The U.S. Government’s Financial Stability Plan

Comments by Stephan Olajide-Huesler

The Obama administration is tackling the financial crisis with a Financial Stability Plan.

“To address the financial crisis, the Financial Stability plan is designed to attack our credit crisis on all fronts with our full arsenal of financial tools and the resources commensurate to the depth of the problem. To be successful, we must address the uncertainty, troubled assets and capital constraints of our financial institutions as well as the frozen secondary markets that have been the source of a significant portion of our lending for everything from small business loans to auto loans.”

Unfortunately, the plan does not address the crisis at its root but instead tries to fight the symptoms with interventionist tools that are not only ineffective but merely expand the distortions within the market. Below you will find comments in blue on the various tools and procedures described in the plan. In order to fully grasp the background of some of these comments it may be necessary to read parts of the book “Eye of the Storm” where the dynamics are laid out in detail.

Efforts to Improve Affordability for Responsible Homeowners: The treasury has implemented
programs to allow families to save on their mortgage payments by refinancing; to assist responsible
homeowners in avoiding foreclosure through a loan modification plan; and, alongside the Federal
Reserve, to help bring mortgage interest rates down to near historic lows. This past month, the 30%
increase in mortgage refinancing demonstrated that working families are benefiting from the
savings due to these lower rates.
An analysis that goes to the roots of this crisis concludes quite clearly that the haircut should ultimately be taken by the investors and not the mortgage holders. However, forcing the pricing mechanism in the markets (interest rates) is unsustainable (and unnecessary).
Consumer and Business Lending Initiative to Unlock Frozen Credit Markets: The treasury and the Federal Reserve are expanding the TALF (Term Asset-Backed Securities Facility) in conjunction with the Federal Reserve to jump-start the secondary markets that support consumer and business lending. Last week, the treasury announced its plans to purchase up to $15 billion in securities backed by Small Business Administration loans.

Business stimulation sure, but do you really want to stimulate consumption? Can we not agree, finally, that consumption north of 70% of GDP is unsustainable? It is very simplistic and flat out false to assume that if we all just continued to consume we are going to be fine. In any case consumption is very far from the root cause of this crisis, it was merely the ultimate manifestation where the distortions found an outlet.
Capital Assistance Program: The treasury has also launched a new capital program, including a
forward-looking capital assessment undertaken by bank supervisors, to ensure that banks have the
capital they need in the event of a worse-than-expected recession. If banks are confident that they
will have sufficient capital to weather a severe economic storm, they are more likely to lend now—making it less likely that a more serious downturn will occur.

I doubt this very much. Banks will, if healthy, lend to some extent, but in conjunction with their changed perception for risks and a slowing business environment in their models; lending will not reach pre-crisis levels for a very long time (more than 10 years).
The Challenge of Legacy Assets: Despite these efforts, the financial system is still working against
economic recovery. One major reason is the problem of “legacy assets” – both real estate loans held
directly on the books of banks (“legacy loans”) and securities backed by loan portfolios (“legacy
securities”). These assets create uncertainty around the balance sheets of these financial institutions,
compromising their ability to raise capital and their willingness to increase lending.

The greatest fallacy of the current debate is this segmentation into “legacy assets” and the rest, which appears in good health. We have to start dividing the assets up differently. In my view it would be much more helpful to separate out assets along functional lines. Specifically, we have to carve out traditional relationship-banking assets. They constitute the bedrock of our financial system, they account for a fraction of total banking assets today and are most definitely much healthier than most of the troubled assets that we are dealing with and will keep on growing as the deleveraging process takes its course.

Breaking off commercial banking assets should be relatively straightforward, since these assets can be quite clearly identified and separated from “investment assets” most of which were securitized and traded throughout the system. .

Commercial banking books are the assets we should be concerned with and the amounts are manageable. If the U.S. government would annex, (for the cost of $1.00) 50% of all commercial banking assets in the U.S., i.e. approximately $3 trillion, the maximum ultimate cost for the taxpayer would probably be no more than $500 billion.

Government can then also influence, from within, the various regulative structures that will have to be rebuilt from scratch, including audit, Sarbanes-Oxley, and financial market oversight. The theory and the tools of Modern Finance will not go away but they have to be applied much more prudently and intelligently.

• Origins of the Problem: The challenge posed by these legacy assets began with an initial shock
due to the bursting of the housing bubble in 2007, which generated losses for investors and banks.
Losses were compounded by the lax underwriting standards that had been used by some lenders
and by the proliferation of complex securitization products, some of whose risks were not fully
understood. The resulting need by investors and banks to reduce risk triggered a wide-scale
deleveraging in these markets and led to fire sales. As prices declined, many traditional investors
exited these markets, causing declines in market liquidity.

