The Bailout: Will the Sequel Pack a Bigger Punch?
Is Financial Rescue 2.0 better than the original?
It was hard to believe following Treasury Secretary Timothy Geithner's vaguely worded unveiling on Feb. 10 of the newest bailout plan for the banks. Obama Administration officials had pledged to restore confidence with a more aggressive effort than the rescue hatched by Henry Paulson, Geithner's predecessor. Instead, investors disappointed by Geithner's lack of specifics sent stocks tumbling. "There's not enough there there," says Thomas Gallagher, head of policy research for institutional broker ISI Group.
Now the market, which had hoped Treasury's new plan would directly buy up the banks' bad assets at inflated prices, must figure out whether Geithner's proposals will work as he fills in the details. Here are key questions investors will be asking.
Will the "stress test" winnow out the weakest banks?
Daniel Alpert, managing director of Westwood Capital, will be closely watching the enhanced "stress tests" that Geithner says all banks with more than $100 billion in capital must undergo. Regulators will comb through the banks' books far more closely than before to see if they have the capital to endure worsening conditions.
The key issue is what regulators will do if that testing shows that many banks would be insolvent if the troubled assets they hold were properly valued. Alpert believes Geithner will force banks to mark their assets down and let all but the most important fail, be restructured, or get acquired if they lack enough capital. R. Christopher Whalen, managing director of Institutional Risk Analytics, is far less convinced that Treasury is ready to clean house. Both agree that bank failures would be a painful yet needed step to avoid a long, Japan-style slump. "I'd look to see if that scenario plays out over the next six months," Alpert says. "If it does, that will cure the banking system."
Will private money get in the game?
Geithner must sign up hedge funds and other private investors to the new public-private partnerships he's proposed to acquire the banks' toxic assets. Getting a few deals swiftly under way could boost investor sentiment.
Details about the partnerships are few. Analysts believe the government might provide, say, the first 20% of the equity, with private investors coming up with the rest. The government would then lend the fund more money so that its seed capital, using a modest amount of leverage, could be stretched.
It's unclear, though, why private investors would sign on. They can buy bad assets now on their own. Treasury hopes its willingness to boost investors' returns with some leverage will entice them. "Financing is so tight, it's difficult for private investors to find leverage," says Jacob Benaroya, managing partner of Biltmore Capital Group in Rochelle Park, N.J.
Will they get the pricing right?
This will be the hardest task of all—and the most crucial. The inability to agree on the value of the soured mortgage-backed assets—even as steady declines have eroded the banks' capital—has been at the heart of the crisis. Treasury fears the politically treacherous course of overpaying, which would essentially subsidize the banks at taxpayers' expense. But if they pay too little, they could force the banks into a new round of write-offs.
Geithner hopes to get around the dilemma by letting the private partners determine prices for the securities they jointly buy. "The private sector will be better at [pricing these assets] than we are," says one official. But until Treasury and its partners come up with a pricing mechanism, no one knows if the idea will work. This approach may not be a panacea: "What happens when there are reasonable disagreements over the value of those assets?" asks Bert Ely, a banking industry consultant.
Will foreclosures slow down?
Treasury won't unveil how it plans to use the $50 billion allotted for foreclosure relief for another week or more. Any sign the government is finally doing a more effective job of slowing foreclosures would go a long way toward restoring confidence.
Such restructuring has proved difficult to pull off, given the reluctance of banks and mortgage servicers to adjust loans to affordable levels. But with the Democrats threatening to let judges modify mortgage terms in bankruptcy court, Geithner may finally have the stick he needs to force lenders to be more lenient.
Ultimately, simultaneous progress on the housing market, the banks, and the recession will be needed. "Executing this is like riding a unicycle on a dental floss tightrope over a sea of razor blades," warns Lawrence R. Creatura, a portfolio manager for Federated Investors. "It's difficult to do well."