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Should We Care That the Banks Don't Want to Play Ball With Geithner?

The Treasury Department's effort to price and purchase the toxic loans clouding bank balance sheets -- the PPIP program -- appears to have failed. And it's failed for a very simple reason: The banks refused to participate. They didn't see it as in their interest.

"Let's say an asset was worth 30 cents on the dollar," explains David Sharfstein, a finance and banking expert at Harvard, "but the financing guarantee makes it worth 50 cents on the dollar. If it's on the bank's books at 100 cents on the dollar, that's still a fairly big markdown."

And it's a markdown banks want desperately to avoid. A couple months ago, however, they had no hope of avoiding it. They needed capital to satisfy both regulators and creditors. They needed clean balance sheets to raise that capital. Conventional wisdom was that the first step to solving both problems was to rid themselves of the toxic loans that had thrown their business into such chaos. Even selling the loans at a markdown would be preferable to collapsing entirely. That's what the PPIP plan sought to achieve.

But then things got better. The banks passed the stress tests. They raised unexpected amounts of capital on the private market. The London interbank offered rate (Libor) fell. Job losses slowed. Green shoots appeared. The external sources of uncertainty, in other words, eased. And so the calculation changed: The banks figured they could hold the loans and let their value rise. Maybe, in a few years, they could sell at 70 cents on the dollar rather than 50 cents on the dollar. And importantly, they judged this a relatively risk-free gamble. "The banks basically have a call option," says Scharfstein. "If things get better, they'll be the beneficiary. And if things get worse, the government will step in again."

That's the key: Let's say the banks are wrong. In six months, the green shoots whither. Oil prices rises. Uncertainty creeps back into the Libor index. The adverse scenario envisioned by the stress tests proves much too optimistic. The banks need capital again, and they find their balance sheets have begun to unsettle the market. They know -- with perfect certainty -- that the government will step in again. Either it will take the PPIP program off the shelf and dust it off or emerge with a new solution. But the banks won't be left to suffer.

Raghuram Rajan, a banking expert at the Chicago School of Business, says that the stress tests were part of this. "The stress tests didn't reduce uncertainty by showing the quality of bank balance sheets," he argues. "They reduced uncertainty by sending the message that the government is going to stand behind these banks. The stress tests basically said this is the price in terms of additional capital you need to raise, and then the government will back you."

For the banks, in other words, it's still heads the economy improves, tails the taxpayers bail them out. The question is whether taxpayers should worry about that outcome. This is arguably better. PPIP was costly to the government. If the banks can handle this on their own, that's win-win.

But it's a big if. "In the best of all worlds," Rajan says, "what you would do is take advantage of a period when the market is really calm to do what needs to be done: Get the assets off the nerve center of the economy -- the banks -- and over to the guys who can hold them in the long term." If that's not done now and doesn't need to be done later, that's fine. But if it does need to be done later -- if we reenter the downturn, and the banks begin to look shakier -- we'll wish we had moved the assets when the market was calm and stable, rather than leaving them to create uncertainty and volatility at the center of the banking system.

"At this point," concludes Rajan, "banks don't have any incentive to sell these loans. But the message of this crisis is that when we didn't use periods of calm to make things better, we found they could get worse."

By Ezra Klein  |  June 9, 2009; 12:14 PM ET
Categories:  Financial Crisis , Solutions  
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Next: Should Banks Be Allowed to Repay TARP Funds?

Comments

Thanks Ezra. Now could you clear one more thing up for me?

How does this relate to the dreaded Japanese "Zombie Banks" scenario? The current situation, of essentially insolvent banks floating on the backing of implicit government guarantees and raising just enough private capital to survive but not thrive, seems eerily similar to what people were saying happened during the lost decade.

But maybe I'm completely wrong.

Posted by: CarlosXL | June 9, 2009 12:45 PM | Report abuse

Does the implicit guarantee of the big banks look a lot like Fannie and Freddie for everyone? Aren't the banks now motivated to open to Big Casino again where the potential profits are huge for the banks and the risks great for the taxpayer? What's to lose? Wheeee!

Posted by: glewiss | June 9, 2009 1:16 PM | Report abuse

Now that the phrase 'moral hazard' has disappeared from public discourse (again) due to the widespread perception that the words 'moral' and 'banks' don't belong anywhere in the same paragraph, we can accept our fate gracefully because that's the way things are: "the banks own everything around here" as some too honest congresspeople have admitted.

While thinking of this dilemma this AM, I thought of an analogy I like (because I haven't seen it applied to this financial farce yet.

A 'normal' family of two parents and two kids in their early teens. The parents have a choice of their own behavior, but haven't articulated it yet in discussion and action. One of them can be a softie, and the other the rulemaker/enforcer. This sometimes works, but the kids get the game early on. So a grounded kid gets to say 'mom (or dad) says I can go out because this a special event'.

Only when both parents (and grandparents and other parents too, quite often) set jointly enforced rules consistently does the magic hand of teen raising appear to work over time.

So, we have the Fed and Treasury (and Congress and the Media, as grandfolks and neighbor parents) with two wild teen actors who display utter disregard for social and economic restrictions. But all the enforcer parties are softies, bought off with an occasional hug or kiss from the kids and a promise to be good.

I think we know how this story ends. The girl-kid gets preggie and runs off with a convicted felon on a bonnie and clyde holdup spree, and the boy-kid moves on up from simple house breakins to meth and crack and then joins a gang that wipes out a couple of rival gang members and a DEA agent on their way to Fed. Max. Security Prison for 30 years. Meanwhile the kids are great entrepreneurs and contribute innovation to society.

Posted by: JimPortlandOR | June 9, 2009 2:34 PM | Report abuse

I'm the last one to talk about finance but didn't banks get the option of marking their assets at something other than their current value?

This break in accounting methods allowed their books to look better.

Wasn't that part of the story?

Posted by: leoklein | June 9, 2009 3:02 PM | Report abuse

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