President Barack Obama and Treasury Secretary Timothy Geithner say runaway borrowing was a root cause of the economic crisis, so there is irony in the way they are trying to get financial markets unstuck with a new program that depends on — you guessed it — access to easy credit.
Gushers of government-backed credit are behind the Treasury Department’s new Public-Private Investment Program. To induce investors to take a risk on toxic assets, the government is letting them plunk down as little as $6 for junk debt with a $100 face value. The U.S. Treasury will match that $6 investment and provide credit to fund the rest of the purchase price.
If cars were sold with such a small down payment and government backing, Detroit would be booming. If the government co-invested with home buyers, matching 50-50 as it will do under Geithner’s proposal, the real estate market would come back to life.
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The proposal Geithner laid out Monday solves some of the fundamental problems vexing the economy, but — no surprise here — it creates a few new troubles that will need attention too.
For example, some analysts worry that banks will hesitate before selling into the auctions of toxic assets that the Treasury will organize. Banks today are holding bad mortgages, while many financial institutions hold securities based on those bad loans. Once the banks do sell those toxic assets they will have to reckon with the true market value of that junk paper and take a hit on their balance sheets.
Banks also might game the system. If they dump only pools of mortgages on which most borrowers made zero payments, while holding onto better-quality loans, the banks could double dip. They would get rid of their most toxic assets, and benefit as a revived marketplace helps their relatively high-quality assets rise in price.
These potential problems will bear watching. But there is a good chance Geithner’s program could bring relief to the broken-down markets at the heart of our economic troubles. That’s because, for the first time since the credit markets seized up about a year ago, the auctions might set a market price for toxic assets. Without price, there is no market. And without a market, all those securities that arose from no-doc mortgages, crazy car loans and credit cards for kindergartners just sit in bank vaults.
They’re as worthless as the fanciful lending that brought them into being, and banks cannot afford to lend when their vaults are filled with such lousy paper.
The Geithner proposal creates incentives for both the buyer and the seller to meet in the market. Buyers get government backing for a risky investment. Sellers get a market price — lower than what they once thought the assets were worth, but more than anyone would pay before today.
The scheme works because it reintroduces leverage, in manageable amounts. Leverage is like the live virus in a flu shot: The right amount makes the body stronger; too much, and the whole economy gets sick. Load up the way we recently did — sometimes at more than 40 times invested capital — and you’ve got a plague.
Under the Geithner plan, a $6 investment, backed by government co-investment and loan guarantees, can lock up a pool of mortgages with a $100 face value. For the hedge funds, pension funds and other institutions likely to participate, the government offers a decent leverage ratio — up to six times the investor’s money, or enough to create an $84 purchase price.
The buyer takes a risk on the toxic assets, with a reasonable chance of profit. The bank gets the toxic waste off its balance sheet, and may soon be able to lend again.
The Geithner program is hardly a sure success. “Even with government support, these assets are very complex,” warns Gordon Baird, chief executive of Paramax Capital, a hedge fund. Still, Baird expects to trade in the markets. If the plan works, it could create the shot in the arm this economy surely needs.
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