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Does Obama Have a Plan B?
Reuters
As the president heads to the G-20 conference, one of America’s most respected international economists warns that the Geithner plan repeats the same errors Japan made in the 1990s.
It is so much harder when the financial crisis is in your own country.
Timothy Geithner, Larry Summers, and a host of other economists—myself among them—spent the late 1990s yelling at Japanese and other Asian officials to clean up their banking crises. A typical conversation would end with the American adviser bursting with frustration: “Don’t you understand? The money is gone. If you just wish for the banks’ asset values to come back, any recovery will be short-lived and you will only get more losses in the end. We all know this from long experience.”
For all of Japan’s supposed intervention in markets, it still lacked the stomach for the government closing, let alone taking over, banks.
Then we would go to conferences and discuss what it was about Japanese (or Korean or Indonesian) political economy that prevented resolute action.
So it is with some irony if not humility that we should approach Treasury Secretary Geithner’s Public Private Investment Plan presented on March 23. A number of major American banks have lost huge amounts of money, and clearly have insufficient capital if they are not literally insolvent. Why else would they be pushing so hard to change the accounting rules to avoid showing what they really have on their books instead of raising private capital? Why else is the U.S. government taking so long to perform “stress tests” and trying to get expectations of overpayment for some of the bad assets on the banks’ books before the test results are out? In short, the U.S. government is looking to shovel capital into the banks without sufficient conditions, hiding rather than confronting the actual situation.
That is just like the Japanese government in their lost decade, or the U.S. officials during the 1980s before they really tackled the savings-and-loan crisis. In those cases, the delay simply made the problem worse over time and in the end the government had to put more money into the troubled banks directly, taking over or shutting down the weakest of them. Whatever the political culture, it would seem we have not learned from experience. Or perhaps we cannot act on our learning. The universal barrier would appear to be the political difficulty of recapitalizing banks. That seems obvious, but the constraint it puts on good policy is enormous.
That is why the Geithner plan is so complex and jury-rigged, to avoid the need for public requests for more money for banks. Unfortunately, it is unlikely to succeed absent additional public money and more-intrusive government action. The plan will buy some time and certainly some appreciation in bank share prices. Current shareholders will be getting a new lease on life with subsidies from taxpayers. For that reason alone, the plan certainly will cost the taxpayer more in the end than a more direct recapitalization with public control would have.
A year or two down the road, we will know for certain whether it worked. By then the banks will either return to normal pre-crisis lending or they will be both too distrusted and too distrustful even to borrow from each other again. As we have seen over the last 18 months, the latter is what near- insolvent banks do. When I was working with the U.S. Council of Economic Advisers and the Japanese business federation Keidanren in 2001-02 encouraging the Japanese government to do finally what was needed, it was the commitment of public money with tough conditions on the banks that we pushed for, and it was the normalization of the interbank market and then of lending behavior that showed success.
In essence, the U.S. Treasury’s plan to subsidize private investors’ purchases of the banks’ toxic assets is a too-clever-by-half mechanism to fix the banks while avoiding going to Congress for more upfront on-budget expenditures. One can imagine the discussions at the White House: We have a budget to pass, and cannot give up those goals to give the bankers still more. Figure out some way to do this off-budget. And so the Geithner plan hugely bribes private investors with taxpayer money, as Simon Johnson, Paul Krugman, Jeffrey Sachs, and I have all described, with one-way government insured bets. Yet the bets are contingent, they only pay when the taxpayer loses—and those losses first appear on the Fed or FDIC balance sheet, not subject to congressional approval.
I know that the very same self-limiting discussions took place at Okurasho, the Japanese Ministry of Finance circa 1995-1998. And they ended with the same result, a series of bank-recapitalization plans that tried to mobilize private-sector monies and overpay for distressed bank assets without forcing the banks to truly write off the losses. Even though the top Japanese technocrats at the ministry were even more insulated from a weak Diet than the congressionally unconfirmed advisers currently running economic policy for the Obama administration, they did worse. Whatever the political context, countries usually try to end banking crises on the cheap, with a limited public role at first, overpaying for distressed assets and failing to change banks’ behavior, only to have to go back in a couple of years later.
