Taunter Media

Crossposted at DailyKos

The Congressional Oversight Panel has released its report on the first six months of TARP, and it is worth reading.  Actually, at 151 pages – including John Sununu’s dissenting opinion that the report is too long, thoughtfully included as an appendix – it’s worth getting to the highlights:

The total value of all direct spending, loans and guarantees provided to date in conjunction with the federal government’s financial stability efforts (including those of the Federal Deposit Insurance Corporation (FDIC) as well as Treasury and the Federal Reserve Board) now exceeds $4 trillion.

Well, that’s a lot of money.  What was the guiding strategy?

This is the fifth TARP oversight report of the Congressional Oversight Panel. In our first and second reports, we asked the question, “What is Treasury’s strategy?” In the absence of a clear answer to that question, in our third report, we looked at whether Treasury’s programs produced a clear value for the taxpayer by valuing the preferred stock that Treasury had purchased using TARP funds.

…

In a letter sent on April 2, 2009, Secretary Geithner provided the Panel with a description of Treasury’s strategy for combating the financial crisis.

Glad we got around to it.  On the other hand, we made it through six months without one and it only cost us $4 trillion; maybe we should just keep going.  Anything noteworthy about what Treasury is up to?

this approach assumes that the decline in asset values and the accompanying drop in net wealth across the country are in large part the products of temporary liquidity discounts due to nonfunctioning markets for these assets and, thus, are reversible once market confidence is restored.

Ah, yes, it is all in our minds.  If we happen to look at house prices in the desert southwest, or employment in Michigan, or bank balance sheets in New York…

The real problem here is one of transparency.  Treasury seems to believe that everything will be fine unless we worry, so it won’t tell us anything and we can cheer a rising stock market and go along our merry way.  It doesn’t want to force major bank write-downs, or let us see where the money is going, because it wants to be able to operate in darkness.  Confusion is a core part of the strategy.

In the words of Willem Buiter:

Governments everywhere are doing the best they can to delay or prevent the lifting of the veil of uncertainty and disinformation that most banks have cast over their battered balance sheets. The banking establishment and the financial establishment representing the beneficial owners of the institutions exposed to the banks as unsecured creditors – pension funds, insurance companies, other banks, foreign investors including sovereign wealth funds – have captured the key governments, their central banks, their regulators, supervisors and accounting standard setters to a degree never seen before.

As the COP report points out, this is exactly the opposite of the successful elements of every other financial crisis resolution:

Transparency. Swift action to ensure the integrity of bank accounting, particularly with respect to the ability of regulators and investors to ascertain the value of bank assets and hence assess bank solvency

Assertiveness. Willingness to take aggressive action to address failing financial institutions by (1) taking early aggressive action to improve capital ratios of banks that can be rescued, and (2) shutting down those banks that are irreparably insolvent.

Accountability. Willingness to hold management accountable by replacing – and, in cases of criminal conduct, prosecuting – failed managers.

Clarity. Transparency in the government response with forthright measurement and reporting of all forms of assistance being provided and clearly explained criteria for the use of public sector funds.

The lack of transparency brings to mind AM Rosenthal’s observation during the Mexican bailout:

This Clinton-Mexico affair reminds me of the time a fellow editor came up to my desk in the newsroom, put a piece of paper in front of me and told me to sign it. When I asked why, he said I was to be his co-signer on a loan.

You can understand I did not want to be crude but I did ask how much as I was writing my fool name. He looked at me, coolness trembling on disdain, and then picked up the signed paper. As he walked away he said over his shoulder: “Bad form, old boy, bad form.” Well, I was ashamed of myself and didn’t get up and snatch the paper back.

The Treasury is counting on complexity to keep the public from understanding, and shame at lack of understanding to keep the public from challenging their decisions.  Read a few Daily Kos diaries and smart political activists will say things along the lines of “no one understands this stuff anyway, I like Obama, the government has experts, this must be the best solution.

There is no need for this.  Financial institutions are complicated, but not overly so – every year a new crop of Wall Street analysts has to be taught, and they are not particularly brilliant.  There are some counterintuitive wrinkles – a deposit is a liability, no matter how much you want to think it is a good thing and should be hanging out with the assets – but if you look at is as a whole, it makes some sense.  Besides, I once was asked by a board member if I could redo a presentation so positive and negative numbers meant “good” and “bad”.  He made millions of euros on that deal, so I guess he had the last laugh.

So let’s start with something pretty basic.  As folks from Jerome to Krugman have pointed out, there is no such thing as a “toxic” asset, at least in the sense of an asset that can infect something else (there are “toxic” liabilities – any asbestos exposure, however small, for example, will drive a company into bankruptcy).  In fact, for any given asset value, the only question is to whom the value is pledged.

