Tuesday 31 March 2009
Geithner treads line between paralysis and resentment
Call it Uncle Sam’s hedge fund. The rescue of the American financial system proposed by Treasury Secretary Timothy Geithner is, in all but name, a gigantic hedge fund. The government would lend vast sums to private investors to enable them to buy loss-ridden assets at discounts from banks with the prospect of making sizeable profits.
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Geithner treads line between paralysis and resentment
By ROBERT SAMUELSON
31 March 2009
Call it Uncle Sam’s hedge fund. The rescue of the American financial system proposed by Treasury Secretary Timothy Geithner is, in all but name, a gigantic hedge fund. The government would lend vast sums to private investors to enable them to buy loss-ridden assets at discounts from banks with the prospect of making sizeable profits.
If that’s not a hedge fund, what would be? The hope is that the US$14 trillion US banking system would expand lending if it could get rid of many of the lousy securities and loans already on its books.
Almost everyone thinks a healthier banking system is necessary for a sustained economic recovery. Can the Geithner plan work? Maybe, though obstacles abound. One is political. Private investors may balk at participating because they fear populist wrath. If the plan succeeds, many wealthy people will become even wealthier. Congress could subject them (or their firms) to humiliating hearings or punitive taxes. Why bother?
Another problem: Investors and banks may be unable to agree on prices at which assets would be bought. But succeed or fail, Mr. Geithner’s plan illuminates a fascinating irony.
‘Leverage’ - borrowing - helped create this mess. Now it’s expected to get us out. How can this be? It’s not as crazy as it sounds. Start with the basics on how leverage affects investment returns.
Suppose you bought a stock or bond for $100 in cash. If the price rises to $110, you make 10 per cent. Not bad. Now, assume that you borrowed $90 of the purchase price at a 5 per cent interest rate. Over a year, the stock or bond still increases to $110, but now you’ve made more than 50 per cent. You pay $4.50 in interest and pocket a $5.50 gain on your $10 investment. Note, however, that if the price fell to $95, you’d be virtually wiped out ($4.50 in interest paid plus $5 lost on the security).
Economist John Geanakoplos of Yale University argues that the economy regularly experiences ‘leverage cycles’. When credit is easy, down payment terms are loose. Investors or homeowners can borrow much of the purchase prices of houses and securities. Prices of assets (stocks, bonds, real estate) rise, often to artificial levels because investment returns are so attractive. But when credit tightens - government policy shifts or lenders get nervous - the process reverses. Prices crash. Leveraged investors sell to repay loans. New borrowers face stiff down payment terms.
To Mr. Geanakoplos, we’re suffering the harshest leverage cycle since World War II. Three years ago, he says, homebuyers could put down 5 per cent or less. Now they’ve got to advance 20 per cent or more. Hedge funds, private equity funds and investment banks could often borrow 90 per cent of security purchases; now borrowing can be 10 per cent or less. ‘Deleveraging’ has caused prices to plunge to lows that may be as unrealistic as previous highs.
Grasping this, you can understand the idea behind Mr. Geithner’s hedge fund. It is to inject more leverage into the economy - not to previous giddy levels but enough to reverse the panic-driven price collapse. Details remain unsettled, but the plan would allow 6-1 leverage ratios in some cases. Here’s an example. Private investors put up $5; the Treasury matches that with another $5. This equity investment could then be expanded by $60 of government-guaranteed loans. The entire $70 could be used to buy assets from banks.
Sounds simple. In practice, it won’t be. Given all the deleveraging - a record 15 per cent of hedge funds closed last year - the market prices of many securities have been driven well below prices that seem justified by long-term cash flows. Mr. Geanakoplos mentions one mortgage bond whose market value has dropped by roughly 40 per cent even though all promised payments have been made and, based on the performance of the underlying mortgage borrowers, seem likely to continue. If banks sold this and similar credits at today’s market prices, they would have to record huge losses. (‘Banks Face Big Writedowns in Toxic Asset Plan,’ headlined the Financial Times.) Their capital would be depleted and they’d have to raise more or request more from government.
Presumably, the government-supplied leverage would enable investors to pay higher prices. After all, that’s the purpose. Still, whether sellers and buyers ultimately agree on prices is unclear. If they can’t, Mr. Geithner’s hedge fund will remain puny. Cautious banks will continue to constrict credit. But success also poses problems. Money managers talk about making huge annual returns of 20 per cent or more from a scheme in which government puts up most of the funds and takes most of the risk. A political backlash might squash the project before it starts.
Mr. Geithner treads a narrow line between financial paralysis and populist resentment. -- Washington Post Writers Group
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