Why Obama’s New Tarp will fail to rescue the banks
By Martin Wolf
Published: February 10 2009 18:06 | Last updated: February 10 2009 18:06
Has Barack Obama’s presidency already failed? In normal times, this would be a ludicrous question. But these are not normal times. They are times of great danger. Today, the new US administration can disown responsibility for its inheritance; tomorrow, it will own it. Today, it can offer solutions; tomorrow it will have become the problem. Today, it is in control of events; tomorrow, events will take control of it. Doing too little is now far riskier than doing too much. If he fails to act decisively, the president risks being overwhelmed, like his predecessor. The costs to the US and the world of another failed presidency do not bear contemplating.
What is needed? The answer is: focus and ferocity. If Mr Obama does not fix this crisis, all he hopes from his presidency will be lost. If he does, he can reshape the agenda. Hoping for the best is foolish. He should expect the worst and act accordingly.
Yet hoping for the best is what one sees in the stimulus programme and – so far as I can judge from Tuesday’s sketchy announcement by Tim Geithner, Treasury secretary – also in the new plans for fixing the banking system. I commented on the former last week. I would merely add that it is extraordinary that a popular new president, confronting a once-in-80-years’ economic crisis, has let Congress shape the outcome.
The banking programme seems to be yet another child of the failed interventions of the past one and a half years: optimistic and indecisive. If this “progeny of the troubled asset relief programme” fails, Mr Obama’s credibility will be ruined. Now is the time for action that seems close to certain to resolve the problem; this, however, does not seem to be it.
All along two contrasting views have been held on what ails the financial system. The first is that this is essentially a panic. The second is that this is a problem of insolvency.
Under the first view, the prices of a defined set of “toxic assets” have been driven below their long-run value and in some cases have become impossible to sell. The solution, many suggest, is for governments to make a market, buy assets or insure banks against losses. This was the rationale for the original Tarp and the “super-SIV (special investment vehicle)” proposed by Henry (Hank) Paulson, the previous Treasury secretary, in 2007.
Under the second view, a sizeable proportion of financial institutions are insolvent: their assets are, under plausible assumptions, worth less than their liabilities. The International Monetary Fund argues that potential losses on US-originated credit assets alone are now $2,200bn (€1,700bn, £1,500bn), up from $1,400bn just last October. This is almost identical to the latest estimates from Goldman Sachs. In recent comments to the Financial Times, Nouriel Roubini of RGE Monitor and the Stern School of New York University estimates peak losses on US-generated assets at $3,600bn. Fortunately for the US, half of these losses will fall abroad. But, the rest of the world will strike back: as the world economy implodes, huge losses abroad – on sovereign, housing and corporate debt – will surely fall on US institutions, with dire effects.
Personally, I have little doubt that the second view is correct and, as the world economy deteriorates, will become ever more so. But this is not the heart of the matter. That is whether, in the presence of such uncertainty, it can be right to base policy on hoping for the best. The answer is clear: rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a “no brainer”.
The new plan seems to make sense if and only if the principal problem is illiquidity. Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers. Indeed, any toxic asset purchase or guarantee programme must be an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions: ineffective, because the government must buy vast amounts of doubtful assets at excessive prices or provide over-generous guarantees, to render insolvent banks solvent; inefficient, because big capital injections or conversion of debt into equity are better ways to recapitalise banks; and inequitable, because big subsidies would go to failed institutions and private buyers of bad assets.
Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing. Trying to make up for this mistake by imposing pettifogging conditions on assisted institutions is more likely to compound the error than to reduce it.
Assume that the problem is insolvency and the modest market value of US commercial banks (about $400bn) derives from government support (see charts). Assume, too, that it is impossible to raise large amounts of private capital today. Then there has to be recapitalisation in one of the two ways indicated above. Both have disadvantages: government recapitalisation is a bail-out of creditors and involves temporary state administration; debt-for-equity swaps would damage bond markets, insurance companies and pension funds. But the choice is inescapable.