It is understandable that when the analysis of the origin of the problem missed the point and does in fact not even touch the root cause, the result will be a confused and unhelpful plan.

• Creation of a Negative Economic Cycle: As a result, a negative cycle has developed where
declining asset prices have triggered further deleveraging, which has in turn led to further price
declines. The excessive discounts embedded in some legacy asset prices are now straining the
capital of U.S. financial institutions, limiting their ability to lend and increasing the cost of credit
throughout the financial system. The lack of clarity about the value of these legacy assets has also
made it difficult for some financial institutions to raise new private capital on their own.
The representatives of government have got to stop listening to the banks, who are at the core of the crisis and develop some original thought.
I get the impression that these people do not believe that we have climbed a huge mountain and are just starting our descent. Does anyone believe that 350% debt to GDP can and should be surpassed, in the name of a little economic growth? In the 7 years leading up to the crisis, every dollar of credit merely created 14 cents of real economic growth, all of it driven by mortgage equity withdrawals.
To address the challenge of legacy assets, the treasury – in conjunction with the Federal Deposit Insurance Corporation and the Federal Reserve – is announcing the Public-Private Investment Program as part of its efforts to repair balance sheets throughout our financial system and ensure that credit is available to the households and businesses, large and small, that will help drive us toward recovery.

Three Basic Principles of the Public-Private Investment Program: Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time. The Public-Private Investment Program will be designed around three basic principles:

1. Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in
partnership with the FDIC and Federal Reserve and co-investment with private sector investors,
substantial purchasing power will be created, making the most of taxpayer resources.

So, in essence, the government has learned from the markets and is opening its own hedge fund with a leverage of 5 times (with an option to increase it 10 times). What are they going to do with 1 trillion, which is a drop in the ocean compared to the size of the likely size of bad assets? What are they going to buy, and at what prices?

2. Shared Risk and Profits with Private-Sector Participants: Second, the Public-Private
Investment Program ensures that private-sector participants invest alongside the taxpayer, with
the private-sector investors standing to lose their entire investment in a downside scenario and the
taxpayer sharing in profitable returns.

OK, so 50/50 partnerships? Capital and ownership? That can’t be right. Under this plan a well-run hedge fund can come in and spend 0.5 dollars for a purchasing power of 10 on the back of the government’s provision of 9.5 dollars for the purchase? Returns are split 50/50. Who would not take that offer? In reality this looks more like a 9.5-to- 0.5 (19 to 1) partnership, where the government takes 95% of the risk and 50% of the upside.

The taxpayer could agree to increase the stake of the private partner if performance is good. For example, if the taxpayer makes his money back (all of it), the funds share could be increased to 10%, or 20% of the upside. Otherwise the taxpayer takes most of the risks and shares only 50% of the glory.

3. Private-Sector Price Discovery: Third, to reduce the likelihood that the government will overpay for these assets, private-sector investors competing with one another will establish the price of the loans and securities purchased under the program.

I am not convinced that this will be an orderly mechanism that fosters true price discovery, in particular since private hands don’t share the downside risks.
The Merits of the Public-Private Investment Program: This approach is superior to the alternatives of either hoping for banks to
gradually work these assets off their books or of the government purchasing the assets directly. Simply
hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of
the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers
will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if
government employees are setting the price for those assets.

