Increasing Criticism of Public Private Partnership Investment Program

There has been recently fairly strident criticism of the Public Private Partnership Investment Program announce by Treasury. One of the sharpest is that made by Professor Jeffrey Sachs, who posted his critique on the Huffington Post website -- "The Geithner-Summers Plan is Even Worse Than We Thought." Mr. Sachs' main point is that there is the possibility of gaming the system by a bank essentially selling worthless assets to a partnership the bank or a confederate has entered into with the government. When the assets prove worthless, the government takes most of the loss, but the bank is ahead by the upfront money it received in the sale minus its small loss in the partnership.

Business Week also criticizes the plan in an article entitled "Geithner's Plan: Loopholes Galore." The article outlines five possible ways, depending on the final rules, to game the new program.

Joe Stiglitz weighs in with an op-ed in the New York Times -- "Obama’s Ersatz Capitalism." A key sentence in the piece: "Even in an imperfect market, one shouldn’t confuse the value of an asset with the value of the upside option on that asset." Stiglitz also states: "Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time."

Peyton Young also piles on in the pages of the Financial Times. The article, "Why Geithner’s plan is the taxpayers’ curse," analogizes the "winner's curse" in the economic literature on auctions to the position of taxpayers under the current Treasury plan -- "This is the singularly perverse feature of the Treasury proposal: the greater the competition among the bidders, the worse off the taxpayers and the more distorted the so-called “market” prices that result." The article further states: "It is truly dismaying that the Obama administration, which publicly champions greater transparency, should put forward a proposal whose main object is to subsidise the banks without appearing to do so."

Paul Krugman, of course, can be counted on to criticize the plan. In his March 23 op-ed article in the New York Times, "Financial Policy Despair," he writes that "the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets." While conceding that "troubled assets may be somewhat undervalued," Krugman argues that the "Geithner plan" is "financial hocus-pocus" that will not work. Financial executives, he argues, lost their bet on the housing bubble and "the related belief that unprecedented levels of household debt were no problem."

Steven Pearlstein, who was an original supporter of the TARP plan to buy assets that Secretary Paulson proposed and then abandoned, strongly and sarcastically criticizes Krugman in a March 24 column in the Washington Post -- "Optimism over Despair." In the article, Pearlstein argues against "nationalization" of big banks. He also argues that, in regard to the assets it is directed at, the Administration's plan "merely restores things to a more normal situation in which the market prices reflect expected cash flow rather than reflecting the unavailability of reasonable financing."

A less pugnacious defense of the plan appeared in the same paper that Krugman writes for -- Joe Nocera's March 28 article, "This Time, Geithner's Plan for Banks Makes Sense." Mr. Nocera argues that the government is not bribing investors "to purchase the assets at inflated prices ... Instead, it appears that the government is trying to return some normalcy to the workings of the market." He concludes that the plan is not perfect or "guaranteed to do the trick," but " could, in the best case, make our banks a little healthier and a little better to extend credit."

Willaim Black, a former official with the Federal Home Loan Bank Board (now defunct) and the Office of Thrift Supervision, is extremely blunt in his criticisms of the current approach to the banking crisis in an interview on Bill Moyer's Journal last Friday. Among other charges, he argues that government officials in the Bush and Obama administrations are violating federal bankin law by not closing down insolvent banks according to the prompt corrective action provisions enacted in reaction to the S&L crisis.

Andrew Ross Sorkin of the New York Times raises another legal issue in an April 6 article, "‘No-Risk’ Insurance at F.D.I.C" (reproduced here along with excerpts from the relevant statute). He suggests that the amount of the guarantees that the FDIC is planning on extending stretches current law, and that, in order to comply with its interpretation of the law, the FDIC is projecting that the expected cost of the guarantees to the FDIC is zero.

Finally, for a depressing view of out current economic situation, there is Simon Johnson's article in the forthcoming May Atlantic, "The Quiet Coup." Among other points, the former chief economist for the IMF argues that Wall Street has way too much influence in Washington. His disturbing conclusion is: "The conventional wisdom among the elite is still that the current slump 'cannot be as bad as the Great Depression.' This view is wrong. What we face now could, in fact, be worse than the Great Depression—because the world is now so much more interconnected and because the banking sector is now so big. We face a synchronized downturn in almost all countries, a weakening of confidence among individuals and firms, and major problems for government finances."

The Adminstration is betting that Mr. Johnson is completely wrong, and that economic conditions will soon begin improving. In that case, the Administration plan with respect to the troubled, toxic, or legacy assets (or whatever their new name is) will look good, at least if the Administration can police it sufficiently to avoid it being gamed. Even then, if some investors are perceived as making too much money, there could be some political problems.

If, on the other hand, the economy continues in a slump, even if not as bad as Simon Johnson fears, then the Administration will be facing all sorts of charges of mismanagement. That liberals are currently attacking the program means that the Adminstration will not have a lot of political capital if things turn wrong and it has to go to another plan and ask the Congress for more money.

