Originally published in The Wall Street Journal
April 4, 2009
Geithner's Bank Plan is a Good Start
By MARTIN FELDSTEIN
The Treasury's new Public-Private Investment Plan should be regarded as a pilot study to see if this approach can remove impaired assets from the nation's banks. If it works, Treasury will have to go back to Congress for substantially more funding to remove enough impaired assets to get the banks lending again.APIncreased bank lending is the key to a sustained recovery. Households and businesses that cannot obtain credit are now unable to spend and to invest, dragging down total demand and GDP. The banks are unwilling to lend because they lack confidence in the value of the loans and other assets they already carry on their books, and therefore lack confidence in whether they have enough capital to avoid insolvency. Removing these high-risk assets is a prerequisite to get the lending mechanism in gear again. The problem of uncertain asset values is particularly acute with respect to residential mortgages. An unprecedented one-third of all such mortgages now exceed the value of the houses that serve as their collateral. Because residential mortgages are generally "nonrecourse" loans (i.e., secured only by the underlying property), homeowners with negative equity have an incentive to default, leaving the banks with net losses. The frequency of defaults is increasing as house prices continue to fall. The Treasury's primary plan is to induce private investors to buy pools of such high-risk mortgages from the banks. Individual banks will offer pools of mortgages for sale. Private investors -- including pension funds, insurance companies, hedge funds and sovereign wealth funds -- will bid for each mortgage pool in an auction. The total purchase price for each pool will be financed by a combination of the private investor's equity, an equal amount of Treasury equity, and private loans guaranteed by the Federal Deposit Insurance Corporation (FDIC). Because the FDIC will guarantee six dollars of loans for every dollar of equity, the auction process is expected to produce prices high enough to induce the banks to sell their impaired assets. Because the mortgage loans will be priced in a competitive auction, there will be no windfall profits for the private-equity investors. The private-equity investors will be responsible for managing the pool of mortgage loans acquired, modifying interest rates, and reducing loan principals in ways that they believe will decrease defaults and increase the value of the loans. If the process produces a gain relative to the initial purchase cost, the private investors and the Treasury will share equally in the profit. If the result is a loss, the private investors and the Treasury can lose up to their entire equity investments. Losses higher than the initial investments would be absorbed by the FDIC as the guarantor of the loans. A similar structure will be used to finance the purchase of securities backed by residential mortgages, commercial mortgages and credit-card debt. Private investors will buy those securities from the banks at auction and the Treasury will co-invest an equal amount of equity. The Treasury will then match the equity investment with a nonrecourse loan. The entire amount will then be eligible for additional credit from the Federal Reserve. This process will again give the private investors and the Treasury equal profits or losses, depending on the investors' success in managing the securities. Losses beyond the equity investment would be absorbed first by the Treasury and then by the Fed. If it succeeds, this plan will remove some $500 billion of impaired mortgages and securities from the banks, will do so at market-determined (albeit artificially enhanced) prices, and will give taxpayers a possibility to gain along with the private investors who manage the assets. It will do all of this without nationalizing any of the major banks. Although the Treasury's plan is aimed in the right direction, it needs to be substantially expanded in three ways if it is to succeed. First, the Treasury must be prepared to inject capital into the banks that agree to sell mortgages. Without additional capital, the banks may not be willing to sell the mortgages that are causing their lack of confidence. Here's why. Although mortgages with high loan-to-value ratios have a high probability of imposing substantial losses through default, they are carried on the banks' books at their full nominal value as long as the borrowers are making their monthly payments. Selling these mortgages would require the banks to recognize losses that would reduce their capital, pushing them toward insolvency. To remedy this problem, the Treasury should offer to provide enough replacement capital in the form of either preferred shares or perpetual debt to offset the loss of capital caused by selling the impaired loans. Second, cleansing the banks' balance sheets will also require much more Treasury money for equity investments and loans. The current plan to remove $500 billion of impaired assets will not be enough to cleanse the banks' balance sheets to a point where they can be confident enough about the remaining assets to resume lending. The banks now own $3 trillion of residential mortgages, $1.5 trillion of corporate real-estate loans, and $1 trillion of consumer debt. While not all of these loans are impaired, the banks will have to sell much more than $500 billion of loans to regain confidence in their solvency. Third, even if all of the existing impaired assets are removed from a bank's balance sheet, the remaining mortgages that now have positive equity are in danger of sliding into negative equity as house prices continue to fall. That risk can be reduced or eliminated if the government offers "mortgage replacement loans" (along the lines that I suggested on this page, March 7, 2008) equal to 20% of the existing mortgage. Such loans would have a very low interest rate but the borrower would have to personally be liable for them, and could not discharge the debt in bankruptcy. Because the new mortgage would have a lower principal, it would provide a firewall -- even an additional 20% decline in a house's value would still leave the homeowner with positive equity and no incentive to default. It's critical that we get the banks lending again and providing the kind of back-up credit lines that facilitate the commercial-paper market. The Treasury plan appears well-designed in principle to do that. If the Treasury shows that it can use the available $500 billion to buy mortgages and asset-backed securities, it will then need to scale up to induce the banks to sell a larger amount of their impaired loans and to prevent a damaging deterioration of healthy mortgages as home prices decline.
Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.