After three weeks in office, U.S. President Barack Obama's administration outlined the first phase of its economic recovery effort Feb. 10. The plan at present requires no new actions or money from Congress. Instead, it relies purely on existing legal frameworks governing the Treasury Department and the Federal Reserve System, as well as authority and funding obtained by the Bush administration from Congress. The stimulus plan before Congress is another ball of wax completely, and if adopted, it would be the second leg of the administration's anti-recession efforts. While the numbers freshman Treasury Secretary Timothy Geithner provided as he sketched out the Obama administration's plan Feb. 10 are certainly large — even mammoth — a deeper look reveals that the plan is neither creative nor new. This is not meant as a criticism of the Obama team — while the devil, of course, is in the details, the plan as announced looks quite sound. But not only does it look like a natural extension of, and a minor course correction from, the Bush administration's bailout policies; it also is revolutionary neither in concept nor reach — only in scope.
Credit Crunches vs. Liquidity Crises
As Geithner stated, subprime mortgages lie at the heart of the crisis' genesis, a diagnosis that is neither new nor controversial. People who should never have qualified for mortgages were encouraged to buy. The brokers who provided the mortgages in turn sold the loans to others, who packaged them together into tradable securities and sold them yet again. When the market functions normally, this secondary market allows investors to flood money into the system, dropping borrowing costs. But when home prices fall or foreclosures mount — both of which have happened in spades in recent months — it is impossible to separate the good loans from the bad in the securities. Shorn of the ability to assess how much any particular security is worth, no one wants to purchase them, so the entire housing credit system seizes up. In September 2008, the problem broke out of housing and affected the broader financial system. Suddenly, banks were unwilling to lend not just to homebuyers, but also to each other. This proceeded on the reasoning that, lacking the ability to assess the stability of a prospective borrower's asset sheet, lenders cannot in good conscience lend. Money thus stopped flowing completely. The accompanying graph demonstrates how the cost of lending between banks shot up during that time. At this point, a technical distinction is required for clarity. When banks stop lending to each other, the economy does not face a traditional credit crunch, but a liquidity crunch. The money is there, it is just unable to flow to where it is needed. A liquidity crunch is perhaps the most damaging thing that can happen to a modern economy. Western banking systems exist to allocate capital to entities that will use it most efficiently and effectively. When banks stop doing that, everything in the affected economy that depends upon credit at all simply stops. Most of what the Bush administration did during the final four months of its term — and nearly everything it did in September and October 2008 — was aimed at mitigating this liquidity crisis. (For a thorough discussion of how it all went down, click here
This liquidity crisis is pretty much over — in fact, it has been for several weeks. Interbank costs have plummeted, and interbank lending has broadly picked up again, as the graph demonstrates. In contrast, the problem of today is a credit crunch. Liquidity is back in the system, but lending from banks to consumers and companies has yet to recover. Banks remain risk-averse not necessarily because they are worried about access to capital or the creditworthiness of their peers (the problem in a liquidity crunch), but because they are concerned about the creditworthiness of their potential customers. Credit checks have become more thorough, marginal borrowers have been declined, and loans on the whole have become harder to get. While such circumstances are obviously recessionary, they are hardly unprecedented. In fact, what is happening now with the credit markets is the same thing that happens in every recession. Unlike the liquidity situation that the Bush administration struggled with in October and November 2008, the credit situation of 2009 is not extraordinary. Thus, the Obama plan for dealing with it is rather orthodox. In essence, the worst is over for the United States. But we mean neither to belittle the pain of the recession, nor to wave away concerns for the future. Instead, we want to point out that the systemic danger has passed, and that the nature of the current problem lies within a more well-understood framework for which mitigation and recovery tools already exist. Some of these tools are simply part of the government's normal tool kit; those that are not were crafted through congressional cooperation with the Bush administration within the last year.