The lack of an effective response by the Administration to the criticisms, especially those involving gaming the new program, is surprising. They should have been able to anticipate this. When it comes to these types of programs, which can be easily painted as helping out Wall Street executives who already are too wealthy, it is not enough to have a program which you think is the correct one. You need to be able to sell it. If you cannot figure out how to do that, maybe you need to rethink the plan.

Treasury and Mortgage Fraud -- A New Focus

The U.S. Treasury Department issued a press release today concerning mortgage fraud -- "Federal, State Partners Announce Multi-Agency Crackdown Targeting Foreclosure Rescue Scams, Loan Modification Fraud." The focus on this is new for the enforcement staff at Main Treasury.

In the Bush Administration, after the enforcement mission and staff of Treasury was altered by the creation of the Department of Homeland Security, the chief interest of the relevant offices had been terrorist financing. One indication of this is the name of the umbrella office the Under Secretary in this area heads -- "Terrorism and Financial Intelligence." Interestingly, the Under Secretary is Stuart Levey, who was held over from the Bush Administration.

The Main Treasury staff reporting to Stuart Levey is small, if one excludes the Office of Foreign Assets Control, which is technically a Main Treasury office but given its size and mission is somewhat split off from the rest of Treasury. The key people under Levey have in the past been most concerned about terrorism and other national security issues, such as the proliferation of "weapons of mass destruction." They are undoubtedly still very focused on those issues, but that they are now making a public effort on mortgage fraud is reflective of how things have changed. No doubt, especially since the enforcement structure at Main Treasury is relatively new, these offices want to be perceived as relevant. We can all hope, though, that Treasury can contribute in this area through its own staff and through its bureau, the Financial Crimes Enforcement Network ("FinCEN").

Sanders and Gensler

In a previous post about the nomination hearing of Gary Gensler to be Chairman of the Commodity Futures Trading Commission, I stated that "it is very likely he will be confirmed." His nomination has, according to press reports, hit a roadblock -- holds by Senator Bernie Sanders and another unnamed Senator.

Often Senators who put holds on nominations are holding out for something they want from the Administration, not because they have a strong objection to the nominee. This is not true in this case though. Senator Sanders objects to Gary Gensler because of his role in the Clinton Administration in getting the Gramm-Leach-Bliley Act and the Commodity Futures Modernization Act enacted. Even though Mr. Gensler has made all the right statements to convince Senator Harkin that he would be tough regulator, it is hard to see what the Administration can offer Senator Sanders to release his hold. It is not clear whether the Senate leadership feels strongly enough about this nomination to bring it to the floor despite Senator Sanders' and the unnamed Senator's objections. To an extent this is a test of will and patience. Mr. Gensler will probably be ultimately confirmed, but it is not a sure thing.

The problem this nomination is having also highlights a problem for the Obama Adminstration. There is a growing consensus that the financial regulatory structure needs to be changed and that some regulatory oversight needs to be strengthened. While the Obama Adminstration can point to what they consider failures in regulatory policy under Bush, two key pieces of legislation, the GLB Act and the CFMA, were enacted in the Clinton Administration and with its support. Some of the people who were involved in the Clinton Administration with these legislative initiatives are now officials or advisers in the Obama Administration. To paraphrase Mr. Gensler in his nomination hearing, views have "evolved."

Greenspan and Too Big to Fail

Last fall, I believe, Senator Bernie Sanders said something to the effect that a financial institution that is too big to fail is too big to exist. This position, though, is not confined to people on the left, and it is an issue that needs to be considered in the debate about financial regulatory restructuring that is coming.

In a March 26 article in the Financial Times (“We need a better cushion against risk”), Alan Greenspan argues that institutions that are too big to fail have “a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage.”

That is an interesting idea and a reversal of arguments I heard when I was devising capital rules for a relatively small group of specialized government securities brokers and dealers that capital requirements for large firms should be less because their size and diversification made them less risky. Large banks are likely to fight Greenspan’s idea if it gains traction.

In addition to “too big to fail,” we also have to be concerned about “too important” or “too interconnected” to fail. For example, the clearing of government securities transactions for the major dealers is handled by only two banks – JPMorgan Chase and Bank of New York Mellon. There are not likely to be any new entrants anytime soon into this business because of its high barriers to entry. The clearing function of these two banks is vital to the functioning of the market for Treasury securities, which has enormous importance for fixed-income markets generally, as well as being essential to both the Treasury and the Federal Reserve. Whatever happens to these banks, this clearing function needs to continue. Moreover, neither banks is likely to want to have the entire market for clearing to itself, because of the risk this entails.

The issue of what to do about systemic risk is not easy. Simply stating that we will give the Fed unspecified authority to deal with it is not anywhere near a complete answer. If we are to change our regulatory system, there needs to be serious thought and debate about what kind of financial sector we should have and whether it is desirable to reverse the consolidation of financial institutions that has been facilitated by legislation, most notably in recent years by the Gramm-Leach-Bliley Act. It is interesting that Greenspan has entered into the fray on this subject with an idea likely to be opposed by the major banks.

