Latest bailout plan has some flaws

February 10th, 2009, 2:37 pm · Post a Comment · posted by Mathew Padilla

Treasury Secretary Timothy Geithner’s new plan to fix what ails America’s financial system may do some good, but a couple of local experts see some significant problems. (See an outline of the plan in my previous post.)

Scott Simon, a managing director at bond giant Pimco in Newport Beach, said there may be a snag to the proposal of a $500 billion to $1 trillion public-private partnership to buy troubled assets from banks. He said investors will seek compensation for the risk that government will dilute their ownership rights in the assets being sold. He cites bankruptcy reform as an example.

Some Democrats in Congress want to give bankruptcy judges the power to change the terms of home loans, such as by lowering the balance due to current market value. Simon said such potential toying with private property rights already is impacting what investors are willing to pay for mortgage-related assets.

He said that’s the problem with jumbo loans these days: they have high interest rates because they are too large to be sold to government-sponsored buyers Fannie Mae or Freddie Mac.

If, for example, someone wants to buy a $1 million home with a $750,000 loan, investors are charging more interest because they are worried the government will limit or prevent their right to seize the home in the event of default. Messing with collateral rights makes the loan akin to credit card debt, Simon said.

“No one would lend you $750,000 on a credit card,” Simon said.

At this point in the credit crunch, the government alone may be able to buy toxic assets from banks at prices that will keep them well capitalized, Simon said. He argues that if the government did that from the start, as was originally proposed, it could be earning a return of $50 billion a year, because the assets are cheap and the government can hold them until markets recover.

To be sure, some economists strongly disagree, arguing it would cost government more to buy the toxic assets than to simply seize the banks, wipe out shareholders and liquidate the assets.

Kerry Vandell, finance professor and director of the Center for Real Estate at UCI, takes a more moderate stance. He said during the savings and loan crisis the economy and credit markets were better positioned to withstand widespread government takeovers of S&Ls.

Today the crisis has spread to the entire banking sector while the economy is in a recession, Vandell said.

The government may need to perform triage, reviewing all large banks, as Geithner proposes, and taking over those that have balance sheets overwhelmed with troubled assets, Vandell said. But banks with less severe problems could benefit from Geithner’s plan, as long as the government sets a floor to the pricing of assets it buys, Vandell said.

Setting a pricing floor would put taxpayers at risk if the assets decline, but taxpayers would share any gain with private investors.

However, Vandell is skeptical that there exists a lot of investor money available for the plan.

“A lot of wealth has just evaporated,” Vandell said.

Both Vandell and Simon said the other pillar of Geithner’s proposal will probably help, at least in the short run — to have government supply up to $1.2 trillion in financing against assets backed by consumer, auto, small business and commercial real estate loans.

And in other news…