The US government must take risks

Posted by Charles Calomiris on 20 February 2009

Tim Geithner, US Treasury secretary, has his work cut out. Any successful plan to revive the financial system will have to raise banks’ asset and stock values, but helping banks is unpopular. Neither Republicans nor Democrats in Congress seem excited about spending money helping banks. And some in the Obama administration probably are counselling the president against taking the political risk of helping Wall Street. Many in the electorate are incensed by the idea of propping up banks and exposing taxpayers to risk of loss.

The political temptation for the president and Congress is to pretend to try to revive the financial system, but not really try to do it - that is, announce a “pretend plan.” A pretend plan would dribble funds out tentatively, take little financial risk and make sure the price tag for taxpayers is low, while making speeches about the need for consensus, transparency and accountability, and the need for “protection” against abuse by banks.

Concern about the political will of Congress and the administration to support assistance to banks explains the market’s negative reaction to Mr Geithner’s speech. The market tanked after his speech because of what he didn’t say. The market saw a lack of political will to do something substantive quickly.

The details floated about the Treasury’s plan are discouraging. The main assistance favoured by the Treasury would involve asset buying that piggy backs on private investors’ decisions, investing government funds in parallel to private investments that are made in anticipation of profit. That would do little to raise bank portfolio or equity values, the sine qua non of a real plan.

The government must convince markets that the crisis and panic pricing are ending. That means removing the extreme downside from the set of reasonable possibilities priced into financial instruments.

To do that the government must take risk, economically and politically. Only by doing this can it put a floor on market beliefs about asset values. Piggy backing on willing private market buyers will fail to remove fears about downside risk and fail to substantially raise asset prices. The government must lead, not follow, the private sector out of this morass.

A financial recovery plan has several parts. First, a quick government review of troubled portfolios to estimate long-run recovery values based on reasonable forecasts in a non-panic environment. That means forming an opinion about the recovery value on, say, a portfolio of subprime mortgages originated in 2005; a reasonable opinion could be that this portfolio eventually will recover 75 cents on the dollar (assuming 50 per cent defaults and 50 per cent losses on defaults). The government can hire advisers to help form that opinion, but it cannot use current market prices or action to discover that price.

Second, the government must undertake either purchases or guarantees of assets based on that analysis. Either approach would work, but I favour guarantees because they would not require the government to manage asset disposition, and would entail less risk to taxpayers. The government would place floors on distressed assets values for, say, three years. Setting prices below recovery values but above current prices, and limiting the guarantee period, encourages banks to keep and manage distressed assets efficiently. For example, if an asset pool had an estimated eventual recovery value of 75 cents on the dollar, the government could offer a three-year put option at 55 cents and charge a small premium. That put option would substantially raise the market value of this portfolio, and any debt instruments written on it.

Third, President Obama needs to explain that the deals he makes are not intended to make money on distressed asset transactions, but rather to raise the values of distressed assets and end financial panic. He needs to admit that the government could lose some money and that taxpayers are unlikely to make a profit. He needs to explain that restoring credit flows, jobs and growth are the real deal, not profits from purchases or guarantee fees.

Fourth, conditions on participating banks should require banks to rebuild their equity levels. Banks receiving this assistance should have to raise new equity, and should not be able to pay dividends during the assistance period. Banks that cannot raise equity should be taken over and sold. Healthy banks will have every incentive to make good loans, which is the only sort we should want them to make.

Fifth, the president was right to back a loss-sharing programme to mitigate foreclosures. That plan should encourage speedy renegotiation. Taxpayers, say, could help fund write-down costs for mortgage renegotiations completed within a short period of time.

The president’s plan rightly avoids across-the-board write downs. Instead, it properly targets assistance to mortgages that are salvageable, not hopeless cases, and keeps renegotiation decisions decentralised, subject to government guidelines that define mortgage viability (which limit costs to taxpayers from supporting non-viable write downs). This approach will help homeowners and reduce extreme downside risks for banks.

Sixth, the Fed must increase purchases of mortgage-backed securities and other assets. The Fed has inexplicably pulled back from quantitative easing in the past two months, despite continuing high mortgage interest rates.

The president can sway naysayers in Congress and the electorate if he is willing to courageously seize the moment. The US will support a real plan, but only if our government provides leadership at this crucial time.


Charles W. Calomiris,
Henry Kaufman Professor of Financial Institutions at Columbia Business School


Editor's note:  This column first appeared on the FT Economists' Forum, 19 February 2009