The Role and Worries of the Federal Reserve

Much of the burden of dealing with the current financial crisis has fallen on the Federal Reserve. If Treasury is not able to get approval for new programs and appropriations to fund them, the Fed may feel called upon to do even more if conditions do not improve.

The Fed, which cherishes its independence but realizes that it has limits, is clearly concerned that it may be getting into areas more properly labeled as fiscal policy. This appears to be what motivated a joint Fed/Treasury statement on March 23 -- "The Role of the Federal Reserve in Preserving Financial and Monetary Stability." This statement did not attract much attention since it was buried by other news.

The Federal Reserve clearly does not want to be in the credit allocation business and wants Treasury to take off its hands as soon as it can the "so-called [and opaque] Maiden Lane facilities." The statement also highlights the difficulty the Fed has had with both implementing monetary policy and dealing with the crisis, and it makes reference to the help the Treasury has provided the Fed in this regard with the Supplementary Financing Program. In addition, the statement mentions that Treasury and the Fed will ask for legislation "to provide additional tools the Federal Reserve can use to sterilize the effects of its lending or securities purchases on the supply of bank reserves." This probably means that the Fed wants to be able to issue its own securities, an idea that has some problems which I am sure will surface in Congressional hearings if pursued.

What this all shows is the continuing overlap in monetary and fiscal policy. The Treasury has been helping the Fed in monetary policy by borrowing funds it does not need, and the Fed has been using its ability to provide financial assistance to certain institutions and sectors of the economy because the Treasury does not have the resources to do it in a more accountable manner.

Treasury Cash

An arcane sign of how much economic conditions have changed is worth noting. Treasury’s cash management has changed. It had been the practice until September of last year for Treasury to maintain about $5 billion at the Federal Reserve and the remainder at commercial banks in Treasury Tax and Loan Accounts. This began to change last September, when Treasury and the Federal Reserve announced that Treasury would issue bills in order to deposit cash in a special “supplementary financing account.” As I discussed in the first post to this blog, this was intended to help the Federal Reserve with it monetary policy operations.

Beginning in late October, the balances that Treasury holds in its general account at the Federal Reserve began increasing, along with cash in the supplementary financing account that topped $500 billion. Subsequently, the amount of cash that Treasury held at commercial banks began decreasing to the $1 to $2 billion level. Currently, holdings of $60 to $70 billion in the general account are typical along with somewhat under $2 billion in Tax and Loan Accounts. Also, as of the end of March, Treasury had almost $200 billion in the supplementary financing account at the Fed. (The Treasury has continued with this program; the latest cash management bill to finance this account was announced on March 30 to be auctioned on April 3. Treasury is offering $35 billion of 56-day bills.)

Treasury does not appear to have made any statements concerning the change in cash management practices. Here are some reasons that come to mind that may explain the changes.

• The amount of collateral banks are willing to pledge as collateral to accept Treasury deposits may have decreased.

• The interest rate on TT&L accounts is set at 25 basis points lower than the fed funds rate. This means that Treasury is not be getting any interest on its TT&L deposits. While deposits at the Fed do not explicitly earn interest, they do drain reserves from the banking system. The Treasury may figure that Fed earnings increase because of the offsetting actions the Fed takes. Since increases in Fed earnings increase the amount the Fed pays Treasury as “interest on Federal Reserve notes,” this is the equivalent of receiving interest on the deposits. If this is a factor in the change in Treasury cash management practices, it is not clear how much implicit interest the Treasury considers it is earning on its deposits at the Fed. Complicating the analysis is the interest that the Fed pays on required reserves and excess reserves since last October.
  

• Treasury may be holding substantial amounts of cash in order to have it ready in order to be able to respond to financial developments quickly.

By way of background, when interest rates began climbing in the 1970s, Treasury began holding higher balances at the Fed since at the time there was a prohibition on banks paying interest on demand deposits. Increases in Treasury deposits at the Fed forced it to take offsetting actions in the repo market, which served to increase Fed earnings and consequently the amount it paid to Treasury periodically. (The Fed remits its earnings above its expenses to the Treasury.) The Fed was not happy about the operational difficulties of offsetting Treasury cash balances, which can fluctuate considerably. Legislation was passed in the late 1970s that enabled banks to pay interest to the Treasury on its deposits. The Treasury set the interest rate at the fed funds rate minus 25 basis points, which at the time was a good proxy for the overnight repo rate. To help the Fed out with its operational concerns with fluctuations in Treasury cash balances, Treasury targeted a fixed cash balance at the Fed. There continued to be times when the balance at the Fed was over the target level. A principal cause of this was the amount of collateral the banks wanted to pledge to accept Treasury cash was limited. Over the years, Treasury has broadened the types of collateral it will accept in order to increase the amount of cash the banks would be willing to accept in TT&L accounts.

(Data on Treasury cash balances are reported in the Daily Treasury Statement.)