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Toxic banks or toxic assets?

by Brad Setser
February 10, 2009

Two weeks ago, George Soros memorably framed the core choice the US now faces as a choice between buying toxic assets or taking over toxic banks.

“The hard choice facing the Obama administration is between partially nationalising the banks, or leaving them in private hands but nationalising their toxic assets.”

There is perhaps a third option: handing the toxic assets over to the banks’ existing equity investors and the banks long-term unsecured creditors, assigning the deposits to the remaining “good” bank and recapitalizing the new bank with public funds.

Judging from this week’s press reports, Treasury Secretary Geithner didn’t like these options.

If Floyd Norris is right, the US Treasury will propose a fourth option: providing credit to private investors that are willing to buy the banks toxic assets.

Private investors then would have to figure out the right value of the banks existing toxic assets. In return, they would get all of the upside. They would also take some of the downside. But perhaps not all the downside.

If the government provided credit to private investors who put up cash to buy toxic asses, the private investors would take the first loss. That discourages overpayment. But with a non-recourse loan the government on the hook if the value of the toxic assets fell by too much. The private investors could extinguish its debt by handing the toxic assets it bought over to the government.

This seems like a transaction that requires the government take on additional risk. But that probably isn’t totally accurate, as the government already in some sense has most of this risk.

So long as the government is committed to protecting the banking system’s creditors – depositors, money market funds and bondholders – from losses, the government already has most of the downside risk on these toxic assets. There isn’t much bank equity left. As a result the government is already on the hook it the banks’ end up taking additional losses on their toxic assets. If the government provided financing to other actors willing to buy the banks bad assets, the government would have more exposure to those players’ toxic assets, but less to the banks’ toxic assets.

The plan Norris describes sounds a bit like the ideas some in the market were circulating a few days ago. The resulting “Geithner plan” also has some similarities to the Brady plan that helped to resolve the Latin debt crisis (really a banking crisis stemming from the banks’ overexposure to some large sovereign borrowers). Both Brady and Geithner seem to want to move bad assets from bank balance sheets to the market. And in both cases the government likely will facilitate the transaction in part by limiting the risks born by private investors. Brady bonds were collateralized by long-term Treasuries, assuring that investors would get their principal back.*

But it isn’t completely clear that Floyd Norris’ story has all the details right. The Wall Street Journal’s reporting suggests a somewhat different potential structure, one based on a public-private partnership. The FT suggests both approaches are under consideration. Krishna Guha:

“The exact details of how the private-public partnership will work are not known. One option discussed by policymakers is for the authorities to co-invest alongside private investors in a “bad bank” or “aggregator bank” that would purchase the toxic assets. Another version would involve the government sector providing non-recourse financing on a large scale for private buyers of toxic assets, possibly in conjunction with guarantees that explicitly limit loss on these assets. “

We will know later today.

The Treasury seems to have concluded that it was impossible for the government to figure out what price it should pay the banks – really the banks existing owners – for their toxic assets. There is a reason why bad bank – like the RTC– generally were created after a bank had already failed and their equity investors have been wiped out. If the government already owns the banks assets (as a result of its guarantee of the banks’ liabilities) it doesn’t really matter what price it pays the “good” bank for the assets of the “bad” bank.

But providing other parts of the financial system – including parts of the shadow financial system — with credit to help it buy the banks bad assets isn’t a perfect solution either.

Implicitly, Geithner and his colleagues seem to have concluded that the “great unwind” has limited the private sector’s ability to absorb the banks troubled assets. Key players no longer can borrow the funds needed to make large bets on troubled mortgage-backed securities. By providing credit to those willing to buy bad assets, the US government hopes to push up their market price up, and in the process induce the banks now holding these assets to sell. The US government in effect is providing the financial system with leverage to facilitate – one hopes – a transition to a less leveraged financial system. The amount that private investors have to put down – relative to the amount they are spending – is a key detail.

And it is quite possible that the market by be suffering as much from a sellers’ strike as much as a shortage of credit. Yves Smith is characteristically direct:

“The elephant in the room is how do we solve the heretofore insurmountable problem that the market price of the bad assets is well below what the banks are willing to sell them for”

So long as a bank can rely on the government to prevent a run (thanks to the government’s guarantee that creditors of large banks won’t take losses; i.e. “no more Lehman’s”) the banks current owners may prefer to sit on its toxic assets and hope the market recovers.