Two Components for Two Types of Assets: The Public-Private Investment Program breaks down into two essential sections, addressing both the legacy loans and legacy securities clogging the balance sheets of financial firms:
• Legacy Loans: The overhang of troubled legacy loans stuck on bank balance sheets has both made it difficult for banks to access private markets for new capital and limited their ability to lend.
• Legacy Securities: Secondary markets have become highly illiquid and are trading at prices
below where they would be in normally functioning markets. These securities are held by banks
as well as insurance companies, pension funds, mutual funds, and funds held in individual
retirement accounts.
The Legacy Loans Program: To cleanse bank balance sheets of troubled legacy loans and reduce the
overhang of uncertainty associated with these assets, the Federal Deposit Insurance Corporation and
the treasury are launching a program to attract private capital to purchase eligible legacy loans from
participating banks through the provision of FDIC debt guarantees and treasury equity co-investment.
The treasury currently anticipates that approximately half of the TARP resources for legacy assets will be
devoted to the Legacy Loans Program, but our approach will allow for flexibility to allocate resources
where we see the greatest impact.
• Involving Private Investors to Set Prices: A broad array of investors are expected to
participate in the Legacy Loans Program. The participation of individual investors, pension
plans, insurance companies, and other long-term investors is particularly encouraged. The
Legacy Loans Program will facilitate the creation of individual Public-Private Investment
Funds, which will purchase asset pools on a discrete basis. The program will boost private
demand for distressed assets that are currently held by banks and facilitate market-priced
sales of troubled assets.
• Using FDIC Expertise to Provide Oversight: The FDIC will provide oversight for the
formation, funding, and operation of these new funds that will purchase assets from banks.
• Joint Financing from the Treasury, Private Capital, and FDIC: Treasury and private capital
will provide equity financing, and the FDIC will provide a guarantee for debt financing issued
by the Public-Private Investment Funds to fund asset purchases. The treasury will manage its
investment on behalf of taxpayers to ensure the public interest is protected. The treasury
intends to provide 50 percent of the equity capital for each fund, but private managers will
retain control of asset management subject to rigorous oversight from the FDIC.

What if they start to realize that their “hedge fund” will need to grow beyond $10 trillion?

At least private involvement is gearing it toward going concerns. But what will be done with those assets that no one wants to buy? How do we auction off everything, without regard to losses? As long as these assets are on bank’s balance sheet, that are so highly leveraged, these banks will be unable to sell these assets at seriously discounted prices. This plan may look good in theory, but in practice we will see that very little will actually happen.

Instead, we should strip the banks of all their noncommercial banking assets and just auction them off. Ask the bank—completely rid of all investment assets—how much capital it needs to survive on its own and provide it. That would mean 100% ownership by government of nearly all banks. Government sets the rules, the regulations, and rehires executive with all new contracts.

Clearly the financial world, and in particular the banks, have run this thing into the ground. They must be expropriated and start new with compensation packages and management options that accrue for long-term performance.

• The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing
assets in the Legacy Loans Program will occur through the following process:

o Banks Identify the Assets They Wish to Sell: To start the process, banks will decide
which assets – usually a pool of loans – they would like to sell. The FDIC will
conduct an analysis to determine the amount of funding it is willing to guarantee.
Leverage will not exceed a 6-to-1 debt-to-equity ratio. Assets eligible for purchase
will be determined by the participating banks, their primary regulators, the FDIC
and the treasury. Financial institutions of all sizes will be eligible to sell assets.

o Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction
for these pools of loans. The highest bidder will have access to the Public-Private
Investment Program to fund 50 percent of the equity requirement of their purchase.

o Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase
price, the buyer would receive financing by issuing debt guaranteed by the FDIC.
The FDIC-guaranteed debt would be collateralized by the purchased assets, and the
FDIC would receive a fee in return for its guarantee.

Guarantor? Meaning taxpayer…

o Private-Sector Partners Manage the Assets: Once the assets have been sold, private
fund managers will control and manage the assets until final liquidation, subject to
strict FDIC oversight.
Sample Investment Under the Legacy Loans Program
Step 1: If a bank has a pool of residential mortgages with $100 face value that it is
seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would
be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector
bidders submitting bids. The highest bid from the private sector – in this example,
$84 – would be the winner and would form a Public-Private Investment Fund to
purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of
financing, leaving $12 of equity.
Step 5: The treasury would then provide 50% of the equity funding required on a
side-by-side basis with the investor. In this example, the treasury would invest
approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and
the timing of its disposition on an ongoing basis – using asset managers approved
and subject to oversight by the FDIC.
What does the seller actually get? Treasuries?
The Legacy Securities Program: The goal of this program is to restart the market for legacy securities,
allowing banks and other financial institutions to free up capital and stimulate the extension of new credit.
The resulting process of price discovery will also reduce the uncertainty surrounding the financial
institutions holding these securities, potentially enabling them to raise new private capital. The Legacy
Securities Program consists of two related parts designed to draw private capital into these markets by
providing debt financing from the Federal Reserve under the Term Asset-Backed Securities Loan Facility
(TALF) and through matching private capital raised for dedicated funds targeting legacy securities.

These should be independent programs run under an umbrella of capital but with varying strategies and partnerships. So-called Chinese walls are important; units should not collude. The overall strategy, however, has to be driven by the awareness that this is the taxpayer’s money. Much of what is likely offered by the banks is completely infected by the virus of Modern Finance and some of it will be worth no more than 20 cents on the dollar. Who is going to represent the taxpayer properly? The current structure clearly favours banks and the private partners in the purchase program.

