Dan Alpert's Two Cents

Financial Stability Plan – Instant Comment

There is much to be admired in the Financial Stability Plan unveiled by Treasury Secretary Tim Geithner in his presentation this morning.  His measured approach, although still lacking in detail, demonstrates a coolness under fire and his having stepped back to examine the forest while others are tangled amongst the trees.

Nevertheless, we are a bit incredulous as to why the Secretary (and, it is apparent from insider reports, that his views prevailed on this score) placed such heavy emphasis on protecting the economic stakes of existing holders of the common shares of troubled banks when the government will still be required to inject billions more to restore capitalization to large systemically critical institutions.

The plan’s elements – while incorporating tools from a variety of financial engineering disciplines – interlock admirably in many respects.  We particularly applaud the emphasis on the stress testing of large banks to determine their ability to survive in a deteriorating economic environment.  We hope that the methods established by regulators in this regard are swiftly promulgated and focus not on snap-shot interpretations of underlying asset values (for housing, commercial real estate, consumer and corporate assets), but a stressed scenario of where such values are likely to bottom out.  For derivative securities, the performance of which is tied to real-world assets, values need to be built from the bottom up based on the value of the underlying assets supporting such securities, and not on a modeling of value based on now-irrelevant historical performance benchmarks or thin trading data.

If properly executed, the review of the few dozen institutions with balance sheets in excess of $100 billion or so will reveal much about the size of the remaining capital hole needing to be filled by government (as the re-capitalizer of last resort) and will assist the process of triage. Just as not all 8,400 banks in this country need to be intervened in by the government, not all major banks need to survive as well.  Smaller institutions that fail will be seized and sold by the FDIC without major systemic impact, although an RTC-type initiative may prove necessary to liquidate their assets.  And larger institutions with stressed capital shortfalls too great to justify their survival as independent entities should likewise be folded in to healthier ones (as in the Wells/Wachovia outcome).  The “good housekeeping” seal on the banks is destined to be kept healthy will be a valuable capital markets signal.

This additional step of proactively and rationally separating the survivors from the doomed, does not, however, alter the fact that considerable amounts of equity capital will still be required of the government to bolster the capital of even the surviving institutions.  For this, taxpayers should be awarded the lion’s share of the potential recovery in the value of government re-capitalized institutions, through common ownership, convertible preferred shares or a combination of methods.  Key to this is to take the issue of potential future dilution off the table, by taking the dilution of existing common shareholders up front and then having the government’s stake progressively diluted as new capital is attracted to the surviving institutions, the future solvency of which would be assured.  We therefore disagree with the assertions of the Secretary and others to the effect that government ownership of the economic upside (especially with the suggested entrustment of common equity stakes and voting rights in the proposed Financial Stability Trust) would deter private investment in banks that are certain to survive and eventually recover and thrive.  We have heard these statements often, but no one, to our knowledge, has made a compelling case to support them.

Plans to use government funds to facilitate off-taking, by private sector investors, of distressed bank assets is heavily intertwined with the above plans.  Secretary Geithner has it right on this score.  The only way to value distressed assets is to let the market have a crack at bidding for them, and the only way for the market to be able to generate rational pricing and sufficient buying power (relative to the sheer magnitude of the assets needing to be resolved) in a market in which conventional leverage is not available is for the government to step into the position of facilitating lender, or guarantor of private lending.  Sensibly risk-priced financing to support reasonably substantial private sector equity investment (meaning investment of 25% or more or purchase price, depending on asset class) should result in the ferreting out of the true value of distressed assets, based on the buyer’s projection of recoverability (which value should generally, on average, tie out well with the government’s assessment of bank assets if that assessment is properly executed as set forth above).  This would be a real winner and we have high hopes for its forceful execution.

Adding to and expanding the TALF program to have the Fed invest in a broader array of securities, such as Commercial Mortgage Backed Securities and non-GSE linked Residential MBS, is sensible enough.  But while this action may bring life to liquidity starved sector of the markets, this is by no means a panacea.  The soon-to-be-renamed facility’s availability to these sectors will open the door for new lending, but the dramatic decline in asset values of all forms of real estate means that existing CMBS and RMBS securities will remain significantly depressed and in need of ultimate resolution.  We doubt the Treasury is suggesting expanding the TALF as a way of artificially supporting the market for existing underwater securities.  These securities will continue to generate losses to the holders thereof.

The Financial Stability Plan also includes the notion of dedicating $50 billion to the prevention of avoidable foreclosures.  This concept – a nod to the FDIC Chairman Sheila Bair’s ideas on the issue – has yet to be fleshed out and we suspect will continue to be a difficult matter.  While government controls nearly 60% of outstanding residential mortgage debt, and will have no difficulty in modifying such loans, the nearly $3 trillion of mortgage loans (the sub-prime, Alt-A, option ARM and jumbo prime loans that are the worst of the lot) held in private label securitizations will continue to pose significant problems in terms of their resolution.  We await further details with some cynicism, but recognize the need for incorporating this element in today’s proposal for congressional political reasons.

Similarly, the oversight and transparency elements of today’s plan, together with the restrictions placed on institutions taking government funds, were clearly incorporated to address the backlash on those issues coming from the Hill and from many in the general population.  We applaud the sensitivity of the plan to these matters, but – other than with respect to the transparency issue, which we think is handled well – the limitations placed on the banking sector are light, and the notion of forcing the banks to track the actual use of monies injected in them, is political pabulum and not only impossible but irrelevant.

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