One of Treasury Secretary Timothy Geithner's chief duties when he took the job was to solve banks' toxic assets problem. His solution: The Public-Private Investment Program ("PPIP"). The program was unveiled on March 23rd. Over three months later, part has been scrapped, and none of it has gotten off the ground. An article from the Wall Street Journal today implies that it might not have needed to.
The PPIP came with a lot of baggage. Banks were worried selling their securities at a discount would further weaken their capital base. Investors were scared to participate and possibly come under government scrutiny ala the TARP banks. The plan itself came under fire because it did not seem to treat small banks and investors the same as large ones.
One half of the program -- the Legacy Loan Program ("LLP") -- was meant to relieve banks of troubled real estate loans. These assets are very hard to value; some are just plots of land in bad real estate markets. Earlier in the month, the FDIC announced that this part of the program is on hold, indefinitely.
Then there's the other part of the PPIP -- the part that is supposed to help banks sell their toxic securities, like ugly mortgage-backed securities. That's also still simmering on low heat. Applications have been submitted, but a security has yet to change hands through the program.
Could this be okay? Maybe the program has done its job -- without even getting started.
The banks bad assets were something of a problem for their own sake, but they were a bigger problem in banks' efforts to raise capital. Investors did not want to touch banks' equity because they were unsure how much all the toxic assets were worth. That was then. Now that banks of been raising capital, is the PPIP even necessary?
The FDIC portion was put on hold for exactly this reason, according to FDIC Chairman Sheila Bair. From the WSJ:
"Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system," Ms. Bair said.
She's not the only one who feels this way. The WSJ also quotes a Goldman banker:
Scott Romanoff, a Goldman Sachs Group Inc. managing director, has referred to the current effort, PPIP, as "the greatest program that never occurred," because it "created confidence in the markets so banks can raise equity capital."
Here's a graph of that confidence, from the WSJ article:
Could the government merely declaring that it had an idea for a program to relieve banks balance sheets of these problem assets have been enough?
I'm not entirely convinced. First, if the market realizes that the program is entirely abandoned, wouldn't that damage the newfound confidence? Sure, some banks have gotten capital already. But this revelation might drive back down stock prices for these banks, since those stock prices probably reflect some nonzero probability that banks will benefit from the PPIP program.
And what about those banks who haven't raised capital? Without the PPIP program, they will continue to have difficulty doing so. I would imagine that a lot more failures will occur if the program never materializes. Of course, some more resolved banks might not be a bad thing if they are beyond repair anyway.
And don't forget that FASB mark to market rules have been relaxed so toxic assets might not appear as such on the balance sheet.
http://www.businessweek.com/investing/wall_street_news_blog/archives/2009/06/how_mark-to-mod.html
More than likely this is a big problem that will rear its ugly head again. The sooner it's really dealt with, instead of swept under the rug, the better. The government took an unfortunate pass on this, and capitalization strength is more than likely an accounting mirage.
Even if it only ever amounts to a confidence measure, it's still a measure that costs taxpayers a lot of money---and that money does line someone's pockets. Bill Gross' and PIMCO's, in particular. Rob Johnson explained as much last week.
The saga of PPIP is instructive, but the survival or further morphing of the program, in and of itself, isn't important.
PPIP suffered from the same fatal flaw as TARP v 1.0 and every other proposal for "dealing" with toxic assets. Price discovery.
Pace Bernake's "reverse Dutch option" or any other Treasury scheme, there's no way to currently achieve a Goldilocks-price at which banks are willing to sell that will attract vulture investors. And the subsidized credit scheme of PPIP just wasn't going to give a big enough subsidy to buyers to make up the difference, which is much bigger than the "liquidity premium" that Bair believed would be sufficient to attract participation of investors. The pricing problem is one of uncertain-but-low asset value, not just lack of liquidity.
It would have been nice in an ideal world to have had lots of transparency, real prices on assets (not the new deliberately murky FASB ruling), and a total cleanup that would have helped to put a floor on the carnage.
But two factors militated against that approach. First, given the high degree of uncertainty re how far the housing market is going to overshoot on the downside, relying on vulture capital to intervene in a market-based cleanup would have necessitated market-clearing prices so low as to put out of business lots of banks that will eventually manage to survive. To that extent, Bair and Treasury's analysis is sound. And second, the Obama Admin (both during the transition and once in office) decided that further dramatic disruption of the major financial institutions would risk accelerating the collapse of the real economy, making even more onerous the jobs of the Fed as substitute-capital-market and Congressionally-authorized fiscal policy to avoid a Great Depression.
So instead we have what I would have hoped Paulson would have done from the outset -- a credible, publicly-signalled triage that makes it easier for "healthy" institutions to raise private capital, puts the somewhat-at-risk institutions into the hospital (capital adequacy, management, asset portfolios and risk management being closely scrutinized by FDIC/Treasury/Fed), and puts the high-risk into the intensive care unit, with non-too-big-to-fail firms moving to the FDIC morgue when they reach the point of no return.
The stress tests were key. Not the absolute results of the stress tests -- who knows whether the scenarios were tough enough to measure just how vulnerable the banks are to more bad news, or whether the amount of new capital determined to be necessary for each bank will, in fact, be adequate. But the stress tests did accomplish a credible triage which, when combined with the government's assurance that the big firms wouldn't be allowed to fail, gave enough confidence for private capital to come back into the financial system.
What the previously announced PPIP-in-principle achieved was a sort of "placeholder" for the markets and financial institutions to assume some way that the "toxic assets" overhang would be handled through a future market-based mechanism that didn't involve wiping out bondholders. But the feasibility of any specific program wasn't important -- just the policy direction signal.
I think we'll eventually get to something like PPIP, but not necessarily government-sponsored. How long the Fed has to play the role of substitute capital market for real estate and commercial paper is hard to predict. But at some point, the bottom of the housing market will start to be visible. Vulture capital won't demand such high risk premiums for either residential or commercial financial assets. Banks that are no longer wondering whether they'll survive the next month will opportunistically start winnowing their portfolios at prices that don't put their entire balance sheets at risk. So both origination and secondary markets will revive, allowing the Fed to get out of those businesses.
I expect that the bulk of the toxic assets that move from bank balance sheets into the market will come via FDIC-intervened institutions. So eventually, an RTC-type facility -- either within or independent of FDIC -- may become both feasible and necessary.
In the meantime, the focus of government policy should be on the macroeconomy to forestall a W-recession that would prolong and deepen the crisis in the financial system. And on the micro side, getting one or another of the mortgage foreclosure intiatives, for which Congress has appropriated major bucks, to actually address a decent volume of mortgages.
Worrying about getting a feasible PPIP up and operating any time soon is a waste of energy -- ain't gonna happen. And the lack of a functioning "toxic assets" program isn't fatal to the rest of the Obama Admin's policies.
Over on BusinessWeek Investing Insights today:
Banks Still Threatened by Toxic Assets