Finding private buyers doesn’t solve this problem. No bank has much incentive to sell its toxic assets at a price that would leave the bank bankrupt. Not selling is one way of gambling for redemption.

Breaking this logjam presumably is the purpose of another reported component of the reported Financial Stability Plan: a review of the balance sheets of large banks and, if needed, additional injections of equity capital into troubled banks. Here the Treasury seems to be moving away from former Secretary Paulson’s desire to put equity into all the banks, even relatively healthy banks, to avoid stigmatizing individual banks.

If the estimates of the banks’ total losses from Nouriel Roubini and Elisa Parisis-Capone are close to right – their estimated losses top those of the IMF, but the IMF’s estimates continue to be revised up – a lot of banks though won’t have any choice. Roubini and Parisi-Capone estimate that the US financial sector’s losses are close to its equity capital, something that no amount of regulatory forebearance can hide. …

It is consequently is likely that the government will end up with a large stake in some banks, even if key banks aren’t formally nationalized. That is fully appropriate. It is clear that the taxpayer is already on the hook for most of the banking sector’s downside. There simply isn’t enough equity left to offer the taxpayers much of a cushion against further losses (in world where the banks’ creditors are protected). If the taxpayer puts in new equity to allow the bank to remain adequately capitalized after the existing private equity is written down to cover past losses, the taxpayer should get a large share of the upside.

Will the Geithner plan work? I certainly don’t know.

Based on what I have read over the past two days, I have two main concerns.

The first is that the desire to avoid “nationalizing” key banks will soften the review of the banks balance sheet. I understand the desire to avoid nationalization. Once major banks are publicly owned, there would be pressure to lend for less-than-commercial purposes. But in some sense the substantive argument isn’t the crucial one. I testified before the Senate Budget Committee two weeks ago, along with Simon Johnson (if you aren’t reading the Baseline Scenario, you should be) and Tim Adams. I got the sense that there isn’t currently political support for a step as significant as nationalizing the key banks. Economics bloggers – and Martin Wolf – aren’t in quite the same place as America’s elected representatives. The Senate wants the banks (meaning their equity investors and management) to pay a price for their mistakes and it wants the banks to remain in private hands. Alas, those two objectives are in tension …

The second is that need to stretch the $300 billion or so available under the existing TARP out may have triggered the push for options that have a limited upfront cost but ultimately pose large risks. The FT’s Guha reports:

“Rather than seek to solve all the problems by pouring vast amounts of public capital into the banking system, the plan hopes to crowd in private capital through guarantees and financing. This reflects financial and political constraints – the administration is having to work, at least for now, within the $350bn (€273bn, £238bn) second tranche of the troubled asset relief programme – as well as a desire not to expand government ownership of the financial sector any more than is absolutely necessary.”

David Brooks reports that the Treasury is shying away from guaranteeing a lot of the assets on the banks’ balance sheet for this reason.

There had been some talk about setting up an insurance program, with the government guaranteeing a low-end price on toxic assets. But Geithner doesn’t think that can work. “If you’re pricing a guarantee or pricing a purchase, you have the same basic problem: the absence of a market price,” he said. It’s better to create a market so prices can be set normally, not by fiat.

That is good.

But the reported plan does seem to involve rather extensive use of the Fed’s balance sheet.

Ultimately, the financial sector’s losses are bigger than can be absorbed by the portion of the $700 billion in TARP funds that has been injected into the banks and the banks pre-existing equity. Goldman estimated that there at least $3 to $4 trillion of “troubled” assets on the books of US banks. That is the stock of troubled, assets – not the losses. But even if the banks existing equity investors take a large share of the losses on these assets, I suspect that the US will be lucky if can escape from the current mess with a net cost (meaning the net loss once toxic assets and toxic banks have been sold off) to the taxpayer of less than 5% of GDP …

Systemic crises tend to be costly.