I hope the Geithner plan, combined with the other financial measures under way, proves to be an exception to the rule and succeeds in stabilizing the U.S. banking system. It could remove some of the bad assets from the banks’ balance sheets and put some capital into the banks. Even in that best case, though, it is clear that the avoidance of on-budget costs makes it penny-wise, pound-foolish, for the U.S. taxpayer. It will likely cost the taxpayer more on net, between the subsidies given and the transfer of most upside gains to the private investors, and the overpayments to current bank shareholders for toxic assets. If the U.S. government steps in more aggressively to take full ownership and pays a low price for these assets, the taxpayer would stand to get the full upside, even though it would require more cash up front. That would still be better than the Japanese experience.
But the pattern of these crises—Japan in the 1990s or the U.S. in the 1980s, and elsewhere around the world—leads me to believe that this partial fix will be temporary at best. The banks will still have the worst toxic assets on their books; their managers and shareholders’ incentives will not have changed. The banks will be playing with a fresh stack of public money with insufficient strings and probably insufficient capital. Then, 18 months or so down the road, the U.S. government will still have to put capital into the banks, because credit markets will break down again, with many banks again under water. But in that case, the necessary recapitalization would have to take place after this round of money is squandered and the current fiscal stimulus will have run out.
Part of the problem is that some of these distressed assets are genuinely toxic. They cannot be consistently valued and priced by anyone because they are part of larger securitized packages and so purchasers cannot disentangle the underlying investments behind them. Under the Treasury plan, those toxic assets are not restructured, but sold as-is just because of the federal guarantee offered against losses. Restructuring these assets would require government supermajority ownership, which so far seems to be politically unpalatable. In which case, the FDIC will end up paying out on the insurance for overpriced assets.
What the Obama team is proposing is disconcertingly similar to the actions of Japanese Prime Ministers Hashimoti, Obuchi, and Mori in 1995 and 1998: Rather than ask the legislature for straightforward recapitalization money, you have the political leadership preferring to risk overpaying current owners of toxic assets rather than forcing sales. For all of Japan’s supposed intervention in markets, its government still lacked the stomach for taking over banks, let alone closing them.
In 1998, Japan did get a reformer, Hakuo Yanagisawa, the first financial-services minister independent of the Ministry of Finance. He got a bank recapitalization under way—but did so without putting enough conditions on the capital, hoping to mobilize private investment and limit the number of bank nationalizations. I remember a dinner with him in Tokyo shortly thereafter, where he spoke with conviction about the need to be tough with the irresponsible banks, and how he was politically independent enough to be tougher than the bureaucrats had been, since he was an elected official running a new agency. Three years later, the Japanese banking system failed again, imperiling the economy, while having accumulated billions more in non-performing loans.
Only when Heizo Takenaka became the responsible minister in 2002 were Japanese banks forced to write down the value of the distressed assets before getting recapitalized. From that point forward, the Japanese economy began growing again, and within months, the worst of the Japanese banking crisis was resolved. In the meantime, a couple of Japanese governments had lost power, Yanagisawa had been replaced three times, and Japan suffered three more years of recession.
Takenaka was a brave academic economist unafraid to cite lessons from the U.S. and abroad and took strength from the personal support of the new reformist Prime Minister Junichiro Koizumi. At least as importantly, though, the failure of the Japanese banking system had become so evident and imminent that politicians had no choice but to do the right thing with public capital injections and some bank closings. It is as easy to imagine the candidates for the Takenaka role in the U.S. today as it is tempting to hope that Geithner’s current plan will work, albeit at excessive taxpayer expense. But I fear that until Congress gets the message, a lasting resolution of the U.S. banking crisis will not occur—and it may take the failure of the current plan to get that message across, as it did in Japan and elsewhere.
Adam Posen is the deputy director of the Peterson Institute for International Economics. Paul Krugman calls Posen “the go-to guy for understanding Japan’s lost decade.” He has been an adviser to the Federal Reserve Board, Japan’s Ministry of Economy, Trade, and Industry, the International Monetary Fund, the European Central Bank, and the Bank of England. He is coauthor with Ben Bernanke et al. of Inflation Targeting: Lessons from the International Experience.
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Lloyd Grove is editor at large for The Daily Beast. He is also a frequent contributor to New York magazine and was a contributing editor for Condé Nast Portfolio. He wrote a gossip column for the New York Daily News from 2003 to 2006. Prior to that, he wrote the Reliable Source column for the Washington Post, where he spent 23 years covering politics, the media, and other subjects.
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Jacob Bernstein is a senior reporter at The Daily Beast. Previously, he was a features writer at WWD and W Magazine. He has also written for New York magazine, Paper, and The Huffington Post.