In most cases, this is a happy problem.  The assets exceed the liabilities (the people whose pledges are expressed in fixed dollar amounts), and the equity (the people who get everything left over) make some money.  In some cases, however, the assets are worth less than the liabilities.  In these instances, not everyone can be paid everything he is owed.  Either some will get out whole and others not at all, or everyone will get a discount.  There just isn’t enough to go around.

Note that this doesn’t say anything about the morality of the liabilities.  In most cases – sit down, AIGFP – the liabilities were entered in good faith, and folks ought to be repaid.  There simply is not the asset value to do so.

The importance of a court-ordered restructuring program – call it “bankruptcy”, call it “Chapter 11″, even call it “Chapter 7″ – is that the value that does exist is allocated equitably.  Without a program to compel all the liabilities to get in a room and assert their claims simultaneously, you end up with a situation where the priority of payout is determined by the historical fact of whose payment was scheduled first.  But we have already established that the historical promises cannot be sustained.  We need a way to make sure that payments don’t leak from the folks we would like to receive the money to people who have a good, but not as good, claim and just happen to be first in line.

This is where we come to the good bank strategy for financial institutions – the Bulow Plan, or the Hall-Woodward-Bulow Plan.

Lots of numbers and some unfamiliar terms.  But here are the basics:

• The good bank takes with it the bank’s name, employees, branch locations – all the attributes of the going business.
• It takes enough good assets to both cover all of the deposits (remember, deposits are borrowings from you and me) and leave a strong “leftover” cushion of equity.  It is, by any definition, a well-capitalized bank.  We can be confident and go about our business.
• The bad bank no longer serves retail customers.

If Citi’s reported asset values are accurate, everyone is unaffected.  If Citi’s reported asset values are too high, the existing equity and bondholders are impaired to exactly the same amount as if the company failed and went into bankruptcy.  If Citi’s reported asset values are too low, the existing equity holders make an enormous amount of money (hardly likely, but God bless them if it happens).

So why push this?  Well, as things stand today, we are stuck when we deal with Citi.  We have promised to protect the depositors, and one of the things we wish to avoid is a bankruptcy of the holding company that sets off a panic as people wait for the FDIC to seize the subsidiary.  We are de facto protecting the bonds, but those bonds yield more than Treasuries and are getting a free ride if we take responsibility.  And we have the management of an incredibly levered organization that acts on behalf of an equity register that represents a tiny percentage of the enterprise’s capitalization.

By splitting the institutions we separate out the depositors, who are the only people we are duty-bound to protect.  For the rest, we may choose to invest or not, we may choose to subsidize or not, but we don’t face the threat of the collapse of a retail institution.  In fact, we can let the bad bank fail and shore up pension funds or insurance companies who are hit at our discretion – we don’t have to offer the same deal to all parties.  And whatever we do, it will be visible.

The same logic applies to AIG and GM, by the way.  They are very different companies, of course, but the principle of arranging a transparent intervention should hold.  In AIG’s case, we could nationalize the domestic operations (P&C, life, and asset management) to avoid any sort of panic, let the foreign subs get nationalized by their various regulators, and then let AIGFP and the rest of the operation file for bankruptcy.  We could simultaneously offer a standard term sheet to any American financial institution that felt it was affected, wherein we would inject capital for debt+warrants.  Instead of endlessly bleeding out capital to whoever was lucky enough to have his CDO mature earlier than some other guy’s, we would see the totality of the obligations and allocate capital in one go as the taxpayer sees fit.

At GM, taking the company into bankruptcy does not mean blowing up the factories or making the workers forget how to assemble.  It means restructuring the business so the operating company can stand on its own two feet, free of a dealer network it cannot support, bonds it cannot service, and pension and VEBA obligations it cannot honor.  It also means that we can target all of our taxpayer dollars to helping impacted workers, instead of squandering those dollars on supply deals that no longer make sense and dealer support that might never have made sense.

We won’t know until we unwind the massive zombie companies and can deal with each stakeholder independently.  This transparency should be our goal, and something that can be clear and supportable regardless of financial training.

To go back to COP:

Regulators permitted lax accounting practices that allowed banks to book the value of their loan assets based on how much they could spare within the capital adequacy ratio. The real financial condition of the borrowers was seldom accurately reflected on the bank balance sheet. The same borrower could have different credit ratings from different banks depending on the level or risk each bank could sustain. Such accounting machinations were tolerated in part due to their political consequences.

When Japan tried to lie its way out of its problems, we told them it would never work, and it did not.  We should have at least as much courage as we urged on them two decades ago.