March 23, 2009, 11:32 p.m.
The Treasury secretary Tim Geithner's program to purchase toxic assets from the commercial banks and restore their balance sheets to healthier days was released today. It had an immediate positive effect on the American and global stock exchanges as the Dow jumped by almost 500 points closing at 7776. The Footsie in the U.K., the DAX in Germany, the TSX and the Japanese index were all sharply higher in response to the new program.The program has many critics including Paul Krugman who argued in his New York Times column that the plan was doomed to fail because the assets that it proposed buying, legacy loans and legacy securities, were largely worthless and the banks that owned them bankrupt.A number of people who commented on the plan in the New York Times were also sharply critical from a populist point of view of bailing out the banks once again.
Columbia university economist Jeffrey Sachs also has an interesting commentary in the Financial Times which argues that the plan makes misleading claims that it is about price discovery when in fact the lopsided nature of the risk borne by the taxpayer compared to the very much smaller risk borne by the potential buyer who can walk away from the loan if the option to buy goes sour means that in fact there is no real true price discovery taking place that justifies such a high potential low risk return to the buyer.
Sachs is correct but the problem remains how does the government get the banks to sell these distressed assets and find the buyers willing to buy them. The only other plausible alternative is outright nationalization which is an anathema to the Republicans and many Americans. The political culture in the US would have to change dramatically in the direction of Canada or Western Europe or Scandinavia for that option to be a political as well as economic winner.
But the critical view of Sachs and Krugman was not the view of many other analysts and economists who see the plan, flawed as it might be, as a necessary and positive step in restoring credit and an eventual return to prosperity.
The plan is controversial because it allows risk oriented private large investors to place what is in effect an option on these assets without investing much of the acquisition cost themselves. The Treasury gave the example of an investor bidding 84 for an asset formally valued at $100 by the selling bank. If 84 was the winning bid in the auction then 72 of the 84 $ would be loaned by the Federal Deposit Insurance corporation to the buyer at an undisclosed so far interest rate, the Federal government would invest $6 and the buyer only obliged to risk $6 in order to purchase the asset.
If the eventual value of the asset fell below 84 to say $78 the buyer could walk away without any further obligation leaving the FDIC and the government holding the bag. On the other hand if the value of the asset rose to $94 the new private owner could sell for a profit of $10 which it would split presumably 50 50 with the government after paying off the loan plus whatever interest accrued. So the private sectors buyers would have a low risk opportunity with a strictly limited liability and the chance to make a tidy profit in the future on these assets. The justification for this is that private partnership with the government ensures that the correct market price is found for these assets.
The Treasury argues that the Government as the sole buyer would have overpaid for the assets and assumed excessive risk. However, by limiting the risk as much as they have at the taxpayers' potential cost the Treasury may well find that the price paid for the assets in the auction process is higher than it otherwise might have been.This is Sachs ' point of view and I agree with it. Since the private sector purchase is highly leveraged by Government loans and equity there is less incentive for the buyer to bid the price lower. The plan might be made more popular with taxpayers if the Treasury were to approve a mutual fund open to small investors as one of the competitive auction bidders for the assets.
Nevertheless, the objective of clearing the balance sheets and setting the stage for the reopening of credit will be advanced by the plan and unlike Krugman I am betting that the plan will work because I suspect that these assets are in fact worth in the future somewhat more than the market currently judges them to be worth.In many cases they represent land and housing stock in attractive residential areas of America. Values may have dropped but the properties are not worthless.
Time will tell us who is correct.The Treasury released a white paper and informative appendices on the plan which are definitely worth reading. We shall see if the bear rally continues in the days ahead.
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