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Jeff Madrick is a contributor to the New York Review of Books and a former economics columnist for the New York Times. He is editor of Challenge Magazine, visiting professor of humanities at Cooper Union, and senior fellow at the New School's Schwartz Center for Economic Policy Analysis. He is the author of Taking America, The End of Affluence (Random House) and The Case for Big Government.
There is an easier, cheaper, and faster way to solve the banking crisis which no one is talking about on Capitol Hill. If collateralized debt obligations (CDO's) are the problem, just get rid of them! Desecuritize them! Just convert them back into the underlying loans. There are $1.4 trillion in CDO's outstanding backed by Alt-A and subprime loans in the form of 3,700 individual securitizations of perhaps 3.7 million loans. Over 68% of the loans backing these bonds are current. Mark to market rules are forcing the banks to carry this paper on their balance sheets at 50%-80% discounts. The problem is that mark to market is a meaningless accounting fiction when there is no market. If you break up these securities and place the underlying loans back on the banks' balance sheets, the good mortgages can be valued at 100% of face, and those behind in their payments or in default can be discounted to maybe 70% because they are still secured by the value of the homes. This would boost the value of the entire asset class from the current 20-50 cents up to 90 cents on the dollar. Restored balance sheets would enable banks to resume lending. Of course it would be a massive admin job unwinding the rats' nests behind some of these securities, but Heaven knows there is abundant subprime and Alt-A expertise available for hire these days. Just sift through the ashes of Lehman Brothers and Bear Stearns. It is a workable plan, and therefore is unlikely to ever see the light of day.
It is inconceivable that the so called "toxic" assets are worthless. If only 5% of the home owners whose mortgages underlie these assets are bad, and the remaining assets after foreclosure, the property/houses, are worth at least 50% of their original value (once a house is foreclosed on there remains the property/bricks and mortar does there not?) that means we are only talking about a 2.5% problem! In addition the total value of housing in the world has declined by only 20% most (95%) of which has hit the homeowner NOT the banks! So what are we talking about here in terms of toxic assets?
If one separates out those Credit Default Swaps that represent wagers by unrelated parties, like some speculators and hedge funds and do not honor them (the most these holders should get back are perhaps the premiums that were paid for the policy)., one can hardly speak of "toxic" assets of catastrophic proportions!
The majority (95%) of homeowners is still paying their mortgage and interest monthly, therefore the owners, the financial institutions and banks, of the bonds that are backed by those mortgages are still getting paid, so where is the problem? Is this a confidence trick? If the toxic assets are worthless the rate of return on them from the holder's point of view must be infinite, because if you receive money on some thing that is worth nothing the numerator in the rate of return formula is zero thus the rate of return is infinite.
Alternatively it is nonsense to state that these assets are worth nothing because they have a steady stream of future cash/earnings. Net present value is a value that can be assigned to an instrument that has a stream of future earnings. So the assets are worth the equivalent of the net present values of the stream of their future earnings.
So is this where somehow the free market mechanism is failing us? The market theory says that if nobody wants to buy these toxic assets, there is no market for them and therefore the assets are worthless. So why does nobody want to buy these assets? Is there another problem that we somehow do not understand or are not being told about? Did the financial institutions overpay by such a huge margin for these assets that the damage is much greater than the 2.5% default problem?
I am probably simplistic and typically the obvious answer may not be the right one. In my opinion the collective financial brains are all frozen in a panic and are missing the obvious. It is inconceivable to me that an army of clerks is not capable of quantifying what is what and how much there is of each asset category and what they are worth. It almost seems to me that the real picture is being blurred deliberately and that everyone just keeps talking and arguing instead of getting on with a mammoth but not impossible job, i.e. categorizing and valuing the so called "toxic" assets.
Are we all being misled? Is there something sinister going on? I never trust any of my business colleagues when they say that they do not understand the extent of a problem, I always think that there is a hidden agenda somewhere when everyone feigns ignorance. Do not tell me that a financial institution which is used to dealing with constantly fluctuating markets is not capable of providing a reasonable estimation of what it has on its books.
Great article.
Why are we being so dense? Why is the administration not looking to history for any guidance whatsoever?
""Don't you understand? The money is gone. If you just wish for the banks' asset values to come back, any recovery will be short-lived and you will only get more losses in the end. We all know this from long experience."" ~ from the article
Exactly. EXACTLY! It's gone. The money is gone. Hell, it was never actually there to begin with! It's gone and it isn't coming back. Learn from your mistakes and move on!
