Cash for Crap v.2.0: The Public Private Investment Program

Summary

The Treasury’s new Public Private Investment program is an attempt to cure the “credit crisis.” But since we really have a debt crisis, it will fail because consumers are trying to reduce debt and increase savings, not borrow more on top of an already huge debt burden. The program will instead unjustly enrich the large banks that helped create our economic crisis. It is also a fat plum given to Wall Street insiders who will make a lot of money on the taxpayers’ dollar with very little risk to them.

By: Jeff Harding

The Obama Administration is making a huge bet that its Public-Private Investment Program (PPIP) will cure the banks and lead us out of the recession/depression.

Here is the situation as Secretary of the Treasury, Tim Geithner, sees it:

• This is a credit crisis, not a debt crisis.
• Banks aren’t lending because they made bad investments in subprime mortgage loans and subprime securities.
• These bad investments are difficult to value so banks aren’t sure if they are solvent or undercapitalized.
• Accordingly banks have curtailed lending to minimize risk.
• This reduces the availability of credit to businesses and consumers who will expand and spend.
• If we get rid of these bad assets from bank balance sheet by selling the assets, banks will have a more certain capital base.
• This will allow banks to raise capital and replenish their capital base.
• Now banks can go ahead and lend money which will stimulate the economy.
• Everything will be better.

Obama Economic Team

The PPIP works by raising money from private investors who invest with the Treasury in an investment partnership which buys these bad investments. The Treasury, the Federal Reserve Bank, and the FDIC put up taxpayer money into the deal. The partnership would then bid at auction for these bad assets. The government would put up 94% of the funds either as a direct cash investment or as a loan. The private investors would have no liability to pay back the money to the government (nonrecourse). Any profits would be split between the private investors and the government.

The government hopes that these investment partnerships run by private investors will be incentivized by high nonrecourse leverage to pay higher prices for the bad assets than they would without the government’s generous investment terms. The government will initially put up $100 billion to start this program. Depending on the investment program, the private investors would have to put up only $6 billion.

The Treasury gives several examples to explain the program. Assuming the partnership bids $1 billion for a pool of bad mortgage loans with a face value of $1.25 billion, the investors would put up $75 million, the Treasury would put up $75 million, and the FDIC would guarantee a loan of $850 million. Thus the private investors only have to come up with equity of 7.5% in the deal, and the rest is put up by the government on a nonrecourse basis.

The problem with this approach is that it won’t achieve the desired goal of reviving the economy.

Like most economists, Secretary Geithner, Larry Summers, Christina Romer, Ben Bernanke and the other economists advising President Obama believe that when crashes and depressions occur, the government can cure them. In fact, they believe that they can actually prevent them from happening—but we know that they have already failed that test.

Let’s examine Geithner’s premises:

1. This is a credit crisis, not a debt crisis.

They think the problem is one of a lack of credit in the economy. While they acknowledge that “we” have over-borrowed, they see the cure as one of getting banks to lend, not the reduction of debt. But the problem with the economy is that “we” made bad investments in housing. This government induced credit expansion bubble caused the housing boom which led to an explosion of debt. When the bubble collapsed (the Fed tightened credit), values collapsed and the debt came due. Now we’ve got to pay the debt off or go bankrupt, and start over.

2. Banks aren’t lending because they made bad investments in subprime mortgage loans and subprime securities.

This is partially true in that some large banks loaded up their balance sheets with bad assets and aren’t lending because they may be insolvent. But, actually most banks are lending or are willing to lend. The Minneapolis Fed did a recent study of banks and businesses in their district and found that banks were willing to lend, albeit on stricter terms, but their customers weren’t borrowing. Most banks in America don’t have these bad assets and are solvent.

3. These bad assets are difficult to value so banks aren’t sure if they are solvent or undercapitalized.

This is really wrong. They could easily find out what these assets were worth if they put them up for sale. There are also market indices that value these types of asset. They are afraid to do this because of what they might find: the true value of these assets is a lot less than the value they are carrying on their books. This would require them to raise capital to meet their Tier 1 capital requirements and they don’t want to do this, especially right now when that might be difficult to do. They don’t want anyone to say the word “insolvency” and the name of their institution in the same breath.

4. Accordingly banks have curtailed lending to minimize risk.

Partially true, especially for banks who hold these assets. Let’s be clear, your local bank doesn’t hold these kinds of assets. It’s the large international banks who made the big plunge into these products. What we are really talking about is a bailout of the large New York-based institutions our economic leaders know well.

