Will it be second time lucky for Tim Geithner? On Monday March 23rd, six weeks after being heckled for a maddeningly vague bank-rescue plan, America’s beleaguered treasury secretary at last gave details of a public-private partnership to invest in the troubled assets clogging up banks’ balance-sheets. Cleaning up this mess is seen as a prerequisite of financial and broader economic recovery, and the Americans were keen to unveil a proposal before leaders of the G20 countries meet to seek a way out of the crisis, in early April. The new plan is certainly a lot meatier than the February effort, and markets for both debt and equities gave it an initial thumbs-up, the Dow Jones Industrial Average rising by almost 500 points and credit-derivative spreads signalling a lower risk of bank defaults. There are, alas, several reasons why it may struggle to succeed.
In a sense, America has come full circle, reviving the asset-buying component of the original Troubled Asset Relief Programme (TARP), a $700 billion rescue fund created last October which was quickly refashioned into a bank-recapitalisation vehicle. This time, however, private investors will do the buying, not the government, though they will get plenty of help, through co-investment by the Treasury, cheap loans from the Federal Reserve and debt guarantees from the Federal Deposit Insurance Corporation. For every private dollar invested in impaired loans, a matching dollar of equity and $12 of other financing will come from the public purse. And the loans will be non-recourse, meaning investors who walk away from loss-making deals lose only their initial investment.
Paradoxically, at a time when private firms are furiously cutting back on debt, the government sees this “leverage,” or borrowing, as the best way to unfreeze the market for mortgages and related securities. In theory private buyers, bidding in competition with one another, should be better than the government at determining the real value of assets; the government is more likely to overpay. Moreover, by combining private and public capital, the government hopes to generate up to $1 trillion of buying power using $75 billion-100 billion of TARP money.
Will private investors nibble? The potential returns look juicy, even though they must share profits equally with the taxpayer. Big firms that would be in the running to manage funds in the programme, such as BlackRock and PIMCO, have given it a cautious welcome. But others, such as hedge funds and private-equity groups, are wary of participating in government-backed plans after witnessing the hysteria whipped up over bonus payments at American International Group (AIG), a clapped-out (and now government-controlled) insurer.
Government officials have tried to quell these concerns by calling potential asset-buyers “good guys” and providing assurances that they will be exempt from pay restrictions aimed at recipients of taxpayer largesse. But fear abounds that they will become the next target of self-righteous politicians, especially if they are seen to be reaping windfalls. “The political risks are scary,” says one hedge-fund manager, who also points out that some of the plan’s details are still missing: for instance, the interest rate and duration on loans for mortgage-backed securities have yet to be determined.
Another question is whether banks will sell. Many are still holding assets, particularly whole loans, at unrealistically high values. With government help, buyers will be able to offer more than they would if relying solely on their own resources. But it may still not be enough to persuade banks to sell, since any amount below the carrying value would force them to take a write-down and deplete precious capital. (This is a bigger issue for stodgy commercial banks than it is for Wall Street firms such as Goldman Sachs and Morgan Stanley, which have aggressively marked down duff assets.) There may be a way round this impasse, thinks Michael Feroli, an economist with JPMorgan Chase: regulators could use the results of the “stress tests” they are currently conducting on large banks to force them to sell assets, in the process topping them up with fresh capital in return for a bigger government stake.
Moreover, the new plan may not be big enough to deal with the bad-asset problem. The sum of $1 trillion may sound a lot, but at least double that amount is in danger of souring in America as house prices continue to fall, unpaid credit-card debts mount and more companies slip into bankruptcy. With the chances of wringing more money out of Congress for troubled banks low and falling, the new plan could hit a funding wall. To date, just under half of the TARP’s $700 billion has been disbursed. Add in other commitments and the toxic-asset plan, and the total climbs to as much as $608 billion. Fine, except that more than the remaining $92 billion may be needed to plug banks’ capital holes once the stress tests are completed.
So Mr. Geithner could face some hard choices. He will desperately want the new plan to succeed, not only because cleansing banks of toxic assets is so important to reviving confidence, but also because its failure could unseat him. He is already reeling from criticism that he was slow to put a lid on the pay furore at AIG. Barack Obama has been forced to defend Mr. Geithner against calls for his resignation.
If the public-private partnership proves to be a damp squib, Mr. Geithner can expect to face a barrage of complaints that he took the wrong course. He rejected both the standard “bad bank” model, in which the government takes on rotten assets, and takes over the banks most riddled with them; and the asset-insurance approach favoured by Britain, in which the state takes on the risk of a credit portfolio for a fee. Whether that is a decision he comes to regret will become clearer in the coming weeks.