The Obama Strategy
The Obama strategy can be broken into three pieces. First, the Treasury Department, Federal Reserve, Federal Deposit Insurance Corp. and other government entities that touch upon the banking sector will run a "stress test" of every bank that seeks any sort of assistance. This test will focus on lending practices and balance sheets; qualifying banks can tap the Treasury for loans to help rationalize their balance sheets. The government will require banks receiving such loans to prove regularly that the government assistance is being used exclusively to extend credit to consumers. There must not be any excessive executive compensation (defined by the Treasury as an annual salary of more than $500,000), and the funds cannot be used to purchase other banks. For funding, this program will use the final half of the $700 billion that Congress authorized to the Bush administration back in September under the Troubled Assets Relief Program (TARP). The primary difference between how the Obama and Bush administrations carried out the TARP is that the Bush administration simply wanted to shove as much cash into the system as quickly as possible to reliquify the system. As such, the Bush administration's $350 billion simply went directly to the banks with few strings attached. But the Obama administration does not have to deal with a liquidity crisis, so it is putting into place the safeguards, "stress tests" and lending requirements to minimize graft and maximize overall lending. The Bush team administered its half of the TARP money within a few short weeks; the Obama team's controls mean it will take months to loan out its half. But bear in mind that the Obama team is addressing a fundamentally different issue than the Bush team was. Liquidity crises are economy killers, while credit crises are "merely" recession-causers. For the Obama team, there is not the same level of urgency the Bush team faced, so the Obama team can afford to take the time to apply its package more comprehensively. In the second part of the Obama plan, the Treasury will set up a public/private investment fund to manage and dispose of the questionable mortgage-backed securities that touched off all of this in the first place (often referred to as a "bad bank"). The plan is to work with the private sector to set a price for the securities that is somewhere between what they were worth when they were originally formulated and their current near-worthlessness. (Remember, all of these securities are backed by actual homes with values that are far more than zero.) The Treasury will provide the initial funds to purchase the securities from banks, and the Fed will provide whatever financing is necessary. The plan is to clean the banks' books while injecting capital, allowing the banks to make loans with more confidence. The government plans to provide $500 billion in financing immediately, and could apply $1 trillion before all is said and done. Third, the government will participate in the secondary debt market for everything from car to college loans. Secondary debt is like the mortgage-backed securities discussed previously, e.g., loans that have been packaged together for trading. Geithner estimates that 40 percent of the capital that supports lending in the United States participates only in the secondary market. As long as banks and investors are skittish, this market does not operate smoothly. Up to $1 trillion will be applied to this via the Term Asset-Backed Securities Loan Facility (TALF), largely through Fed financing.
A Profitable Bailout?
Altogether this sounds like a lot of cash, and it is. The total price tag comes in at roughly $2.4 trillion, more than the entire government budget in a normal year. But this is not nearly as bad as it sounds. In fact, the government is likely to make money on this over time. First of all, the TARP money is all loans. Banks that received the first batch from the Bush administration have to pay 8 percent interest annually. Additionally, under the terms of TARP, the banks had to give the government the right to veto policy decisions. So the Obama administration enters its time with TARP with all the tools in place to change bank policy to match national policy. Specific terms as to how the Obama team will rejigger TARP remain to be seen, but if anything, the terms of the TARP loans will be tightened — making it more likely that the government will come out ahead — rather than loosened. Second, the public/private debt management effort almost certainly will produce a fat profit for the government. The government will be buying up the distressed securities at well below market prices, and then will sell them at a time and place — and most important, a price — of its choosing down the line, ostensibly after the housing market recovers. The problem is not that the money will disappear; it is instead an issue of opportunity cost and time frame. With a potential $1 trillion in assets under management, this program could well take more than a decade to flush out completely. The closest comparison in American financial history is the Resolution Trust Corp. (RTC), a federal program of the 1980s and 1990s designed to help the country recover from mass bankruptcies in the savings and loan sector. Once one adjusts for the change in the size of the economy from then to now, the RTC program was about half the size of Geithner's public/private program, and it still took six years to complete. Third and last, participating in the secondary debt market is a temporary measure, and the government fully intends to pull back from that market as soon as the private sector's appetite for investment resumes. This is the only part of the program announced thus far that STRATFOR anticipates will operate at a loss once all the accounting is finished. Debt trading works on the idea that private investors are better than the government at reducing costs and directing capital. So not only would government employees (albeit very knowledgeable and financially experienced employees) be playing the market, they will be doing so with the intent of keeping things moving rather than making money. That will generate losses. But even here, the price tag is not as bad as it sounds. While the Treasury will use up to $1 trillion to run this program, every asset purchased will be sold, so the cost will be largely administrative. This does not mean that all of the Obama team's policies will be cost-neutral. As noted in the first paragraph, this is only the first step of the Obama administration's plans for dealing with the recession. Each of these steps deals with the financial aspects of the recession, and none actually changes anything directly related to how much trouble homeowners are having making their mortgage payments. All of the spending and tax cuts in the stimulus package before Congress are funded with deficit spending — very real costs that will create very real debt that will definitely need to be paid back. Additionally, Geithner gave notice in his presentation that the administration will announce a fourth effort in the weeks ahead. That effort aims to provide debt relief to homeowners and small businesses, primarily to help prevent foreclosures. STRATFOR does not wish to judge that effort before it is announced, but anything that uses the phrase "debt relief" normally has a lot of costs attached.