Category: Banking Crisis

 The lending performance of Irish and other European banks might be improved by the creation of asset management companies to absorb banks’ toxic assets and replace them with cash or near-cash assets.  The types of toxic assets held by banks differ across European countries; they are mostly bad property loans and collateralized-mortgage-based securities.   

There will be a considerable decrease in banks’ accounting book value when it sells toxic assets for cash value since the toxic assets are being carried on the banks’ accounting books for more than their true market value.  The decrease in accounting book value, which will come out of the banks’ book value of equity, has to be modest enough so that the banks are not declared insolvent after the transaction.

The Geithner plan offers a valuable template for Europe in designing a toxic asset transfer scheme. The Geithner plan invites private firms to bid competitively for the toxic assets of US banks. The funding for the bids come from three sources: equity provided by the bidding firm of 3% to 10% of total capital provided, an equal amount of equity funding provided and owned by the US government, and a non-recourse US government loan for the remaining 80-94% of capital provided.  The required yield on the nonrecourse loan will be somewhat underpriced  relative to its risk, so there is some degree of subsidy.  This is necessary to make the plan work; this entire subsidy should in theory accrue to the selling bank and shore up its capital base.  This is the only subsidy in the plan.

Since the US government will own up to 97% of the asset management companies’ assets, there is considerable financial/administrative/legal expertise needed by the government to provide reasonable oversight of these asset transfers and subsequent management of the assets.  This could make such a plan problematic if implemented by Ireland on its own.  Also, it is critically important that there are multiple bidders, competing aggressively against each other in the toxic asset auctions.   Additionally, the nonrecourse loan must come from a government entity borrowing at risk-free rates (and then lending to the asset management company at a higher rate).  It is a clever type of “targeted quantitative easing” (my own term).  Ireland is not in a position to borrow vast sums to purchase the toxic assets of its own banks.  The targeted quantitative easing should come from the sovereign issuer of our currency.

This is a great opportunity for the European Central Bank to play a role as a true regional central bank.  It can easily provide the non-recourse debt in a European version of the Geithner plan.  National governments can be responsible for the matching equity investment, and the ECB can provide the oversight, along with national governments.  Implementing the Geithner plan in Europe would also appease the US government which wants to see some burden sharing by European governments in dealing with the credit-liquidity crisis.

Krugman feels that the Geithner plan, although moving in the right direction, is too weak to be effective. However if the EU joined the US and instituted a very similar plan there might be a positive-feedback effect on confidence and liquidity which could boost the global impact.     

Calculated Risk links to video of Austan Goolsbee of the White House Council of Economic advisers, discussing how the Geithner plan aligns the incentives of the public and private sector participants.  I had dubbed this idea a fib but Goolsbee makes it sound plausible: “if the private guy makes money, the government makes money. If the private guy loses money, the government loses money.”   CR links to an example that explains how this plan could still see the private guys make money and the government lose money but it doesn’t explain how the price gets set, which is sort of the crucial issue.  So, here’s a simple numerical example that shows how the price gets set.  The point is probably pretty obvious, but I found it self-instructive to work through the figures.

According to the New York Times, pools of distressed mortgage-related assets of US banks have been 30 cents bid, 60 cents offered, in recent weeks. The bidders are hedge funds, the potential sellers under-capitalised, but State-guaranteed, US banks.

The Geithner plan appears to include a new type of investment vehicle with capital structure 3% private equity, 12% taxpayer equity, and 85% debt, also provided by the taxpayers. The holders of the 3% private equity would provide management and would bid for the distressed assets at auction. The expectation is that they would bid more than 30 cents on the dollar, thus improving banks’ balance sheets.

If the State equity is fully participating, it changes nothing from the standpoint of the fund manager. Only if the 85% debt is available at terms better than debt currently available to the hedgies (who will bid no more than 30 cents) can the plan work. The NY Times says that the 85% debt will be non-recourse, which certainly helps, and that it will be ‘cheap’, details to follow!. If it is provided at anything close to T-bill rates or short Treasury note rates, it’s a steal, and the Geithner hedge funds will of course bid more than 30 cents. I suspect that 85% non-recourse lending to distressed-asset hedge funds is not available at non-stratospheric prices right now. This is not a certainty-equivalent game since nobody knows the true value of the distressed assets, but cheap, non-recourse leverage will improve the bid price for any plausible distribution of returns.

The government could achieve the same objective by lending cheap non-recourse money to existing hedgies, unless I am missing something. But this would lack opacity. The critical economic component in all of these plans (including bad banks and insurance schemes) is the distribution of gains and losses. The critical political components appear to be fig-leaf involvement of private equity, the avoidance of overt nationalisation, and non-transparency.