Wednesday, April 1, 2009

Encouraging the Sellers, Not the Buyers, of ‘Toxic Assets’

Last week the Obama administration released what has become known as the “Geithner plan”: an administration policy to reorganize asset ownership in the banking sector. The plan may have its desired effect of loosening up the market for “legacy assets,” but probably not for the reasons the Obama administration has stated.

Banks own mortgages (either directly, or through ownership of mortgage-backed securities) whose values plummeted in 2008, because the mortgages are collateralized with real estates whose values crashed.

Conventional wisdom about the banking crisis says that bank lending to the wider economy cannot occur because banks have been unable to sell these assets, which adds to their difficulties in making new loans.

As United States Treasury Secretary Timothy Geithner says, a secondary market for mortgages “does not now exist” because there is a “lack of clarity about the value of these legacy assets [which makes] it difficult for some financial institutions to raise new private capital on their own."

I agree that (to a good approximation) a secondary market for legacy mortgages does not exist. But the biggest reason is not lack of clarity, but rather the lack of a viable government policy to deal with the banking crisis. Until now, perhaps.

But let’s stick with the conventional wisdom for a moment more. According to that wisdom, it does not help for the Treasury and the FDIC to subsidize and leverage the purchase of legacy mortgages from banks as Secretary Geithner proposes, because the plan does nothing to (a) create clarity in legacy asset value or (b) ensure that banks no longer have significant direct or indirect holdings of mortgages on their balance sheets.

As Professors Paul Krugman and Joseph Stiglitz have explained, the Geithner Plan does increase the value of legacy mortgages to its owners, because it subsidizes the purchase of them. But it does not increase the clarity of those values, and in fact reduces clarity.

Consider an example, again from the conventional wisdom. Market participants are not sure whether a pool of mortgages will be worth $30 million or $50 million, and are concerned that the current owner knows a bit better and thus will offer for sale only the weakest of the weak. This $20 million worth of uncertainty, according to Secretary Geithner and the conventional wisdom, stops the secondary market from operating.

Thanks to the emergence of the Geithner plan’s subsidy and its leverage, the pool of legacy mortgages last week suddenly became worth $40 to $90 million (the Geithner subsidy raises private investors’ value of all types of bad mortgages, and its leverage increases the gap between the value of the best and the value of the worst). Yes, the legacy mortgages are worth more, but the profit of owning them is now less certain.

To make matters worse, the Geithner plan has no provision to stop banks from funding some of the ventures that will purchase the banks’ own legacy assets. The result may be bank ownership of mortgages that is less direct, but ownership nonetheless.

Thus, if the conventional wisdom is right, this plan will fail because it creates no clarity, and it does little to separate banking from legacy mortgage ownership.

But I believe that the conventional wisdom is highly exaggerated. Instead, the secondary market for legacy mortgages has stagnated largely because of the (ultimately correct) anticipation of a massive government subsidy. Banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to eventually step in and help push the prices of those assets higher.

We all witnessed last week the massive capital gains to banks that came with the unveiling of the Geithner plan. A bank would have been foolish to sell off its legacy mortgages during the fall or winter, before such a plan was unveiled and executed, because a fall or winter non-bank buyer of legacy mortgages would likely be ineligible for the ultimate subsidy.

Thus, the secondary market for legacy mortgages has failed so far due to the lack of a plan rather than a lack of clarity. In order to get the market operating again, the Geithner plan does not need to alleviate the market weakness improperly identified by its authors, but only needs to stay on the path to execution.

1 comment:

DWAnderson said...

For your argument to be correct, wouldn't the Banks would have to believe that there was no better offer coming by waiting a few more months? If so, why do they believe this now, but not last October?