Did Timid Timmy Under-Sell?

On February 10th, having postponed it for a day, newly confirmed Treasury Secretary Timothy Geithner, unveiled the broad outlines of the Obama Administration’s strategy to resolve the credit crisis. His presentation was under-whelming. Where he needed to shock and awe, he was soporific. The markets responded accordingly.

The old saw is “don’t shoot the messenger”, but in this case, perhaps the problem lies more with the messenger than the message. It is not simply a question of managing expectations. The markets had a right to expect more. Geithner is well steeped in the issues and, as the President of the New York Federal Reserve since November 2003, has been intimately involved with the policy response to crisis since the very start.

Perhaps more than any other cabinet appointment, except of course of Defense Secretary Robert Gates, Geithner should have been able to hit the ground running. The American public and investors were not alone. Judging from the media coverage, the Treasury Secretary had a lot of explaining to do to his G7 counterparts.

The message was obscured by the messenger, who, if not careful, will share the fate of Paul O’Neill, George W. Bush’s first Treasury Secretary, who, even if right on the issues, proved terribly ineffective. But there was a message. While details were sorely lacking, a general framework was offered that could be the real thing. “Could” is the operative word. There is the potential. Investors need to have a better understanding of that framework so the implementation can be monitored and the implications understood.

Three-Prong Strategy

This is not the first financial crisis that we (we as in this generation) have experienced. We know how to fix it. Despite the many parallels being drawn between the current crisis and the Great Depression, one key difference is that it is not the presence of fear that is the problem, as FDR identified, but the lack of will.

There are three key components: removal of bad assets, re-capitalization of banks and reviving the capital markets. Geithner’s ill-represented plan addresses each of them, and in this regard, is considerably more comprehensive than earlier efforts.

Initially TARP was supposed to have financed the removal of the bad assets, but as we now know, Paulson, well, changed his mind. In his presentation, Geithner had the cojones to rename the seriously distressed financially engineered instruments “legacy” assets, but he did realize their removal was essential.

The Financial Stability Plan (supersedes TARP) calls for the removal of the toxic or “legacy” assets. Apparently, spending much thought on the name-calling game that Democrats typically are so poor at, Geithner unveiled the Public-Private Partnership…what the media calls the “bad bank” and others have called an aggregator bank (aggregates the toxic assets). It is finally the RTC-like structure. It will be empowered to buy up to $1 trillion of Mr. Geithner’s legacy assets from the banks.

Innovation

Yet to give Geithner his due, the particulars seem innovative. Stone & McCarthy, the research company, have suggested that one way it could work is that the Public-Private Partnership (PPP) pays for the toxic assets only partly in cash and partly in stock in PPP.

One of the thorniest problems that bedeviled Paulson and Bernanke was how to price those toxic assets. Remember Bernanke trying to explain that there were two prices, the distressed selling price and the hold-to-maturity price and that under TARP, as initially conceived, closer attention would be paid to the latter. But that begged even more questions.

Geithner’s innovation is acknowledging that the true price for many of these assets is obscure and cannot be known now. Therefore some part of the price paid needs to be able to be adjusted later. That is one of the benefits of making part of the payment in shares in PPP, which later could be adjusted when the asset is eventually sold. The equity component means that the banks keep a vested interest, albeit a claim on a more diversified pool of toxic assets.

The key here is the removal of the toxic asset, so the cash component could be relatively modest, forcing the banks to take a greater part in equity. Although Geithner did not say so, the establishment of a secondary market for equity in PPP could be useful in the greater price discovery process.

To He Who Has is Given

That the details are sketchy is really alright as there will be time to work them out, because prior to the PPP, it appears that Geithner intends to conduct “stress-tests” on the banks to determine if the bank is a viable institution under even more severe conditions. It is not clear what happens to a bank that fails the stress test. There have been some pundits that have suggested it could be under such a pretext that could lead to nationalization, though this does not seem to necessarily be the case. The Financial Stability Plan is instead of nationalization. In a Catch-22, those who do pass may then qualify for more assistance.

The capital injection component of the plan comes from the Financial Stability Trust. Only banks with consolidated assets of over $100 bln would qualify for what appears to be a generous recapitalization plan. The amount available seems unlimited and the government would take convertible contingent equity in the banks. The conversion price would largely be a function of the price of the common stock on February 9 and would also not be grossly dilutive as was the case with Fannie Mae and Freddie Mac.

The final component of Geithner’s plan is aimed at reviving a key part of the capital markets that remain largely moribund—securitization. In late Nov 2008, the US Treasury announced the creation of the Term Asset-Backed Securities Loan Facility (TALF), under which the Federal Reserve would buy up to $200 bln of securities backed by lending to small businesses, consumers and students. Geithner announced that the size of this program would be increased to up to $1 trillion—a five-fold increase—and it required no congressional approval. Moreover, the program may be expanded to include commercial mortgage-backed securities, and private-label (not Fannie or Freddie) residential mortgage-backed securities and other asset-backed securities (David Bowie bonds?).

It appears that the terms of TALF are also generous, aimed at reviving the securitization market rather than trying to punish its abuse in the past. By breathing fresh life into the asset-backed market, officials hope to help jump-start consumer and small business lending again. They hope to achieve this through attractive terms of non-recourse loans, leverage, and official back-stop. It seems even more generous then the Fed’s commercial paper program, which appears to have been fairly successful.

The neo-conservative Robert Kagan reminds us that in earlier times to do what was necessary was to be virtuous. Geithner did a poor job selling the new policy framework for doing what we know has resolved other financial crises. His plan has the necessary components: remove bad assets, recapitalize the banking system and pry open the capital markets. More information is still needed to be confident, but this framework is important and just might work. Stay tuned.