There's Virtue In Geithner's Vague Bank Plan
At least he doesn't want to guarantee more bad debt.
By MATTHEW RICHARDSON and NOURIEL ROUBINI
On Jan. 27, Bank of America sold a whopping $6 billion of three-year notes at a yield of 2.2% -- a good 3.5% less than what its other bonds of similar maturity were trading for. How did it manage this feat?
For a mere fee of 0.75%, BofA accessed the FDIC's Temporary Liquidity Guarantee Program, which backs all bank debt of less than three-year maturity with the full faith and credit of the U.S. government. In essence, they got to issue debt at government rates.
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Since the program started last Nov. 25, BofA has gone to the well 11 times for a total of $35.5 billion. Other banks have lined up 91 times for a staggering $168 billion. They include GE Capital ($27 billion), Citigroup ($24 billion), J.P. Morgan ($19 billion), Morgan Stanley ($19 billion), and Goldman Sachs ($15 billion).
Feelings about the liquidity guarantee program weren't always so rosy. On Oct. 31, 2008, the law firm Sullivan & Cromwell wrote the FDIC on behalf of nine banks, arguing that the government program to back the bonds of financial firms did not provide strong-enough guarantees. The letter asked that the guarantee cover principal and interest payment obligations as they became due, backed by the full faith and credit of the U.S. government. The guarantee was included three weeks later when the final rule was issued. No prize for guessing which banks signed the letter.
The government's motivation for this program is to get banks back in the lending game. But in an economic and financial crisis, we want healthy banks to lend to creditworthy institutions and individuals, not for unhealthy banks to take another flyer on credit spreads.
There is, however, a remarkable coincidence between the banks with the largest writedowns -- one measure of sickness -- and those accessing the FDIC program.
It's not as if we haven't seen this before. On Sept. 7, 2008, the government put Fannie Mae and Freddie Mac into conservatorship. They were bankrupt because of an accumulated portfolio of $1.5 trillion worth of mortgage-backed securities, of which $225 billion was subprime mortgages and the other $1.275 trillion were illiquid prime mortgages.
While some of Fannie and Freddie's portfolios were hedged against interest rate movements using interest rate swaps, the subprime portion was an outright bet on default rates of low quality mortgages. How much cushion did they have? Only $1 of capital for every $25 of debt. What type of crazy creditor would lend to them? Almost anyone, because the debt had the implicit, now explicit, guarantee of the U.S. government.
With the economic dangers we now face, do we really want to go down this road again?
We don't, and that's why, for all the criticism, Treasury Secretary Tim Geithner's plan -- call it Bailout 2.0 -- does have a silver lining. It stops the madness.
Yes, Bailout 2.0 lacks details, but it is clear it won't propose more bank freebies -- no new loan guarantee programs or backstops of losses on their bad assets, or government capital infusions in the form of underpriced preferred shares. Now the banks will have to prove themselves via a "stress test" on their solvency to access new capital. It won't be a pretty picture.
And by the way, if banks want Uncle Sam to buy all those "toxic" assets, the government is now going to do it alongside private capital. These investors aren't going to overpay, so that game is up as well.
Since Mr. Geithner's plan has been unveiled, the stock prices of the financial sector are off about 19%. This is not necessarily a bad thing. The banks were expecting another handout.
While it was not his intention, the reality is that Mr. Geithner is going to confirm the insolvency of the financial system. Once we face this truth, there really isn't much left to do but nationalize.
We are not talking about the government operating the banks for the long-term. But, as was done in Scandinavia in the early 1990s, we are talking about orderly clean up, then reselling the banks to private investors.
The good news is that much of the risk will be borne by the banks' common and preferred shareholders and their long-term unsecured creditors -- as opposed to by taxpayers. This makes sense since shareholders and creditors were the ones who bet on banks in the first place. We'll also stop repeating the mistakes we made with Fannie and Freddie.
Messrs. Richardson and Roubini are professors who have contributed to the NYU Stern School of Business book, "Restoring Financial Stability: How to Repair a Failed System," forthcoming by John Wiley & Sons.