DeansTalk

Selection of posts:

Welcome to the Treasury Amateur Hour, Tuesday, February 10, 2009

So our new Treasury Secretary comes out after having plenty of time to work out some details, and what do we get?

More uncertainty. Just what the markets and the economy need.

There is a beast in the room, and nobody wants to move because they don't know which way the beast will run. The beast of course is the Federal Government, doing their best to avoid the laws of unintended consequences.

A few quotes from the Wall Street Journal's story are very illuminating:

"But critical details of the plan remained unanswered, despite the weeks of planning leading up to Tuesday's announcement."

"Mr. Geithner said the plan to stem foreclosures would be announced in coming weeks."

"He also provided few details of the asset-purchase plan, which is designed to be done in partnership with the private sector."

"The absence of detail speaks to the thorny issues that lie at the heart of the financial crisis: how to value the toxic assets causing banks to report losses and how to shuffle aid to homeowners and stem the rise of foreclosures."

OK, these are not new issues.

The Government has two choices: One, come up with a credible and specific plan to buy toxic assets from financial institutions and support the ones that become insolvent as a result of having to take losses on the sales. Or two, step aside, and let natural market forces restore equilibrium.

Right now, the Government is effectively blocking mutually beneficial trades from taking place. Who wants to argue that financial institutions are the natural holders of these risky mortgage assets right now, instead of private investors? They never should have had such a concentration in the first place, so let's get on with the business of transferring that risk to those who are most willing and able to bear it...

The 2004 Banking Leverage Rule Change, Monday, February 09, 2009

We can expect a lot of revisionist history in the next several months, as policymakers and pundits attempt to spin the historical record to fit their interests.

We had a speaker at Tuck today who mentioned the SEC's 2004 rule change, which eliminated some leverage restrictions on investment banks in favor of capital requirements by type of asset as well as more reliance on self-regulation and reporting to the SEC. A good reference for a similar story is here in the NYT.

I have been meaning to look into this "smoking gun" for some time as it did sound intriguing. Of course, the headline is usually something like the NYT's: "Agency's '04 Rule Let Banks Pile Up New Debt." The subheading is, naturally, that we need more regulation not less and that the Bush administration was at fault.

Now there might be some issues about regulation of the banks, and I myself am very surprised at how poorly market forces seemed to enforce reasonable behavior on the part of the banks. Like Alan Greenspan, I have I guess a nostalgic view of how self-regulation should work (well).

But as to the story on the 2004 deregulation -- it simply does not hold water. I pulled out the Bear Stearns 2003 and 2006 annual reports -- before and after the regulatory change, but before falling asset prices caused an endogenous increase in liquidity.

In 2003, Bear had an overall leverage ratio of 26.4, and a net adjusted leverage ratio of 12.4. In 2006, the respective numbers were 26.5 and 13.6.

Do you think the NYT reporter could have looked that up and told us as well?

TARP: Take Two (Hopefully in Earnest This Time!), January 21, 2009

It appears that the core of the original TARP idea is being resurrected: buying bad assets and securities from banks and putting them into a government-controlled vehicle with the intent of reselling at a later point. From the WSJ over the weekend:

"The U.S. government, recognizing that the banking crisis is far larger than originally thought, is laying the groundwork for a second phase of its rescue attempt, with plans to purge bad assets that are paralyzing the financial system.

Officials at the Treasury, Federal Reserve and Federal Deposit Insurance Corp., in consultation with the incoming Obama administration, are discussing a plan to create a government bank that would buy up the bad investments and loans that are behind the huge losses that U.S. banks continue to report, say government officials."

How is this different from the first incarnation of TARP? Well, even less detail on how the bad assets would be acquired -- at least Paulson had the idea of using an auction -- and also now there is talk of creating a government bank.

So leaving out talk of an auction and introducing the sketchy idea of a "government bank" makes things better (does a government bank take deposits from anyone other than the Fed?)

The allure of injecting equity was the idea of leverage: if we put $100 of equity into a bank, and they are leveraged 10 to 1, then we will get $1,000 of new loans made. Ah, but where does that $900 of capital to lend out come from? With toxic assets on the balance sheet, no new lenders want to throw new funds into the pot that will just go to protect all the existing creditors and equity holders. Indeed, judging from the last few months, the equity injections by themselves have done very little to create more lending.

The balance sheets of the banks have to get purged of the assets that are currently so hard to value. That was the genius behind TARP, and could still be implemented. I bet that we will soon see something very similar to the Resolution Trust Corporation. Hopefully we will not have to wait for banks to actually fail to get assets into the new institution. Talk to some auction theorists and get those auctions moving to buy assets from solvent but illiquid banks, put them into a new RTC, re-securitize them (this time with only one class of pass-through certificates) and return the profits to the taxpayer.