When these various ideas were proposed I was skeptical but hopeful initially. A lot of smart people seemed to think the ideas were going to work. But after hearing and reading more about the Administration's plans I am becoming increasingly skeptical that what they are proposing will be successful. Actually, right or wrong, I had it figured out ever since this latest bubble burst that if we cut our losses {which I know are enormous-thanks Wall Street, et al.}, then we can impose tough regulations, eventually we will recover and this sort of thing shouldn't happen again for several generations. In other words, this entire mess, though unavoidable, is really a correction. We all have to take our medicine.
HOWEVER, if we give the wrong doers and the institutions themselves a bailout, if we resort to subsidizing graft, if we attempt to blow-up that bubble again by trying to go back to an economy & housing market based on inflated values & ridiculous consumerism, then the prosperity will come back, briefly, to be followed by a meltdown which will make this Great Recession look like a bad day on Wall Street.
I want to believe in this guy Geithner. In spite of the unfair bad press he's had on trivialities, like the way he speaks articulately in detail and doesn't have a colorful personality, he seems very intelligent, thoughtful, and to have the country's best interests at heart. And I have a great deal of confidence in President Obama, however, it looks to me {admittedly a layperson} and if I'm not mistaken to Paul Krugman and others, like the big plan here is to basically prop up a seriously reckless & flawed system.
The point is, there is going to have to be a long and painful price paid for all this nonsense. The question is when and to what degree. We can pay it now when it will be very bad for most, or we can pay it later when it will be catastrophically severe for EVERYONE.
I'm truly not prone to doom & gloom speak, but I honestly feel that this will get us through the next few years, but the next time the bubble bursts there will be no recovery within our lifetimes. Imagine the sort of calamity it would be for such an interconnected world armed to the hilt to face a Great Global Depression, where the world's richest, most powerful nations went completely bankrupt... Civilization as we know it and likely democracy in general would not survive.
Ok. Now I need a drink.
I have friends who have put thier money on a cyclical recovery begining this year. They are buying equities, they are sanguine about real estate. The US is not Japan and never has been: very different cultures, very different savings rates. With all due respect to academic economists, I prefer to bet on the opinions of experienced people who risk THEIR OWN money when they take a position. It comes down to this: if real estate values continue to decline, which Krugman and crew are assuming, then many CDO tranches ie. the toxic assets held by the banks are indeed going to be worthless. However there is the distinct possibility that real estate values will stabilize at which point Messrs. Krugman & Co. will have been relentlessly and needlessly negative at a very vulnerable time. What Krugman really seems to want is to decapitate the financial services industry, because they are bad people in his opinion and to wipe out thier stockholders because they had it coming for not understanding the under pricing of risk that was the basis this problem. Fine let him go viral in the blogosphere every two minutes, but if he had his way the DOW would probably drop another 2000 points and people migt wake up tomorrow unable to cash thier paychecks or use their ATM cards.
@ just-the-facts-mam
I used to sing
Along with
'Hey Paul Krugman'
On You Tube
Now
I'm feeling
Your post
And thinking
This Obama
Guy
Is deep.
The whole administration are over their heads in the problems of Washington. And I don't want to hear it wasn't on Obama's watch. Ask Barney and Chris when the banking problem started.
Adam, great article - who doesnt remember American economists yielling at the Japanese.. .
Restoring the banks is probably key but not the entire solution. The shadow banking system is in paralysis and this is frightening when looking at how big that market was. Declining lending will remain a drag on growth in the quarters ahead. Lending statistics reveal that current levels in lending will not be sustainable. An indication of a continuous reduction in lending comes from money statistics. The broad money aggregate can be seen as total deposits in the banking sector. The "gap" represents the difference between broad money and lending to the private sector. Selected economists estimate a 50% lending gap/GDP for the UK and only 18% for the eurozone. In the US the gap is much wider potentially close to 180% of GDP. The trend has been rising for the past 15 years, which is not surprising given the US economy has always been more leveraged. Despite foreign money still piling into the US dollar and Fed facilities to support lending in the months to come, lending will need to shrink. While the potential shrinkage of lending is troublesome, fiscal and monetary stimulus is expected to deliver some support to growth, particularly in the second half of 2009. But the net effects still point to very lackluster growth in the quarters ahead...
Is there a Plan B? what a stupid question followed by some very stupid comments.
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I certainly hope he does; because, while I like Geithner, I don't know if I agree with his strategy for overcoming this. Nationalization looks increasingly like the most viable option.
