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Expect more give and less take from the mortgage rescue.
Economist Staff, The Economist
October 13, 2008
THE signing into law of America’s $700 billion bailout was never likely to save the financial system. In the event, it did not even come close. The Troubled Asset Relief Programme (TARP) could still do some good but to maximise its effectiveness, the Treasury will almost certainly have to stray from its core mission of buying distressed mortgage-related assets.
It has that option, thanks to a clause in the TARP that allows it to buy almost anything in the interest of stability, including direct stakes in banks, as long as it notifies Congress. Tellingly, a group of regulators issued a rare statement on October 6th, pointing out that the Treasury could "directly strengthen" bank balance-sheets. Hank Paulson, the treasury secretary, later said he would use "all of the tools" at his disposal, presumably including shoring up capital-starved banks with large dollops of preferred stock. He had played down this idea when the TARP was being drawn up, but the continuing deterioration of the financial system appears to have forced a rethink.
Meanwhile, the Treasury is acting quickly. In response to market turmoil, the selection of the firms to manage TARP's assets was squeezed into a single week. The winners are expected to begin work in mid-October. Overseeing them will be Neel Kashkari, a 35-year-old assistant treasury secretary and a former banker at Goldman Sachs, who helped Mr. Paulson to craft the TARP. The first purchases are expected in four to six weeks, perhaps even sooner.
The original idea, and still the stated goal, was to free banks and other financial firms of the most noxious loans and securities on their books by purchasing them in auctions. The hope is that a big buyer (i.e., the government) will end up paying more than today's fire-sale prices, temporarily depressed by the lack of buyers, but less than their "intrinsic" value if held to maturity (so the taxpayer does not lose). But designing the auctions will be tricky, given the complexity and mix of structured financial products. "These are not tulips or roses," says one securitisation lawyer.
The government faces hard choices. Which is likely to do more: buying a lot from a few big banks, or a bit from everyone? The clamour from banking's lower ranks is growing louder. Thousands of small community banks are desperate to offload the duff loans they made to shopping malls and small businesses.
Another question is whether to keep the focus tightly on mortgages, even as other parts of the economy head south. According to analysts at JPMorgan Chase, the severity of losses on securities tied to car loans could rise close to those on subprime mortgages. And defaults on junk bonds and other commercial debt are soaring. Relieving banks of these assets may become more urgent over time, but that would leave less to spend on dodgy mortgages, points out Alec Phillips of Goldman Sachs.
Another dilemma is whether to hold assets or sell them. By holding assets to maturity, the government could benefit if they rise in value. But selling them to private investors would free up more money to help straitened banks. One option reportedly being considered is to sell assets to special vehicles jointly owned by private investors and the government, with the latter financing part of the sale to make the assets more attractive. This worked well after the 1980s savings-and-loan crisis. But distressed-debt buyers may balk at missing out on part of the upside. Joseph Mason of Louisiana State University thinks most of them would prefer to buy into banks that have been stripped of their worst assets.
The biggest question hanging over the plan is whether it does enough to restore and maintain banks' capital. The woes of Lehman Brothers, Washington Mutual and Wachovia suggest that many banks are still carrying assets at unrealistically high values. For these institutions, selling to the government, even at a price above distressed levels, could deplete their capital as they crystallise their losses. Those that take out insurance on their loans, another option under the Treasury's plan, would neither gain nor lose capital, but would have to start paying premiums. In any event, putting in fresh capital may now be more pressing than pulling out ropy assets.