WSJ: What Paulson Is Trying to Do

http://online.wsj.com/article/SB122402984044334627.html
Less than two weeks into it, the $700 billion Troubled Asset Relief Program (TARP) is stuck between a rock and a hard place. Next week, several hundred billion dollars of credit default swap (default insurance) payments on Lehman's debt default are due. No one quite knows who owes what and if they're good for it. Hence the urgency in Henry Paulson and Ben Bernanke's plan to inject $250 billion directly into bank balance sheets, which seems a necessary evil to get capital to the right place and help weaker banks save face. The credit markets agree -- so far.

Wall Street and banks live by short-term loans. But as a loan shark might say, right now, nobody wants to lend to nobody. The rate that banks charge each other, the London Interbank Offered Rate (Libor), has been trading so high above three-month Treasury-bill rates (on Monday it was 4.75% vs. 0.11%) that no one is lending. This so-called TED spread -- the difference between what banks pay and what the Treasury pays to borrow for three months -- signals the health of credit markets and has rarely been over 1% since the 1987 crash. The Treasury is clearly focused on this metric and needs to get it down to historic spreads. First it has to change the current mentality of "who wants to lend to the next Lehman or Wachovia?"

The original TARP plan was to buy all the bad loans, mortgage-backed securities and collateralized debt obligations (CDOs) currently weighing down bank balance sheets. That is still the right (and profitable) thing to do. History shows that well-capitalized banks eventually do lend since hoarding doesn't make money.

But here's the current dilemma: If Treasury pays more than market price for these distressed securities, it would look like a taxpayer gift to Wall Street. That's politically unfeasible. So Treasury has to pay the current distressed prices. (Despite this week's stock-market bounce, prices are still dropping on toxic CDOs.) But if Treasury pays current, fire-sale prices, it would lead to major write-downs at banks. Since most of these securities are collateral for other loans, and regulators force banks to have minimum capital requirements and cash on hand, any write-down in value immediately means new capital needs to be raised.

Is this the right thing to do? Probably not…But it's the only thing to do at this stage.

And then who would throw good money after bad? Sovereign wealth funds have already been burned. Dubai invested in Citigroup less than a year ago via preferred shares that convert into Citi stock at $32 to $37 per share. Citi is now around $18.

Other banks are still scrambling. Morgan Stanley's shares bottomed under $7 last Friday on fears that Mitsubishi UFJ Financial Group, a Japanese bank with $1.8 trillion in assets, would pull out of a previously announced deal to buy 21% of the company for $9 billion. Luckily for Morgan Stanley, the Japanese think long term and did the deal anyway, even though it makes no economic sense at the moment. Other U.S. banks wouldn't be so lucky.

So here we are with no interbank loans and no equity financing. Treasury would bankrupt banks if TARP buys securities at market prices, forcing them to do the impossible task of raising capital in an ugly environment.

The direct capital injection is a way to get unstuck. In effect, first Treasury injects money into bank's balance sheets, then buys the toxic loans at market prices. Even if there are write downs, banks will have enough capital to live. What about healthy banks like J.P. Morgan, Bank of America and perhaps Goldman, which don't need capital? They get it too. The Treasury is forcing every top bank to take the government investment. Why? Because if they didn't, the ones that do take the capital would look weak and loans to them would remain dry.

Is this the right thing to do? Probably not. Despite some limits on compensation, bad management stays in charge. Government investment in financial institutions will raise a gazillion temptations and conflicts of interest. Politicians won't be able to help themselves and will inevitably meddle. Just look at the pork loaded into the TARP bill. But it's the only thing to do at this stage. Next stop is full nationalization and no one wants that. Already the TED spread is coming in, dropping to 4.36 from 4.64. The market likes the plan, at least for now.

One concern: Won't cranking the monetary printing presses to finance all this lead to runaway inflation? Probably not. Remember that after the 1929 market crash and subsequent bank runs, 10,000 or roughly 40% of banks failed, $2 billion in deposits were wiped out and 30% of the money supply disappeared. So did a similar percentage of GDP. Today, bank deposits are mostly safe, but with $1 trillion in bank and Wall Street writedowns taken or soon to be taken on bad real estate securities, some multiple of that in money supply will vanish with the stroke of an accountant's pen. Restarting bank lending is the only way to top it back up.

Many questions remain: When will Libor rates and the TED spread go back to normal so lending can restart? Then, when does the government sell the preferred shares so we can return to a market economy? Can we put an expiration date on government programs? (Most New Deal institutions are still around.) Furthermore, what do we do with the returns on investment?

Thanks to deposit insurance, there are no huge bank runs going on. There is, however, a "loan run," meaning no one will lend to weak banks. Yes, it's distasteful for government to own any private enterprise, especially in finance. But if you hold your nose, the new TARP seems like a way to end this loan drought. There is no economy until this is fixed. Then we can start arguing about the inevitable reforms to come.

Comments

[youcancallmebuffett]

and to think YOU are following the europeans....ts, ts, ts....all those jokes...how was that? 'unless we want to emulate the europeans'...oh i forgot, you got the ipod...300m fat slobs hanging on top of THE ipod.

[Advill]

Job in the next weeks of guys like you and others is assuming (as most of us are), in the fact that government intervention is necessary for now, and once in a while in the future, but MAKING VERY CLEAR THE LIMITS OF THAT IS BASIC TO KEEP THE FUNDAMENTALS OF FREE ECONOMY.

Regulation is the word of the future, keeping politicians on line is the job of the future....a difficult job indeed.

Best regards.

[Derek Syphrett (Clarkson University Economics)]

Andy - My boss loves getting your perspective on things. However I think you give Paulson way to much credit.

If these CDO's and mortgages actually had value then somebody would be buying them. There are billions of dollars earning little to no interest and many hedge funds sitting on cash but nobody is interested in buying these deeply discounted and distressed assets.

If CDO's are the buy of the century that you make them sound like somebody would be buying them - but to date there have been no buys of any size. Merrill's sell at 22 cents on the dollar doesn't count because they're offering to insure that sell for losses over 8 cents and they didn't collect a premium for that insurance.

And as for a solution the only way to get out of this - there are two crisis that must be addressed:

1. money supply shrinkage - can't be fixed by the private sector at this point, balance sheets are too broken and too much capital has been destoryed.

2. borrower crisis - banks won't be able to lend to consumers or businesses whose balance sheets were optimized for a leveraged world... Borrower balance sheets have to be repaired.

All asset classes should continue to fall until the money supply begins growing again and borrowers are qualified to borrow.

The best solution that I see would be global currency dilution that raised the nominal value of all asset classes... allowing debters to repay debts. Diluting currency on a global basis would be sterile for exchange rates.

[Rajeev]

Hello Andy,

I understand the logic of first injecting liquidity into banks before buying out the so-called 'toxic assets'. However, it raises 2 questions:

1) Is $700 billion enough to inject liquidity AND buy the toxic assets?
2) If answer to 1 is yes, would it have been better to buy out toxic assets from a particular bank and then give them (just) enough cash to prop up their balance sheet?

Also, Paulson seems to have stopped at step 1! He's given money to banks - and mostly big banks that were expected to be able to manage on their own - and then washed his hands off the whole thing! Does it make sense to you? Should Geithner pick up where Paulson left off and complete the original plan?

[Tom Smith]

If CDO's are the buy of the century that you make them sound like somebody would be buying them - but to date there have been no buys of any size. Merrill's sell at 22 cents on the dollar doesn't count because they're offering to insure that sell for losses over 8 cents and they didn't collect a premium for that insurance.