UPDATE: Geithner’s plan

* The Brady plan guaranteed full payment of principal on the bonds of troubled Latin borrowers, as the principal of Brady bonds was fully collateralized by Treasury bonds. Countries that participated in the Brady bond bought this collateral with loans made available from the IMF. In return for the government’s support for the restructuring process, the banks agreed to restructure (lower interest rates, reduced principal) their original loans. The overall effect was to take bank loans to troubled sovereign borrowers off the books of the banks and put them into a traded market …


  • Posted by cdr

    If not being a regular subscriber to the publicly pronounced assumptions then the true error becomes the inability to blow bogus securities out of their legal existence which would lead directly to disappearing the scope of the problem (remember 1/5) by unwinding instead of subscribing to ridiculous over-liquidity that ends up being parked in Treasuries (call it private or public) but at the same time lead to erosion off Basel II fantasy “capital” and collapsing of the US CA deficit e.g. the “equal trade” thing. The assumptionists think all hell will break loose if they do that. Me thinks it will not if you first transfer “normal” deposits to a good bank – everywhere not just in the US and approach this one with western globosphere at least consensus! Hence this being the crossroads.

  • Posted by Indian Investor

    My simple version is that if you’re holding very doubtful assets: you get a dummy private investor and agree on a value of say $500 billion for them; the private investor who will get a loan form the Feds, say $100 billion and buy the doubtful assets with the loan money.Suppose the $500 billion goes doubtful and doesn’t yield anything back; the private investor can walk away from it. Once the PI walks away, she owes nothing to the Feds.
    Suppose it gives back more than $500 billion, the private investor gets the profits and pays back the Fed.
    Overall, this plan is the same as nationalizing the whole doubtful assets pack of cards.
    I noticed Dr. Roubini and Dr. Taleb in an interview together where Dr. Roubini recommends nationalization. That’s what this is. It’s nationalization with a private investor name thrown in.
    As to why the market fell yesterday, that might be because of some oil geopolitics. The Kuwaiti price was talking about crashing the crude down prices further, so that the Russians and the Iranians can be scared out of their wits further. Maybe that’s why the market was reacting yesterday.

  • Posted by cdr

    And incidentally, “the box” is defined by Fed’s big hug over 4-6 terrified big boys. You do not have to end this love affaire to get out of the box. There’s more but I’ll stop.

  • Posted by toxic_employees

    Think we have a case of Toxic banks, Toxic assets and Toxic employees.

    Federal regulators should seize the assets of all the MD’s, Executives and CEO’s.

    A part of taxpayer money should be allocated to Trials and Indictments. Why is Stanley O’neal NOT INDICTED? Why is Dick Fuld NOT IN JAIL? Why is HERB GREENBERG not under ARREST?

    Why did some highly paid Bankers who sold and packaged MBS and CDO’s quit in 2007 and then with personal funds SHORT the FIRMS who bought them? Making more money on way DOWN than on the way UP!

    I’m appalled and disgusted with Wall Street. I will never invest a dime in U.S. financials and I’m sure I’m not alone. Majority of my neighborhood is just as outraged as myself.

    Thank you!

  • Posted by Ying

    “Toxic banks or toxic assets?”

    The question should be weather to do nationalization, government bailout of private firms or some sort of public private hybrid?

    For my understanding, a public private hybrid model has demonstrated tremendous problems in the past. Examples include Freddie and Fannie, rating agencies, to Public Private Partnership infrastructure model, Commercial banks (in some sense).
    It is extremely complicated to spell out the responsibilities of each partner. Lots of resources went to figure out what is the right amount of true asset value, who should get what etc.

    Government job is to maintain a healthy economy for Americans. Taxpayer’s money bailout of private firms is not justified.

    The only option left is nationalize its banking sector. Given the severity of the crisis, the speed and simplicity of the action will bring, this option should be seriously considered right now.

  • Posted by Karen

    Proper valuation is needed for toxic asset purchases or proper mortgage modifications. This platform addresses both and protects the taxpayer, and un-biased on valuation.

  • Posted by Karen

    The platform is called Mo Mod built by Smithfield and Wainwright

  • Posted by Twofish

    Observer: Loan are assets. Banks hold these assets to earn the underlying cash flow….

    But they are matched by short term deposits to provide money to buy the loans.

    Observer: First of all, if you got a piece of security in your hands that nets interest in the double digits, why would you want to ‘monetize’ it.

    Because you have lots of interest rate and default risk that you need to manage. One way of doing this that can be a lot safer than holding loans is to make money off origination and servicing fees. You immediately sell off the loans, make money from the origination and servicing fees and then use the cash to make new loans.

    If you aren’t reselling loans, then the loan volume goes way down, which is what has happened.