If Mr Geithner or Lawrence Summers, head of the national economic council, were advising the US as a foreign country, they would point this out, brutally. Dominique Strauss-Kahn, IMF managing director, said the same thing, very gently, in Malaysia last Saturday.
The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new “good banks”, leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new “bad banks”, leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic.
By asking the wrong question, Mr Obama is taking a huge gamble. He should have resolved to cleanse these Augean banking stables. He needs to rethink, if it is not already too late.
Copyright The Financial Times Limited 2009
For all those who constantly talked about how much a failure George Bush was, it is too bad those same folks aren’t going to be so critical of President Obama. If he was not aware of the status of the country and is acting like he had no idea of what he was getting into then he surely isn’t going to be the President we need to get things done.
I couldn’t imagine if we had been attacked Domestically or if we are attacked in the next 1 to 4 years. This is exactly what Osama Bin Laden talked about in the video after 911, the US will be brought down by economics.
It is amazing that Anonymous could see this coming. Written on Feb 13th 2008
Anonymous on 13 Feb 2008 at 9:18 pm
“This is the status quo if I have ever heard it. If he is able to make the changes he proposes in his last few speeches Washington will have to move to France. It sounds good and I really do hope that changes are made in Washington however the Lobbyists, aren’t going anywhere. Congress, and the Country Club, I mean the Senate, are in control of what things happen in Washington. Even if he is able to get all of those club members to go along with his proposals your tax dollars are going to fly out of Washington like chips out of a Mobark.”
“Who is going to pay for all the irresponsibility of individuals? You, me, the government, you and me. I am cashing in my certificates taking my cash and digging a hole. Punish Corporations, punish wealth, punish achievers, and reward single moms working at Dunkin Donuts with some story that sounds like bad decision making. Invest in teachers and the educators that have put us exactly where we are in the first place. This is where Barack is making a plea to the NEA. Why does Barack refer to the single moms like they are the only women out there having a hard time growing with life and making decisions? Try not being a single mom and think a bit before you, well.”
“Give, give, give. Give to the people in New Orleans that weren’t smart enough to come out of the rain much less rebuild a city. It wasn’t an Epiphany of only George Bush to know days before Hurrincane Katrina hit it was going to be a huge storm. If they weren’t smart enough and prepared enough to find alternate means of getting out then why should we invest in that kind of mindset? Harsh as it might seem tough love isn’t ever easy, ask Barack. Super Obama is going to fix it by giving money to inept people, doing inept things, and he will have a Bureaucrat report directly to him and that will make it all better. Just give needles and heroin to an addict and hope they all act like good citizens and don’t use it. Barack will be in meetings for his entire Presidency just to keep up with all the people who are going to have to report to him personally regarding the status of every program of every department, county by county, city by city, state by state.”
“The talk of free, education, free health care, increased minimum wages to keep pace with inflation; Look, these are personal responsibility decisions of every persons life and the Government of Barack Obama isn’t going to fix this. I agree Health Care is expensive but the cost is not the reason people don’t buy it. They expect people like Barack Obama to come along and give them something while they have cell phones, big screen tv’s, gold chains around the neck and spinner wheels on their car that cost as much as a yearly policy. They go on trips, hang out at the Mall buying high priced goods on a 18+% credit card then claim we need Credit Card Policy Reform. In the future I will opine with specificity about his plan for Education Funding, Tax Credits, Alternative Minimum Tax Rates, Minimum Wage Increases, and the Incentives he proposes for Industry. Finally it amuses me to here such a brilliant individual propose Oil Independence. Saudis get ready Barack is going to turn off the Oil Faucet and Americans get ready to experience a major shift in the utilities you are currently paying. Now that I think about it wind is free.”
“I want a utopia just as much as the next guy but also realize the entrenched mindset and tradition Washington and Politics has. Politics has become a lucrative occupation and as long as there are millions and billions of dollars on the line it will be the Status quo.”