Dr. Doom Finds Promise in Obama’s Toxic-Asset Plan

From the New York Times Deal Book: dealbook.blogs.nytimes.com/2009...plan/

March 24, 2009, 6:23 pm

“Nouriel Roubini, a/k/a “Dr. Doom,” is giving the Obama administration’s new plan to buy toxic assets the thumbs up”

That may be surprising given how critical Mr. Roubini, the bearish economics professor at New York University, has been in the past regarding various government plans to fix the economy. But Mr. Roubini seems to have seen something he liked for a change.

“My take is generally positive, with a couple of caveats,” Mr. Roubini told DealBook about the new plan. He said he liked that the government was finally stepping up to clear the toxic assets off the bank’s balance sheet and that private capital would come in to make a market for it.

“Having five people bid on a toxic asset, rather than a clueless government, will ensure that the government doesn’t overpay,” Mr. Roubini said in a telephone interview. “People say, ‘the government is putting in 95 cents on the dollar, so why not put 100,’ to do it all by itself. It’s because private-sector participants have the incentive to get the best price.”

It wasn’t all positive: Mr. Roubini said he did not like that banks have the option not to sell an asset after the auction concludes, as this would create confusion and frustration on the part of the buyers. He also believes the government should use its leverage over the banks to force them to participate, whether they want to or not.

In an opinion piece scheduled to be published Wednesday in The Daily News of New York, Mr. Roubini and a fellow N.Y.U. professor, Matthew Richardson, argued that “the reason that financial institutions should be “pressured” into participating is because that “they are the cause of the financial crisis.”

“They took advantage of loopholes to avoid regulatory requirements, taking a huge bet on securities they were never meant to hold in the first place,” the two professors wrote.

But unlike many critics of the plan, like Paul Krugman, a Princeton economic professor and columnist for The New York Times, who prefers full nationalization of the banks now, Mr. Roubini believes that the Treasury’s plan does not preclude nationalization at all. Rather, he said, it will help to clear the way to full government takeover some troubled institutions.

“I see the option of nationalization” and the one presented by the Obama administration “as being complementary,” Mr. Roubini said. He believes that the stress tests the government plans on conducting on the banks will reveal which are solvent and which are insolvent.

In his view, those banks that are deemed insolvent will not participate in the toxic-asset plan and will be taken over by the government. Banks deemed solvent will be the ones that get to participate.

Nationalization “is fully on the table for banks that are insolvent,” Mr. Roubini said.

He cited Tuesday’s Congressional testimony by the Federal Reserve chairman, Ben S. Bernanke, and Treasury Secretary Timothy F. Geithner.

“The most important thing is what Bernanke and Geithner said today about the need for an insolvency regime for systemically important institutions,” Mr. Roubini said. “You are going to need that not just for the A.I.G.’s of the world, but also the bank holding companies as they go into Chapter 11.”

He added, “You are going to need that in shutting down, potentially, a bank like Citigroup.”

–Cyrus Sanati

So to clarify my viewpoint: I see the Geithner plan as being relevant only to banks that are solvent. For those that are found - after stress tests - to be insolvent I see as the proper solution - -as I have widely written - to nationalize them and thus clean them up to prepare them for re-privatization.

The stress test should do a triage between banks that are illiquid and undercapitalized but solvent given the provision of capital and liquidity and those that, under a reasonable stress scenario are effectively insolvent. Those that are insolvent should be nationalized.

Those that are solvent will still have many toxic assets that need to be disposed of; and the Geithner plan provides a way to properly dispose of the toxic assets of solvent banks. So my partial support of the Geithner plan - with all the appropriate caveats regarding forcing banks to sell toxic assets and accepting the results of the auctions - is consistent with the complementary idea of nationalizing the insolvent financial institutions.

The bad assets of insolvent banks that are nationalized could be separated from the good assets and then worked out by the government (but the government is not very good in that business); or they could be sold to private investors through an auction mechanism along the lines of the Geithner plan; or they could be sold - together with the good assets - to the investors purchasing a privatized bank that was temporarily privatized (along the lines of the Indy Mac deal where the investors purchasing the bank received a government guarantee on the bad assets after a first loss).

The toxic assets of the solvent banks still need to be disposed of as no private investor will participate in the recapitalization of solvent banks that are still full of bad assets. Of the four available options for disposing of the toxic assets of the of solvent banks (the government purchashing them in a reverse auction; keeping them on the banks' book with a guarantee after a first loss (the approach talken with Citi and Bank of America); selling them to private investors with a guarantee after a first loss; or finally the Geithner plan) the Geithner plan provides a solution that is likely to be superior to the other three. If the government were to buy these assets it would be the only bidder in a reverse auction and price revelation problem would be severe. Keeping them on the banks' books with a gurantee after a first loss has been a disaster - as the experience with Citi and Bank of America shows. Selling them to private investors with a guarantee after first loss would be very non-transparent in the price revelation objective. So, having private investors bidding for the toxic assets - as in the Geithner plan - ensure a better price revelation that would be impossible in a reverse auction where the government is the only bidder. Also note the the idea - supported by many including myself - of converting some of the unsecured debt into equity to recapitalize banks - works for insolvent bank that go through a receivership proces; it cannot be applied to solvent banks that need recapitalization. In conclusion the Geithner plan is not an alternative to nationalization: insolvent banks should be nationalized and the Geithner plan should not apply to them. But solvent banks still need to have their toxic assets disposed of; and for this banks the Geithner plan provides a solution that - all in all - is better than the alternative. Those who dont like the Geithner plan on the basis that they prefer nationalization are right - as i agree - that the insolvent banks should be nationalized. But they usually dont give an explanation of how they would dispose of the toxic assets of solvent banks. They seem not to like the Geithner plan because it would provide a subsidy to the investors. But ensuring participation of private investors in the risk and in the price revelation is worth that subsidy. Otherwise those who criticize the Geithner plan as a solution to the toxic assets of solvent banks should come up with an alternative that works and that is less costly to the government than the Geithner plan.

-- Nouriel Roubini