5. This reduces the availability of credit to businesses and consumers who need it to expand and buy.

Again, this is partially true, but the fact is that borrowers aren’t borrowing because they are uncertain of the future and already have too much debt. The solution to our crisis is to reduce debt, not increase debt.

6. If we get rid of these bad asset from bank balance sheet by selling the asset, banks will have a more certain capital base.

True. But they might not like what they see.

7. This will allow banks to raise capital to replenish their capital base.

I have a problem with this point. It sounds logical that banks will just sell stock, raise additional capital, and go back to normal. The flaw is that I think many of these large banks are not going to survive. Right now they are lying about their balance sheets because they are carrying these bad assets at a value higher than actual market value. Many of these banks deserve to fail because of the mistakes that they made. We shouldn’t reward those who got us into this mess. This is what is called “moral hazard” by economists. A lesson needs to be learned by those who led us into this mess. Which brings me back to their ability to raise capital—I think the market will be reluctant to give them more capital. Many of them should and will go under and be liquidated by the FDIC as they should be.

8. Now banks can go ahead and lend money which will stimulate the economy.

This is the biggest flaw in the government’s theory. We are in a deflation and nothing the government does will stop this from happening. Deflation is how economies cure themselves from the massive investment in bad assets. You can’t simply flood the economy with credit and expect people to feel as if everything is fine. What about the debt? What about housing prices that are still dropping? What about overleveraged consumers? What about auto loans, credit card debt, commercial real estate debt? It will be resolved by people paying the debt or going bankrupt. Consumers borrowing more money and spending more money is the problem, not the solution. What will happen is that, like banks, consumers will repair their own balance sheet. They do that by saving, not spending. This, as I’ve said before, is not pretty, but it’s quick. Japan took 14 years to correct their crash because they made many of the same mistakes we are making now.

Let’s put it this way. If you are a 60 year old former big spender, you have experienced a decline in the value of your home, an asset that you thought would keep increasing in value. You thought you’d sell the big house and move into a nice condo on the golf course and bank the remainder of cash for your retirement. If you had a portfolio of stocks in your IRA or 401K, it’s now worth half of what it was a year ago. You owe money on your boat, your Harley, your RV, and the new patio with the barbeque. Things aren’t turning out like you expected. What to do?

I think most rational people would say, let’s save everything we can, pay off our debts, keep working as long possible, and hope that Medicare and Social Security doesn’t go broke. They have changed their world outlook and nothing the government does will change this. Since Baby Boomers are the largest and wealthiest demographic group in America, this will change the economy for many years to come.

Many of the critics of the PPIP have pointed out that there are many opportunities to game this deal. Maybe, maybe not. But several things are obvious. First is that this is a bailout of large banks. They made horrible decisions and the taxpayers are going to give them money as a reward for their folly. I’m not a conspiracy theorist, but the economic advisors in the Obama Administration were serious players in the world of Wall Street. I’m a big fan of Wall Street, but let’s face it, these big banks have political clout. That’s not capitalism, and Joseph Schumpeter (who developed the theory of “creative destruction” as being a positive force in capitalism) would agree with me.

Also, it’s a great deal for the big players. I would love to get into this market. I think opportunities abound. But I don’t have a billion dollars. The government is structuring this deal for only the very big players. One of my favorite bloggers, Finbar Taggit calls them Goldmorgan Stanley. A year ago, I offered a modest solution for the problem: break up the bad mortgages into regional pools and let regional players handle this. You know, take a big problem and break it down into a bunch of little problems and pretty soon you have only little problems. No government money would be needed. I was shouting into the hurricane. Goldmorgan Stanley is going to make a killing on these deals.

Lastly, what happens if the partnerships bid too low? Investors aren’t stupid, they see housing prices still falling and that will affect the price they are willing to pay for mortgage debt. Will the banks accept these bids? My guess is that they will not. This is what they were afraid of in the first place. This would, in essence, force them to mark-to-market which would lower their capital base and possibly render them insolvent. (I have argued that mark-to-market is actually a good thing.)

My guess is that if the PPIP is not successful, the FDIC may force them to accept all bids, which is a de facto mark-to-market move. The government would do so because they are afraid of catching the Japanese disease (stagnation). Geithner said in his letter: “Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience.”

The Japanese called their moribund banks, “zombie banks.” As the excellent commentator Mish Shedlock said, instead of zombie banks, the government is creating “zombie taxpayers.” By that he means because of voodoo Keynesian economics we and our descendants will wander the earth burdened by economic stagnation and huge federal debt.