Where is the Stick?

Posted March 28, 2009

Obama needs to acknowledge that his bank rescue plan cannot be entirely voluntary. He will force weak banks out of business by making them sell assets at prices that acknowledge their insolvency.This is not especially fun for a politician — but it is essential that he do it anyway.

Treasury Secretary Tim Geitner has put forward a serious plan that enlists private equity, hedge funds, and pension funds to invest
side by side with the government.

Obama expects them to put up about a dime of every dollar and to set the offer price for nasty assets (bundles of mortgages or loans based on them). The government would kick in a dime of TARP funds and an 80 cent loan guaranteed by the FDIC. This means that profits are shared 50-50 with private investors, but losses are 90% paid for by the taxpayers. There are details about the loan guarantees that matter a lot and are not clear to me, but the idea is that banks get cash and we get trash – at a big discount.

Why let the private sector price the bum assets? Because investors hate losing money a lot more than federal officials do, so they are much less likely to overpay. Taxpayers will on average get a much better deal. Why the loan guarantees? Because they do not require Congressional approval and, if the pricing is done right, they will not kick in.

The big question is why banks would sell at prices low enough for investors to want to buy? The banks have all of the information about the assets and if they sell them at a fire sale prices, it forces them to acknowledge insolvency. So banks understandably do nothing. While they hope that their assets will some day be worth more, we starve for credit. This is roughly what cost Japan its "lost decade".

Which is why that once assets are priced by private sector auction, the feds must force banks to sell at that price. Forcing banks to sell assets is one use of the solvency "stress tests". It is also one use of our huge ownership position in most big banks. That is the stick – and Obama forgot to mention it.

The stick is tricky because at the first hint that their bank has failed a stress test, the shareholders sell and poof! — a weak bank is a dead one. So, naturally, bankers denounce the fed's stress tests. The tests may be lame, but when I hear the CEO of Bank of America (the same genius who paid $4 billion for sub-prime king Countrywide) call federal solvency tests "asinine", I heard a student denouncing a test that he knew he was going to flunk.

Obama's has offered a fine carrot. Having private investors price the assets is smart, even though some of them will get rich and people will ask why the government didn't do it (answer: the government would have overpaid). But Obama needs to come clean about the stick. The fed's irreducible job is to separate solvent
banks from insolvent ones. (Pause for moment of hard earned schadenfreude: these banks happily rule on the solvency of their creditors but fight like a bag of cats when the feds rule on theirs).

Obama needs to assure voters that the feds will liquidate insolvent banks — even large ones. The FDIC does this routinely. It unwound 25 small banks last year and 16 so far this year. Most of us cannot name these banks and often it doesn't even rate a mention in the local newspaper. Winding up banks isn't always cheap — but it's cheaper than nursing sick organizations that pretend to be banks. But as Shiela Blair, the increasingly impressive FDIC director knows well, you cannot do this work with incentives alone.