predicted that the Obama Administration would not change course significantly on the economic policy front. This was largely due to the make up of his proposed cabinet and their previously stated positions on economic policy. Frankly, they are subject to cognitive regulatory capture and beholden to the same special interests in the financial sector that the Bush Administration were.
Rather than repeat myself, I would like to use today’s commentary from Christopher Wood of CLSA to demonstrate my point. Wood is a well-regarded investment strategist based in Asia who in the early 1990s wrote the book, “The Bubble Economy” about Japan’s own tussle with debt deflation and deleveraging. He now writes a newsletter for CLSA appropriately called GREED & fear. Clearly he knows a thing or two about banking crises. I have highlighted the most interesting bits.
US Treasury Secretary Tim Geithner failed to deliver any hard details on what the Obama administration plans to do about the banking system. This is shocking to GREED & fear because it is such an obvious public relations disaster. If the Obama administration has not yet figured out the best way forward on the banks, it would have been better to have said nothing at all rather than disappoint expectations so much. But beyond the public relations issue, it is also shocking that after so many weeks to think about what should be the key issue for the new Democratic administration, the Obama team has clearly not yet figured out the best way forward. Remember there was an elevenweek interlude between the election and the inauguration. What were they all doing?
The result is that the American policy making establishment is now looking ever more Japanese in its continuing failure to face up to the painful consequences of what is a massive systemic crisis. This is clear from the continuing talk about, and evident desire to resort to, politically convenient “backstops” and “guarantees”. This is also clear from what seems the latest ruse to attempt to jump start securitisation with a massively expanded Term Asset-Backed Securities Loan Facility (TALF). That is to provide sweetheart non-recourse financing to hedge funds and the like to buy asset-backed securities. In GREED & fear’s view this effort to get the game going again is doomed to fail. But it is also a shocking misuse of taxpayers’ funding. Yet, unbelievably, the case for recognising reality and “nationalising” the worst banks is still deemed as way too “radical”.
In a nutshell, Geithner is unwilling to nationalize any banks, preferring to roll the dice on a scheme whereby the Fed and the Treasury buy up toxic assets in order to provide liquidity to the market for those assets. The theory here is that these assets have fallen in value by much more than is necessary. If the market for the assets has more liquidity, these assets would rise in price and the problem of poor bank capitalization would be solved.
But, is that really true? What if many of those assets have a lower real valuation than is presently used on banks’ books? What if the government is creating a market in something that is still overpriced? Remember, we still have a shed load of commercial real estate loan, credit card loan and auto loan losses to writedown. Add in the leveraged loan, student loan, and prime mortgage loan writedowns and you have a problem. Under that scenario, FAS 157 — otherwise known as mark-to-market — comes into play in a negative way. And that would mean everyone needs to mark those assets down, not up.
Now, I am not saying that the ‘toxic’ securities have further to fall at all. The fact is no one knows how much some of these derivative instruments are really worth (in part because the economy has yet to bottom and the scale of credit losses is not yet known). However, while making a market in illiquid markets is a commendable thing, I fear Geithner is playing a very risky game. Moreover, this is the exact same plan that Henry Paulson presented us originally under the TARP (Troubled Asset Relief Program). We have seen this all before.
Let’s get back to Woods’ comments for a second because he makes a few notable additional comments about the politics of this. Again, I have highlighted the appropriate areas.
The result is that GREED & fear’s fears about the dysfunctional nature of Obama’s economics team look at this juncture ever more justified. Hopefully, the US stock market’s bearish response to Geithner’s ill-fated press conference this week will prove a wake up call for a president whose political honeymoon is already over. But for now this looks like a continuing misguided effort to create an economic policy via committee consensus when what is needed is firm leadership from the top. GREED & fear is also beginning to wonder if the new president understands conceptually what is at stake with the banking system. It is natural that he wants to leave the technicalities to the experts. But there is a need here for the president to govern and that means taking responsibility for the most important policy decision. That is not the fiscal stimulus or what to do about the housing market. This is why mundane waffle about the merits of the mostly pork barrel fiscal stimulus is not sufficient. It also does not inspire confidence that Obama delegated the drafting of the fiscal stimulus to House of Representative Democrats.
The other interesting and also troubling development is the news reports over the past week that Paul Volcker, chairman of the President’s Economic Recovery Advisory Board, is upset that he is being sidelined by the Director of the National Economic Council, Larry Summers, in the formation of economic policy. One point would seem clear. That is that GREED & fear finds it hard to imagine that policies based on backstops, guarantees and non-recourse loans to hedge funds and the like would find the wholehearted endorsement of the former Fed chairman. Volcker surely understands what need to be done. That is to get rid of the zombie banks, whatever the cost to bank shareholders and bank bondholders. For this is a problem of solvency, not liquidity……
GREED & fear would also say that offering private investors non-recourse taxpayer-financed financing to buy asset-backed securities is also not in keeping with the times. And indeed it is likely to prompt a hostile response from Joe Sixpack. In this respect nationalisation of the bust banks and separation of good assets from bad assets is the only honest way forward, politically, for dealing with the current escalating mess in the American financial system. In this respect GREED & fear is of the view that ordinary Americans want to be told the truth and are fed up with gimmicky solutions involving adding debt on debt. It is also the case that the Obama administration risks a populist backlash on any policy based on bailing out banks. This is why it is even more amazing that Obama does not understand the political appeal of the nationalisation option.
I would agree whole-heartedly with thrust of this argument. President Obama has a limited window of opportunity here. He will need to decide the correct path and delegate appropriately. Sidelining Paul Volcker for Larry Summers does not leave one with a good tingly feeling. Bailing out banks when populist sentiment is rising shows a tin ear to the shift in national sentiment. On the whole, I am very worried that Obama does not see the poor optics of all of this. Politically, this is not a good plan.
When Obama spoke to Terry Moran of ABC News about all of this recently, he suggested that his plan is actually crafted because — despite rising populist sentiment — Americans will not tolerate nationalization. The exchange went as follows.
MORAN: There are a lot of economists who look at these banks and they say all that garbage that’s in them renders them essentially insolvent. Why not just nationalize the banks?
OBAMA: Well, you know, it’s interesting. There are two countries who have gone through some big financial crises over the last decade or two. One was Japan, which never really acknowledged the scale and magnitude of the problems in their banking system and that resulted in what’s called “The Lost Decade.” They kept on trying to paper over the problems. The markets sort of stayed up because the Japanese government kept on pumping money in. But, eventually, nothing happened and they didn’t see any growth whatsoever.
Sweden, on the other hand, had a problem like this. They took over the banks, nationalized them, got rid of the bad assets, resold the banks and, a couple years later, they were going again. So you’d think looking at it, Sweden looks like a good model. Here’s the problem; Sweden had like five banks. [LAUGHS] We’ve got thousands of banks. You know, the scale of the U.S. economy and the capital markets are so vast and the problems in terms of managing and overseeing anything of that scale, I think, would — our assessment was that it wouldn’t make sense. And we also have different traditions in this country.
Obviously, Sweden has a different set of cultures in terms of how the government relates to markets and America’s different. And we want to retain a strong sense of that private capital fulfilling the core — core investment needs of this country.
And so, what we’ve tried to do is to apply some of the tough love that’s going to be necessary, but do it in a way that’s also recognizing we’ve got big private capital markets and ultimately that’s going to be the key to getting credit flowing again.
I suggest that Obama try yet more ‘tough love’ because this plan is not going to cut it.