The Geithner Plan by nvbc7n893

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									                                                                                                                                                  April | 2009




                                                                   The Geithner Plan
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             On March 23 US Treasury Secretary Timothy Geithner finally announced the practical details of the US government's plan to improve the
health of its financial system. This note covers the plan and its implications.

             To get the subject in perspective: The US economy is facing its biggest crisis since the Great Depression, and part of the responsibility for
this lies with the financial system. In an environment of low interest rates and easing of regulation, the system took much more risk than was
recommendable – this is basically the story of the period 2000–2006. As from 2006 the winds began to change, most visibly in the housing sector. The
appreciation of real estate values began to reverse, and this brought into evidence the excesses committed over the immediately previous period. The
intense expansion of credit supported by doubtful criteria created a situation of great fragility for financial institutions. In the second half of 2007 the
financial problem took on another dimension when it also began to affect economic activity, beginning a vicious cycle in which the deterioration of the
financial system negatively affected the economy, and the consequent worsening of economic conditions itself exacerbated the financial difficulties.
These dynamics are a reasonable summary description of the period starting in the second half of 2007. Thus, the solution for this crisis requires two
types of measures – those to reactivate the economy, and those to improve the health of the financial system – and they need to come hand-in-hand. As
Federal Reserve Chairman Ben Bernanke has reiterated, the solution for the severe crisis of the US economy requires both reactivation of the economy
and also, necessarily, a solution for the problems of the financial system.

             How to sum up the problem of the US's financial institutions? Well, the description is quite simple: they have an enormous quantity of assets
(securities and loans) of doubtful quality, the value of which has recently fallen significantly, and because of this they have had to recognize large-scale
losses, seriously affecting their equity situation. One of the consequences has been a major reduction in the supply of, and corresponding increase in the
cost of, credit. This was the mechanism through which the situation of the financial system finished up affecting economic activity.

             In spite of being easy to describe the problem, its solution is not that simple. Financial crises almost always end when the public sector
decides to assume the losses of the private sector, but the process that leads to this point is usually very traumatic. The difficulties show themselves
firstly in the process that leads the authorities to recognize that the participation of the public sector is essential, and then to decide on the mechanisms
by which this participation will actually take place. The initial phase has been relatively short. The virulence of the crisis led US authorities to quickly
accept the need for their intervention. Examples are the participation in the sale of Bear Stearns and other banks, the nationalization of Freddie Mac and
Fannie Mae, and the financial help given to the insurance company AIG. In all these examples, the US government acted using a case-by-case approach;
but when the situation worsened this format ceased to be feasible, and a demand for systemic solutions emerged. This was the beginning of the second
phase – the phase of decision on the mechanisms by which the participation of the public sector in the solution of the problem would actually become
effective and systematic. Chronologically, that began in September 2008, during the Bush administration.

             The proposal by then Treasury Secretary Henry Paulson consisted basically of a program to buy the banks' rotten assets through market
mechanisms, with public money. The idea was that this process of cleaning of bank's balance sheets would enable them to start lending again, and that
the mechanism chosen would avoid debates about the control of the financial institutions, which would arise naturally if the public sector chose to
directly to capitalize institutions with problems. The proposal was soon abandoned, because the Bush administration realized that the mechanism
would be difficult to put in place.

             The new administration took over at the end of January signaling in advance that its proposal would be different. But the presentation made
by Timothy Geithner on February 10th was considered disappointing for two reasons: first, for its similarity to the Paulson proposal, and second, for its
lack of details. These details were finally disclosed on March 23rd.
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                        So what is Geithner's plan? It involves two strategies, intimately related. The first is a scheme to capitalize the banks (Capital Assistance
Program, CAP) based on a process of evaluation of their capital needs in pre-determined stress situations. Under this system, the public sector would
come in directly injecting capital, while at the same time institutions would be stimulated to seek financing also in the private sector. The second
strategy is the purchase of toxic assets (securities and loans) from the banks in a scheme of co-participation between the public and private sectors, but
using a significant subsidy from the public sector (the Public- Private Partnership Investment Program, PPIP). As in the Paulson proposal, the idea is to
use market mechanisms to “discover” the prices of the toxic assets: the aim is to create markets for thes, determining prices and making the survival of
the financial institutions feasible.

                        In our opinion the great advance that the Geithner plan shows in relation to the proposal of the previous administration is recognition, even if
implicit, that the solution of the financial crisis necessarily requires allocation of a significant volume of public sector funds into the financial institutions,
either throuh direct injection of capital or indirectly, throuh the subsidy given to the private sector for the purchase of the toxic assets. It is true that the
Obama administration decided to discard, at least for the moment, the alternative of assuming direct control (nationalization) of the institutions, but it
seems clear to us that it has already been decided that all the necessary funds will be allocated.

                        What are the risks of the plan? In principle, they are associated with the difficulty of implementation and the possible failure of the strategy of
purchase/sale of toxic assets, which could happen, for example, if the prices set by the mechanisms established by the plan turn out to be lower than the
prices stated by the institutions in their financial statements, obliging them to recognize even greater losses and, consequently, increasing the amount
of funds necessary for their capitalization. Another risk could be the simple absence of interested parties, mainly due to the negative investor
environment that arose after the disclosure of the controversial bonus payments to AIG employees. At another level, the risks are linked to the lack of
political will to take the plan forward, principally in relation to the availability of necessary funds. As mentioned above, it seems clear that the Executive is
aware of the situation and disposed to put in all the funds necessary, but in the Legislature things don't seem so clear. In any event, the challenge will be
for President Obama, who will need to use all his political capital in the negotiations.

                        Finally, it cannot be forgotten that the US is going through an extreme situation, and that the plan is not perfect, nor could it be. Indeed, it
would be difficult to put together a perfect solution even in normal circumstances. Hence it is very important to recognize that finally the American
government does have a plan, which points in the right direction, and seems coherent, from the conceptual point of view. We should also remember that
in recent months a great deal of the volatility originated from the uncertainty, that we could call regulatory uncertainty, associated with the absence of a
coherent strategy for combating the crisis. The program's real chances of success will only become apparent as we watch the next stages – but the
market's initial reaction appears to us to be promising.


Gino Olivares
Opportunity’s Chief Economist, holds a Ph. D. in Economics from PUC-Rio.




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