Tuesday, February 10, 2009

Economic Recovery Plan: Analysis and Suggestions

Despite hitting a few bumps in the road, President Obama's plan for Economic Recovery is almost ready to be enacted. The plan has two main features; 1) a Treasury-led rescue of the financial sector (Financial Stability Plan) 2) substantial public works spending (American Recovery and Reinvestment Act of 2009).

In toto the Economic Recovery Plan will add more than $1T to the already rapidly increasing Federal Deficit and given the rather short duration of US Federal Debt, one key issue will be finance.

Last week's release of the quarterly refunding details explains how the Plan will be financed; 1) by increasing the quarterly refunding amounts 2) adding a monthly 7-year note auction 3) reopening the 30-year Bond in the month following the quarterly auction.

It's a quarter later than I expected (if you recall I argued that the November Refunding could be the straw that breaks the US$'s back- I was surprised by Paulson's decision to finance TARP with bills) but the effects will be similar- substantial increases in longer dated Treasury issuance will lead to higher rates and a weaker $ over time. Additionally, the risk of a "failed" auction on other markets will grow. While today's auction of 3-yr Notes went reasonably well (99.87, 2.67 Bid-to-Cover ratio, $14.3B to indirect bidders) weak foreign demand for longer dated issues, like this week's 10 and 30-yr and the monthly 7-yr will be ominous signs. With petro-$ recycling, thanks to the crash in oil prices, not a large factor, Asian demand for US Debt becomes paramount.

The Financial Stability Plan, as described by Treasury Secretary Geithner has four steps:

1) Clean and strengthen banking sector balance sheets by initiating more consistent, realistic and forward-looking risk assessment practices and providing additional capital support to banks in need thereof.

2) Establish a Public-Private Investment Fund whereby the Treasury will partially finance private sector purchases of so-called "toxic debt."

3) Work with the Fed to buy newly securitized loans in the small business, student, consumer, auto and commercial mortgage markets from the banks

4) launch a comprehensive housing program- details to be released later.

As best I can tell, Mr. Geithner's plan is merely a combination of the two approaches Paulson considered and will leave us, the tax paying public, with both toxic banks and toxic debt. I suspect a less ethically challenged Treasury Secretary would have devised a plan that apportioned more of the losses to bank shareholders.

To digress a bit, appointing Mr. Geithner to Treasury given his tax issues is akin to appointing an old Dead Head like me to the Office of National Drug Control Policy. Methinks Mr. Geithner is already learning the difficulties of cleaning house with dirty hands.

As a shareholder of a local bank I'm talking my book here and suggest a better plan would be to treat the big banks which failed to assess risk properly as failed ventures, wipe out their capital and use the funds to finance the expansion of regional banks with a better track record of risk assessment. Let's do some creative destruction and clear the financial decks, so to write.

Comparisons have been made between the US response to the current crisis and Japan's response to the crisis which emerged in the early 90s to the effect that the US response is (and needs to be) more "expeditious and forceful," by which is meant quicker and more expensive. I think we will find that greater speed and more capital will not be the answer. Japan's problem is our problem- bloated financial corporations which have gained power and are reluctant to relinquish it.

In a sense the same argument which put Geithner at Treasury despite his tax problems is that which informs his plan- just as he, despite his shortcomings, was supposed to be the best man for the job, so too are the current leading financial institutions, despite their obvious shortcomings, supposed to be the best for their job. This has little to do with Capitalism but much to do with Cronyism.

In sum, while I think real sector conditions, barring a "failed" auction (not a small probability event) will improve marginally in the spring, I suspect, as was the case in Japan, it won't be too long (late summer/early fall of '09) before debate begins on another Financial Stability Plan- one which will hopefully lean more on the wisdom of Volcker and less on that of Summers and Geithner.

In blunt terms, the "changing of the guard" the election of President Obama was heralded to bring has yet to manifest in Finance. As Einstein argued, insanity is defined as doing the same things and expecting different results.

Let's do something different.

Let Capitalism work.