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The more I think about it, the more I realize Treasury Secretary Tim Geithner's plan to rid banks of toxic assets won't work. At first glance, I thought it had some attractive features -- and it does -- but I'm quickly realizing they're seriously overshadowed by its faults.
Here are four big holes the plan fails to address:
1. Liquidity isn't the problem
Since day one, a major flaw has been treating the financial crisis like a liquidity issue rather than a solvency issue. Liquidity’s all about how quickly money can be moved around, while solvency deals with companies’ ability to remain going concerns. There aren't armies of cash-strapped investors salivating over the prospect of toxic assets. There's plenty of cash out there. Its owners have just realized that bad assets are really, really bad. The idea that investors will suddenly grasp the hidden beauty of these assets if you give them cheap leverage isn't realistic.
Nor is it supported by the facts. Last August, Merrill Lynch (now part of Bank of America (NYSE: BAC ) ) provided cheap, non-recourse funding for a collateralized debt obligation (CDO) sale to private equity firm Loan Star Funds. The terms were almost identical to what the Treasury is offering today -- 75% financing, no recourse. Even with all that extra juice, Merrill was only able to sell the assets for the grand sum of twenty-two pennies on the dollar. And that was last August, when things were still "good."
2. Price discovery might backfire
Speaking of prices, the current belief is that bad assets aren't being priced accurately because the market is busy wetting its pants in fear. Provide a little liquidity, the thought goes, and the true price will be "discovered." Once a real price is found, clouds will part, rainbows will form, and markets will regain confidence, wise men tell us.
While an awesome idea in theory, it's only beneficial if the discovered price is higher than what banks currently assume. What happens if a CDO sitting on Citigroup's (NYSE: C ) or Morgan Stanley's (NYSE: MS ) books is held at $0.80 on the dollar, but Goldman Sachs (NYSE: GS ) sells a similar asset via the Geithner plan and "discovers" it's worth only $0.40 on the dollar? Banks that don't even want to sell assets could be forced to take writedowns to comply with mark-to-market accounting rules. While that certainly isn't a bad thing -- I'm all for accepting reality -- the price discovery process could blow open the doors and reveal a big, sad group of insolvent banks. Call that the mother of all unintended consequences.
3. Will anyone show up?
And who are all these private investors we hear about? A few notable names have announced they'll participate, but a meaningful turnout seems questionable -- and not because Congress has proven to be the world's worst business partner after the AIG (NYSE: AIG ) snafu.
With 6-to-1 leverage, these asset sales are designed so investors will either make a killing, or lose everything. As attractive as non-recourse funding is -- since it limits borrowers' risk -- there simply isn't an appetite for high-risk, high-reward investments these days. This is not the kind of environment where hedge funds are eager to dive into a deep, dark, unknown world of arcane investments.
This is a world where investors are happy to buy 30-year Treasuries at 3.6%, and the default risk of Berkshire Hathaway (NYSE: BRK-A ) (NYSE: BRK-B ) is perceived to be higher than the Republic of Colombia. There's a tremendous premium on safety and almost no interest in anything with less than 100% certainty these days. That doesn't bode well for assets that need premium prices to clear.
4. Haven't we tried this before?
On the other hand, trying to find a true market price won't happen unless a true market exists. While cheap leverage might lure in enough capital to start clearing trades, it's not a true market -- it's a propped-up one. Just like housing supported by subprime leverage, "real" prices can become a cruel fantasy when unsustainable leverage is involved.
Hence, as soon as the cheap funding stops, we're back to square one. No one knows when that will happen, but it will happen. It's also safe to assume the plan could be scrapped if it works so poorly that taxpayers are stuck with massive losses, or so well that hedge funds are vilified for making triple-digit returns off taxpayer money.
If Geithner's strategy doesn't work, what's plan B? Nationalization?
Where to now?
While the plan is a step in the right direction, I'm hesitant to think the Treasury can uncover gold where private capital sees dirt. Maybe I'm just discounting Geithner's alchemy skills. Then again, probably not.
What do you think of it all? Feel free to share your thoughts in the comment section below.