Hopefully we can turn this economy around and actually focus on solving the deeper, systemic issues for why we're in this situation. Obviously bad banking's a good place to start, but there are other issues, like global poverty, that have huge economic and geopolitical ramifications.
The Borgen Project (www.borgenproject.org) has some interesting insight into addressing the issues of global poverty, something we can remedy easily and sustainably.
Some interesting figures to ponder:
$30 billion USD: The annual shortfall to end global poverty.
$550 billion USD: The annual US defense budget.
I think Krugman and some of these guys are still just irked because none of them got the job.
@Uberjeff
In the
2008 election
Krugman leaned
First towards Edwards
And then
Hillary
It's hard to sort out
How much of
The dispute
Is economic.
vankuyk writes:
"Did the financial institutions overpay by such a huge margin for these assets that the damage is much greater than the 2.5% default problem?... Are we all being misled?"
Yes.
The money we gave the banks is gone because it isn't about toxic assets. That implies a "thing." It implies that the CDOs simply need to be cut apart, and organized properly, and all will be well.
This is not the same as the Japanese banking crisis. This is not like the Swedish one. This catastrophe was whipped up by computers and leverages of 32 to 60 some-odd were applied -- and sold all over the world.
This financial system has evaporated. But Geithner is heroically trying to jump start it with a fabulous, almost riskless deal -- greed bait.
We can only hope it works.
I feel it won't. But once again, this is not Japan and I think we can come up with a workable solution quicker than they did -- though our political system needs to have it's "come to Jesus moment" before anything significant can be enacted.
I believe Posen is handing out too much credit to Takenaka and Koizumi. The forced writedown of the dubious assets on Japanese banks' balance sheets had not much to do with their growth after 2003. It simply coincided with the onset of the Bush bubble, and the resurrgence of a property boom in Tokyo. Geithner's plan seems to be an all-out gamble on another bubble..
Are we all being misled? Is there something sinister going on?
Two things I'd like to know:
1. Can we really de-securitize these loans? I'm hearing lots of anecdotal cases where the contracts cannot be matched to actual loans/houses.
2. How much of the underlying value is based purely on the expectations that the loans COULD be securitized? If it merely mimics what does have value (a Palm Springs address, eg, but in an area where it could only be traded for a balloon payment far enough in the future to be securitized, we may have a lot of property that is NOT worth much, and the near zero market value may in fact be real.
Mr. Posen,
Isn't this rather self-serving? Are you being a revisionist?
How could you have missed that the bank resolution via public funds was deterred from Aug. 1992 (the opposition from big business leaders), political opposition since 1993 (less from the right but from the left -- see my blog in Krugman's page) and the public outcry after Jusens were closed down via public funds and banks' debt forgiveness in 1996?
You pushed for inflation targeting when the BoJ was purchasing long-dated JGBs even prior to Nov. 1997.
You then pushed for fiscal stimulus when massive amount of money was in the pipeline -- indigested from three extra stimulus packages and when local governments were screaming that they could not spend so much money.
You did not push for bank resolution until well after it was a sweeping consensus among any educated Japanese.
You failed to understand that most intelligentias and officials knew all along that bank workout/resolution was a precondition for a self-sustaining economic recovery from Aug. 1992.
When you yelled at the Japanese to clean up the banking mess, you just proved how naive you were.
I am a keynesian very much in favor of fiscal stimulus. But Japan's current oversized national debt is a result of a policy error -- helped by Washington's demand.
Japan spent massively in the late 1980s to mitigate the adverse impact of the yen's surge and to rectify the bilateral trade imbalance under the US-Japan trade negotiations -- yes, Japan's public works spending was on the agenda as it was perceived to increase imports from the US.
The liberalization of three-storey wooden houses was also part of that deal -- helping fuel Japan housing boom of the late 1980s.
After Miyazawa faced the opposition for the use of public funds, Japan overcompesated by macroeconomic measures, pretended the problem was going to be solved via macroeconomic measures. The US Treasury Dept. pressured for massive fiscal spending throughout 1990s so did most economists, both in Japan and abroad. Unfortunately, this gave an illusion that bank workout was not needed. You helped in this illusion as many other economists.
MSS
You claim of too much time taken for the stress test is wrong. Taking two months to check every complex transaction -- both on and off balance-sheets -- of 25 or more banks is time consuming.
If the test takes only a few weeks, I would not trust the results.
MSS
Thank you.
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