A Public-Private Partnership?
To Chris’ comments about the banks and the knowledge of the debt that they hold, this is generally my view of things although I suspect that it is not as much that banks do not know what they are holding (they most certainly know what is in their portfolios) as it is that they have yet to fully grasp the extent to which there are toxic assets in their respective portfolios. No one should expect an accurate assessment at this point. There are so many different factors in play between asset valuations, economic conditions and the real estate markets that this will not be determined until all the uncertainties (the buried bodies if you will) play themselves out and conditions in both the economy and the financial markets stabilize. Furthermore, this is not going to be a fast process since a lot of the 2005-2007 vintage debt is still in the markets in sizable quantities (I think this is where a lot of the problems lie because underwriting standards were very relaxed if not nonexistent in certain sectors). It could take banks, conservatively speaking, 12 to 24 months to figure this out. In the meantime, commercial banks will proceed slowly, lending on a very selective basis and using the belt-and-suspenders approach to manage its risk exposure on new loans. With the so-called “shadow banking system” completely out of the picture as it is now and with commercial banks taking it very slowly, under current conditions, we could be well into 2010 before we see anything different than what we are seeing now. I don’t expect politicians to sit idly by.
What to do? Although I admit there being a real possiblity of at least a temporary bank nationalization (something six months I would have dismissed outright), I think the government-as-shareholder model is a terrible idea and so conflict-ridden that it should only be considered as an absolute last resort of all last resorts (hat tip to Kip at A Stitch in Haste). I do not think there is more I need to say on this note. I think restoring TARP to its original purpose is a potentially interesting alternative; however, it is not without its problems. My biggest concern is that with billions of dollars of loans outstanding in vast worldwide financial markets with bad assets all over the place, it is going to be incredibly difficult for a single government body, even working in conjunction with the banks, to be able to develop criteria, a strategy and be able to execute it in a timeframe that I think is necessary right now.
Although it would probably be politically unpopular, and I would like to consider the possiblity of a decentralized public-private partnership strategy. Private capital to the tune of billions has been raised to target distressed debt. Most of that capital has yet to be deployed due primarily to 1) market conditions and the expectation that prices have not bottomed out; and 2) the bid-ask spreads between what buyers are willing to pay for discounted loans and what banks are willing to sell them for (likely the value on the bank’s books) are very wide (30%-50% differences). I am also confident that the people in these markets have extensive knowledge of where the opportunities exists and can target them very quickly.
The government’s role would be akin to an insurance program where it would guarantee some miniumum value (or return) to the investors with the purpose of eliminating a considerable amount of the downside risk in these transactions. While a market manipulation to be sure, a measure such as this would be aimed to reduce the amount of uncertainty that is factored into market pricing. Basic principles of risk and return suggest that with lower risk, investor return requirements will also be lower. As such, either investors would raise prices to the point where banks holding “toxic assets” would be willing to transact or new investors with a similar risk profile would enter into the market.
I understand that it is far from perfect. For one, there is no guarantee that the banks themselves would sign on to such a plan and I think it would be difficult to convince lenders to sign on if the bid-ask spread does not tighten sufficiently enough. I would find it distasteful to have to force lenders into this sort of arrangement although I would probably (and very reluctantly) be amenable to this scenario if taxpayer money continues to shore up the balance sheets of these banks in the way it is being done at the moment. There is also the problem of cost. While I envision a program like this not to require large outlays at first, it is going to take time to determine the true extent of the toxic assets in our financial system. I have no idea what this will cost and I will not even pretend to make an estimate.
However, I think a compromise can be reached on a point that could be particularly sticky: to the event a deal generates a return higher than the miniumum (or some other benchmark), the government participates in the upside. Using broad numbers, if the minimum return is 5% and a deal generates 15%, then the cash proceeds that generate the return in excess of the guaranteed minimum would be divided between government and investor based on some predetermined percentage. Otherwise, it is yet the potential of appearing like another program where the losses are socialized and the profits are privatized. Given the amount of risk borne by the taxpayers, I think this program would be a tough sell (if it isn’t already) if the potential liabilities of such a program are not at least in theory partially offset where deals perform above expectations.
This is an idea I have kicked around in my head and this is the first time I’ve made any attempt to put it to paper. Whether or not people agree with my idea, I do believe that the private sector can play a significant role in shoring up our financial markets, at least as it pertains to idenfitying and attempting to purge the bad blood out of the system. In my opinion, possibilities involving public and private sector coordination should be explored to their fullest extent before the discussion of bank nationalization gets legs. I do not pretend to know the answers to these difficult questions but I hope this discussion can at least get people thinking in this direction.