I am a bit more hopeful about the Tim Geithner’s latest plan to take troubled assets off the balance sheets of US banks than the sceptical economists led by Paul Krugman.
Mr Krugman does not like the plan – at all – because he regards it as a mere reshuffling of the original Tarp plan suggested by Hank Paulson last autumn, which seems like ages ago. He points out, rightly, that it involves a government subsidy to private investors in the form of guaranteed debt.
On the other hand, the plan is quite cleverly structured to split the equity returns between the government and ensure that the private sector asset managers bid for the assets, rather than the government trying to establish the right price.
If this were the only thing the government was doing, as it would have been under the original Tarp plan, then I would agree it was inadequate. Banks also needed injections of fresh capital, which was why Mr Paulson veered towards using the Tarp funds to provide preferred equity.
But, as part of a broad package of rescue measures, it seems to me that the public-private plan has a place. Although it is not perfect – no plan that tried to meet its aims would be – it strikes what feels, at least on first glance, like a decent balance between the need to support banks and the taxpayer’s interests.
In the flurry of commentary on the eve of its publication this morning, the most significant thing to have been missed is the distinction the plan makes between legacy loans and legacy securities.
The biggest difference between the ways in which the two are treated is leverage.
In the case of legacy loans, the government will provide FDIC-backed debt to create up to a six-to-one debt to equity ratio for the funds that buy the assets. It is providing much less leverage for the funds that will buy legacy resident and commercial mortgage-backed securities.
For example, for each $100 of equity it provides and each $100 private sector fund managers invest, the Treasury is promising to lend only an additional $100 in debt. It might then lend another $100 but, even then, the debt-to-equity ratio would only be one-to-one.
This is, relatively speaking, quite a conservative approach. One banker I spoke to before the announcement of the plan suggested that it would definitely work – in the sense of the private sector being willling to buy legacy securities – if there was debt to equity leverage of two- or three-to-one.
That would, he suggested, provide enough investment potential for a fund buying these assets to pay more than the price to which they have been marked down by banks while being reasonably confident of making profits. Given a lower leverage ratio, it may be a finer calculation.
The results of the plan are uncertain, of course, but I am not inclined to write it off before it is tested, either on the grounds of moral hazard or of efficacy.
