US markets extract heavy toll

Bloomberg

U.S. Treasury Secretary Timothy Geithner ducked the tough questions investors want answered as he rolled out a plan to repair the financial system on Tuesday - and stock traders made him pay for it.

Driving investor doubts was Geithner’s failure to clearly address three issues: Will banks saddled with toxic debt be forced to fail? How will illiquid assets be removed from bank balance sheets? And what will be done to arrest the decline in house prices that triggered the turmoil?

The risk is that the market reaction sabotages the plan before it gets under way, forcing Geithner to change his approach in response - a position that his predecessor, Henry Paulson, frequently found himself in. That may mean the plan "may just end being an interim step," said Kenneth Rogoff, a former chief economist at the International Monetary Fund.

"Tim Geithner did a great job in É laying out general principles, but it was a big disappointment not to have more details," Rogoff said.

The Standard & Poor’s 500 stock index tumbled 4.9 percent on Tuesday as investors dumped bank stocks on skepticism whether the plan will work. Bank of America plunged 19 percent and Citigroup dropped 15 percent.

The program Geithner laid out has three main elements: Injecting fresh capital into some of the biggest financial institutions; establishing a public-private partnership to buy as much as $1 trillion of banks’ bad assets; and starting a credit facility of up to $1 trillion to promote lending to consumers and businesses.

U.S. banks have sustained $756 billion in credit losses until today. "The recession is putting ... pressure on banks," Geithner said in unveiling the plan in Washington. "This is a dangerous dynamic, and we need to arrest it."

President Barack Obama, speaking at a Feb. 9 press conference, said it was critical that the government restore investor trust in the financial system.

Added uncertainty
The trouble is that investors abhor uncertainty and Geithner only seemed to add to that with a proposal short on specifics. "He should have waited until he had his ducks in order," said Ward McCarthy, of Stone & McCarthy Research. "The lack of detail leaves ... room for confusion, misinterpretation and speculation."

Anil Kashyap of the University of Chicago Booth School of Business, gave Geithner credit for getting regulators to agree to subject the country’s 18 to 20 largest banks to stress tests to determine whether they have enough capital to withstand an even worse economy.

Geithner said the tests would be used to determine which banks need more capital. Left up in the air is whether the government will shut down banks that the tests show are all but insolvent, rather than putting more money into them.

Zombie banks
That’s a step that experts such as Rogoff advocate. "You don’t want to try to keep zombie banks on life support," he said. Until it’s clear which, if any, of the big banks the government may take over, investors will be wary of putting any more money into the sector for fear of being wiped out.

That’s a problem for Geithner because he is counting on investors to provide the bulk of the financing for his program to lift toxic assets from banks’ balance sheets. The illiquid securities, mainly tied to mortgages, have made lenders loath to extend new credit.

The so-called Public-Private Investment Fund that will purchase securities will have an initial capacity of $500 billion and could grow to $1 trillion. The details of how the fund will work have yet to be decided and it could take months to come up with a final program.

Officials said the program will aim to provide potential buyers of the assets, including private equity firms, with longer-term financing that they say they need to carry out deals.

"There is a lot of capital that seems to be waiting on the sidelines to acquire the distressed assets," said John Lyons, chief executive officer of Savills, a real estate investment banking firm. "The issues are nobody knows what the value of that product is, and we still have the falling knife syndrome," in which plunging prices make investors reluctant.