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Americans can be forgiven for experiencing a sense of deja vu as they digest the
details of Treasury Secretary Timothy Geithner’s Public-Private Investment
Program (PPIP) for troubled bank assets. What was rolled out on the pages of
newspapers this week read like press releases on the various plans over the past
year from Mr. Geithner’s predecessor, Hank Paulson.
The two Treasury secretaries share a touching faith in public-private
cooperation to lift the value of troubled assets. This assumes, of course, that
those assets are troubled because their true values are obscured by irrational
self-doubt and market illiquidity, and not by fundamental problems in the
prospects of repayment. It also assumes that the solution to problems created by
excessive leverage is for government to encourage more leverage.
Notably absent in the Geithner plan is any progress on the barrier at which
Mr. Paulson stumbled last year: What are the right prices for troubled assets?
To believe that the solution lies in harnessing the public and private sectors
in tandem shows a misunderstanding of these sectors’ incentives.
Public officials want this problem to go away without being stuck with the
smoldering wreckage of large and complicated financial institutions. That
requires buying assets quickly from problematic firms at the highest prices
Private investors want to make a profit. That can best be achieved by
delaying purchases, thereby lowering prices and sticking the government with as
much of the loss as possible.
The possibility of outsized profit, made possible by government guarantees
and matching capital contributions, is the carrot government can offer to those
with private capital willing to commit to the enterprise. The problem is that
Congress has been demonizing the financial sector and considering ex post
expropriation of bonuses.
For the PPIP to work, the government will have to use the expertise of
much-vilified financial professionals, create massive expected profit
opportunities to entice capital, and tap places where there are deep pools of
money — including sovereign wealth funds. If the PPIP is successful, is there
any chance that Congress would not be holding hearings complaining about the
massive rewards to those who took on the risk? Unless members of Congress cool
the heat of their rhetoric, the potential profits Mr. Geithner is putting on the
table will simply be left there.
When the government’s carrot does not work, next will come the stick.
Remember, 19 of the largest financial firms have been asked to submit to stress
tests detailing the adequacy of their capital.
Talk about irony. Financial markets are in disarray today because leading
firms chose to bury complicated instruments in their books. The results were
opaque balance sheets that hid the considerable use of leverage, and proved
misleading both to investors and examiners. These same firms are now being
required by regulators to use these misshapen accounts to make far-ahead
But the objective of the stress test is not to get useful forecasts. Rather,
it will provide the excuse for regulators, outside the usual process of
examination and resolution, to open a discussion with major firms about the
adequacy of their capital.
A dialogue, once started, can then proceed to capital infusions, forced
mergers and other forms of balance-sheet relief. This will all be with an eye to
creating strong incentives for bank managers to attract private capital. If
necessary, the stress tests can be used to force fire sales that will attract
private capital through the PPIP.
So the government, once again, has opted for a circuitous route to the goal
of sorting out financial firms. This will take longer than necessary and
sacrifice clarity. But obfuscation was probably a design principle. As yet, the
American public does not appear ready to admit that its government will have to
absorb large losses to restart financial markets. Until that day comes,
government action will continue to be indirect and probably insufficient.
This circuitous route can work, provided that the branches of the government
pull in the same direction. Politicians are going to have to understand that the
longer-term good of the nation involves cooperating with, not castigating,
financial professionals. And the Obama administration will have to understand
that its approval rating is to be used to convince the public of hard choices.
Vincent R. Reinhart is a resident scholar at AEI.
The new Public-Private Investment Program looks similar to, and faces the same technical challenges as, plans proposed by then-treasury secretary Paulson last year.
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