    Observer: Second of all, you are talking about a theoretical situation where there’s a run on bank deposits.

    It’s not a theoretical situation. There were massive bank runs on the investment banks and money market funds after Lehman, and a bank run is what killed Washington Mutual. Banks have very little cash on hand, and even a small drop in deposits can be a huge problem. Since now everything is FDIC insured, it’s not a huge problem for depositors, but it is one for the government.

    You haven’t seen people line up in front of banks demanding their money, but that’s because all of this is happening over the internet.

    Observer: That certainly can happen, but in this discussion of bank’s cash flow, that’s neither here nor there.

    It did happen. Bear-Stearns, Lehman, and Washington Mutual, and the investment banking model were all killed by bank runs.

    Banking would be easy if you didn’t have to worry about bank runs, but you do. Part of the reason that finance has changed so much is that a lot of “let’s not worry about these events” have actually happened.

    Observer: Now that these assets have hit a floor in pricing, and that banks have plenty of liquidity to releverage, it’s the perfect time to earn those cash flows.

    They haven’t hit a floor in pricing, and banks don’t have plenty of liquidity. If you can get a situation in which the unemployment rate stabilizes *then* people will start purchasing those assets, but until unemployment stabilizes, people aren’t going to be too interesting in buying.

  • Posted by Twofish

    Observer: If I’m not mistaken, Thain unloaded a lot of this stuff to private equity.

    He tried to. The trouble is that if things get worse, and private equity doesn’t buy, you are stuck with these assets. If you haven’t hedged them, then you have large problems.

    Observer: So I’m confused by this statement. David Goldman doesn’t advocate everyone buying these assets, just those who have the stable financing and are not constrained by capital requirements.

    Except that no one has stable financing and everyone has capital requirements.

    You have a chicken and egg problem here. Hedge funds and private equity need financing and loans from banks to buy these securities, but banks aren’t going to provide hedge funds and private equity with that financing because they have these assets on their books.

    Observer: Now that these assets have hit a floor in pricing, and that banks have plenty of liquidity to releverage, it’s the perfect time to earn those cash flows.

    It’s not a good time right now, while we have massive job losses each month. The assets haven’t hit bottom and banks don’t have plenty of liquidity.

    Karen: Proper valuation is needed for toxic asset purchases or proper mortgage modifications. This platform addresses both and protects the taxpayer, and un-biased on valuation.

    This sounds like a press release that got injected into the system, and it sounds pretty bogus to me.

    Valuation is essentially a very subjective process, and trying to pretend that it isn’t will get you into a lot of trouble.

    Ultimately a lot of finance depends on staring someone in the eye, and trying to figure out if you can trust them or not.

  • Posted by Michael Carroll

    The Treasury should force the auction of 0.1% of the non perfoming loans of every banks each week with an opening bid of one penny per nominal dollar value. At one penny on the dollar it will be hard not to make some money as some of the loans perform marginally and others are redeemed for collateral so overtime demand at the auctions will grow and the government coersion can be relaxed.

    Even if the banks make no money, writing off a 5.2 percent loss on this stuff over a year is well within the current scope of what we are facing and the banks actually have an incentive to make this work because it works like a loss leader to get the credit market moving again. Hell they should toss in some gold ticket assets randomly just to spice up the pot.

  • Posted by locococo

    “there are no assets”

    that s written on the piece of paper hidden in these toxic assets.

    They are not toxic but partially non-existing. There therefore are no toxic banks at all. All we can argue here about is their” existing” and “non-existing” part.

    Their value thus depends on probability that
    a) no one discovers that piece of paper
    b) we can overprint to such an extent that this vacuum gets refilled
    c) that b) can in fact not be done due to the current »environment« we find ourselves in
    d) we ll lock in the needed total amount of fresh greenbacks on a huge but partial but regular and sustainable quarterly basis through congress for years to come to keep up the cash flow required for that picture to emanate to sink in the bottomless pit called »banking« these days
    e) foreign CBs don t wake up as to what constitutes a “reserve” or can be scared/persuaded enough not to remember (e.g. appreciation)

    but not on
    a) any model even those not yet invented that derive their result (value) from the underlying asset “happening”

    We re ok at the a) and the e) for now tho shaky, c) then scratched b) away, d) might take its dive along somewhere. That s exactly what the markets have lately been trying to say here