Wednesday, 25 March 2009

Wasteful Timmy

The Geithner plan, understandably, has generated many column inches since it was unveiled on Monday. There is little consensus among the commentariat, but the markets have taken it well. What should we take from Timmy's last (or at best next to last) stand?

First, it might actually work either by accident - because we are through the worst anyway and it doesn't hurt - or by design. It is certainly positive in the short term for the shareholders of American banks. And it betokens a reluctance to nationalise which, while negative for the taxpayer, is the kind of thing markets like.

Second, it is clearly an ineffective use of money. The government is providing nearly all the cash. If the same amount had been spent on recapitalising the banks, then there would be more leverage and hence more assets controlled for a dollar saved. Taxpayers should be outraged by this.

Third, it indicates that Geithner believes that an interestingly modern form of systemic risk is important: the risk that quasi-forced sales by one institution causes losses at others via mark to market. This plan achieves a de facto recapitalisation (albeit wastefully) via the ability for all banks to mark their assets to the purchase price in the plan. This means of course that the plan managers will be strongly encouraged to pay more than the market price for the assets: something they can afford to do given the government subsidy built into the structure.

In summary, then, the plan is far from optimal, but it will probably help a bit. The concern is that it won't be enough. If that happens, then Timmy will need a new job.

Update. Felix Salmon picks up an interesting quote from Sheila Bair. This makes it clear that the intent of the plan is to crush the non-default component of the credit spread:
They [the prices assets are bought into the plan] will still be, they will be market prices. We're just trying to tease out the liquidity premium. What's weighing on market prices right now is that people can't get financing to buy assets, they can't get financing to buy assets not many people want to buy, you don't want to buy. And then you have to hold on to them forever because there's nobody to sell them to. So, that's -- by providing that liquidity that's lacking now, we're hoping to get the prices up to what would really be a true market level.
They are doing this by removing all the risk - funding risk, liquidity risk, and credit spread volatility risk. It's an awfully expensive way to recapitalise the banks.

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