1. Expanding TALF to Legacy Securities to Bring Private Investors Back into the Market:
The treasury and the Federal Reserve are today announcing their plans to create a lending
program that will address the broken markets for securities tied to residential and commercial
real estate and consumer credit. The intention is to incorporate this program into the
previously announced (TALF).
• Providing Investors Greater Confidence to Purchase Legacy Assets: As with
securitizations backed by new originations of consumer and business credit already
included in the TALF, we expect that the provision of leverage through this program
will give investors greater confidence to purchase these assets, thus increasing market
liquidity.
• Funding Purchase of Legacy Securities: Through this new program, non-recourse
loans will be made available to investors to fund purchases of legacy securitization
assets. Eligible assets are expected to include certain non-agency residential
mortgage-backed securities (RMBS) that were originally rated AAA as well as outstanding
commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS)
that are rated AAA.
• Working with Market Participants: Borrowers will need to meet eligibility criteria.
Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the
underlying assets.

2. Partnering Side by Side with Private Investors in Legacy Securities Investment Funds:
The treasury will make co-investment/leverage available in order to partner with private capital providers
to immediately support the market for legacy mortgage- and asset-backed securities
originated prior to 2009 with a rating of AAA at origination.
• Side-by-Side Investment with Qualified Fund Managers: The treasury will approve up
to five asset managers with a demonstrated track record of purchasing legacy assets,
though we may consider adding more, depending on the quality of applications
received. Managers whose proposals have been approved will have a period of time
to raise private capital to target the designated asset classes and will receive matching
treasury funds under the Public-Private Investment Program. Treasury funds will be
invested one-for-one on a fully side-by-side basis with these investors.
• Offer of Senior Debt to Leverage More Financing: Asset managers will have the
ability, if their investment fund structures meet certain guidelines, to subscribe for
senior debt for the Public-Private Investment Fund from the Treasury Department in
the amount of 50% of total equity capital of the fund. The Treasury Department will
consider requests for senior debt for the fund in the amount of 100% of its total
equity capital, subject to further restrictions.

Sample Investment Under the Legacy Securities Program
Step 1: Treasury will launch the application process for managers interested in the
Legacy Securities Program.
Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital
to participate in joint investment programs with Treasury.
Step 3: The government agrees to provide a one-for-one match for every dollar of
private capital that the fund manager raises and to provide fund-level leverage for the
proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is
able to raise $100 of private capital for the fund. The treasury provides $100 equity co-investment
on a side-by-side basis with private capital and will provide a $100 loan to
the Public-Private Investment Fund. The treasury will also consider requests from the
fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total
capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although the fund will
primarily follow a long-term buy-and-hold strategy. The Public-Private
Investment Fund, if the fund manager so determines, would also be eligible to take
advantage of the expanded TALF program for legacy securities when it is launched.
And how are these fund managers compensated, incentivized, overseen? Are we really going to make those who have driven us into this mess immensely rich by sorting out their own mess? Sounds grotesque.
I must repeat, the risk here is entirely on the taxpayer. Somehow the assumption seems to be that all this shuffling back and forth may actually be profitable. As a taxpayer, I don’t want to have any capital at all in the rubbish that the banks will be stripped of. Now, as it stands, not only have I got all the risk and get the worst of the rubbish (80 to 100% write-down?) but if, for some magical reason, I should make a profit on a project, I have to share it with private hedge funds. Ultimately, the plan is nothing but a smoke-and-mirrors version of bailing everyone out, with the additional insult of sharing the crummy spoils with the very people who caused the mess. It is quite hard to believe that they are actually going ahead with this. It will generate the ultimate worst-case scenario. This plan looks just about as bad as the Bush Administration’s, if not worse.
This is what I would call Super Bailing.
I must also repeat that in the entire document there is—possibly purposefully—no mention of financial markets regulation, which is at least as important as an actual auction. The plan describes an auction process in which we are actually paying banks something for their rubbish, but there is so much more to financial stability than just an auction that obscures the fact that the taxpayer ends up holding the bag.
1. Commercial banking has to be re-established as a specialist business.
2. Glass-Steagall has to be reinvented. Both points 1 and 2 will assist the restructuring of risk management in the financial industry and inform the discussion on proper treatment of real economic risks in the market place.
3. Those financial-market instruments long hidden in the shadows must be made more transparent and be listed.
4. Global monetary policy coordination is necessary.
5. The Fed needs to be completely overhauled and an independent financial authority of oversight needs to be established.