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."
June 9, 2009; 12:14 PM ET
Categories: Financial Crisis , Solutions
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