Geithner's Problem In A Nutshell

Yesterday was his boss’s turn. Today’s it’s Tim Geithner’s.

There are two crises going on, a financial one and an economic one. Yesterday, Obama went to Indiana (a red state that he flipped and needs to suck up to, so they’ll keep going blue), and then to national television, to talk about the economic situation. His message was that the only way to make the economy better is to spend a lot of borrowed money, right now, and it almost doesn’t matter what we spend it on.

The economic crisis is actually rather easy for the President to deal with, on the terms in which he has framed it. He’s not actually interested in returning the US economy to stable, sustainable growth, while repairing the global macro-imbalances which are part of what caused the crisis.

All the President wants to do is to “create or save” 4 million jobs. He already has a disingenuous economic report in hand, published on January 9, which presents a spreadsheet version of an economics-101 case that $800 billion or so in government spending produces 1.5 times that much additional GDP, which by Okun’s law will create or save 4 million jobs. QED.

Whatever happens in the economy, even a return to Great Depression-level unemployment rates, Obama will always be able to say that the situation would have been 4 million jobs worse than it is. His job is all done, except for the PR.

Geithner’s job is just beginning. He has to stabilize the financial system. Success for him is being defined as a return to reasonably-normal levels of private credit formation. He’s going to announce today that he really has no clue how to make that happen.

In a nutshell, Geithner’s problem is that America’s biggest banks aren’t actually dead, they’re just on life support. That constrains his options. Let me explain.

There are at least two reasons why banks aren’t lending. One is that weakness in consumer demand is also depressing demand for credit. This is something that Obama explicitly disagreed with last night. He’s wrong, of course. People want to save money rather than spend it. Thinking he was telling us something we didn’t know, Obama said that the pattern of financing consumption and investment with debt must come to an end. It already DID come to an end, about three months ago.

The more proximate reason banks don’t lend is because they’re undercapitalized. And that’s of course because they’re still working off the losses that they suffered in the collapse of the housing bubble.

Now it turns out that it’s quite difficult to add new capital to a bank. If you do, then existing bondholders get most of the economic benefit (because the higher capital level reduces the perceived default risk of the debt). This isn’t a good deal for the new shareholders, so private investors tend not to play along. This is one of the reasons that banks tend to go out of business when they fail, unlike industrial companies (which tend to renegotiate their costs and capital structure under court protection and keep operating).

There’s always the option of adding preferred stock, as Warren Buffett (a man with a vulture’s eye for low-cost opportunity) does. But this creates another tier in the capital structure above the common equity, and ultimately doesn’t make it easier to attract more common holders.

The existing TARP rescues are an attempt to have it both ways. They’re placements of preferred stock (which were mandatory and not discretionary, in the case of the nine largest banks), with very low coupons and relatively generous covenants. I’m not sure what Paulson was thinking at the time, but the existing TARP financings have some of the characteristics of common stock rather than preferred.

If you doubt that, just look at the recent CBO report whose widely-publicized headline was that the Treasury overpaid for the equity. I just gave you the reason why, several paragraphs up. Putting common stock into failed banks is generally not a good investment.

But accept the fact that the taxpayers can do things that rational investors never would. (After all, we have no choice in the matter.) Even so, the lending picture didn’t improve. Adding $350 billion in capital to a system that has already lost over a trillion and may lose another trillion or more… well, the image of the Dutch boy plugging his fingers into a leaking dike comes to mind.

Geithner’s job would be simpler (but not easier) if he could simply nationalize the banks, as the Swedes did in their banking crisis in the early Nineties, and as we did during the S&L crisis.

The reason he can’t nationalize the banks is because they’re not dead yet. They’re still functioning, many of them profitable, the rest with losses mostly under control, and they have a lot of common shareholders still alive and kicking. The destruction of shareholder value that would come from a nationalization isn’t palatable to anyone, not to mention the fact that a lot of these banks are in fact pretty well run.

As I’ve said before, we have a banking system frozen in amber. It’s not dying, but it’s not providing credit to the economy. In past recessions, we’ve lowered the base cost of money (the “Fed funds” rate), and allowed the banks to rebuild their balance sheets over time. This time, interest rates are already zero and can’t go lower. And the losses are far too big.

So Geithner would ideally like to find a way to entice private capital to come back into the banks. Let me tell you why he will fail.

In his words (which you will hear in his speech today), there’s a lot of capital out there which would like to enter, but can’t get financing. That’s an understatement. Private investors don’t make deals for the greater good. They need solid assurances that things are back to some kind of normal that they recognize and understand.

The kind of public-private partnerships that Geithner will propose (by way of creating secondary markets for distressed assets and encourage the formation of new consumer credit) are very far from normal. Any structure that’s exposed to oversight by Congress is subject not to risk (which can be measured and hedged), but rather to uncertainty (which can’t). You never know when Barney Frank will have a bad day and decide to completely upend the way you do business.

Obama’s executive-pay cap is a fine example of just such an exogenous event. Another is the possibility that Congress will force banks to increase mortgage lending. No sane investor puts money into something so unpredictable.

And then there’s the poor economy itself, as well as the secular picture of lower overall returns on capital. These are all excellent reasons to avoid investing in any business that makes its money from interest rate spreads. There’s just not enough opportunity in today’s banks, with their existing cost structures, to justify private investments.

The final point is that, even if you took every dollar of the private capital that’s sitting on the sidelines (in hedge funds, private equity firms and the like), I don’t believe that you’d have enough money to fully recapitalize the banking system. You’d probably have an amount of money that’s about the size of the original TARP plan. Geithner’s hope of saving the system with private money will fail because there isn’t enough private money.

The bottom line is that we’re in for a long period of relative economic underperformance. This does NOT have to be a catastrophe, to use the word that the President has been incautiously throwing around.

We’ve lost too much money to recover quickly, or by magic tricks. It’s just going to take time.

This post originally appeared at The New Ledger.