Apr 5th 2009

Wall Street vs. Public: 6 - 1

by Sin-ming Shaw

Sin-ming Shaw is a private investor and former visiting scholar at Princeton University.

Wall Street cheered the Geithner Plan to save the American financial system unveiled on March 23. The S & P has rallied by over 22% at this writing (April 2) since the outline was leaked in early March. Shares of selected fund management companies took off like a rocket.

On March 26 President Obama invited over 30 top Wall Street bankers to Washington to ask for their cooperation to "help each other".

On March 30 President Obama forced the resignation of Rick Wagoner, chairman of General Motors, as a precondition for further government aid. In addition the President wanted the entire board of directors of GM "restructured".

Failed executives and their irresponsible boards cannot be relied upon to become "born again" miracle workers especially if they need the public to save them.

The same logic has escaped Mr. Obama when it concerns Wall Street. No "master of universe" has been asked to leave, no board to be replaced.

Wall Street cheered the Geithner plan because it is a handout to the banks and to a selected group of fund management companies.

The plan implicitly endorses Wall Street's contention that some major banks are sitting on an inventory of "toxic" assets that if marked to market would undervalue those assets, unjustiably diminising the banks' true value.

The government will form joint ventures with selected private fund management companies on a 50-50 basis. The government will provide non-recourse loans to the joint ventures with leverage up 6 times the equity amount.

The eye-popping feature is this: taxpayers bear nearly all of the downside since loans to joint ventures have no strings attached if the investment decisions go wrong. The government will be reaping disproportionally smaller returns compared to what the fund managers would earn if the investments work out.

Joseph Stiglitz, 2001 Economics Nobel laureate and other eminent professionals have pointed out that it is a win-win-lose plan: win for Wall Street, win for private fund companies and bank shareholders and lose for taxpayers.

There is a wall of silence on the part of the US Treasury, The Fed and the banks as to how much money is really stuck in those assets? 1 trillion? 5 trillions? More?

Geithner's "stress tests" outlined in his disastrous maiden policy speech were going to provide answers.

What happened to those tests? Not sure.

One regional bank chairman far from Wall Street recently pointed out that a well-run bank would be doing internal "stress tests" all the time to provide the senior management an accurate, up-to-date assessment of their financial conditions.

The fact that such internal tests have not been done at the distressed banks could only suggest one of three possibilities: the managements are incompetent and negligent; the boards of directors are incompetent and negligent; and lastly, they do have had their internal "stress tests" results and do know how bad the situation is but are not telling.

Nearly all professionals believe the banks and Geithner know the truth. They keep silent by design.

So, the real agenda of the Geithner plan is to get the fund management partners to overbid for those toxic assets to allow the banks to possibly show a positive book value. Once that's done, it is hoped, the banks will start lending again to get the economy back on its feet.

Even the plan's most devastating critics hope the plan would work. Yet there is a more than 50% probability that it will not.

The Plan seeks to generate effectively an artificial market for toxic assets. Why artificial? Because the real market says the average market-clearing price is X while the banks and Geithner want to be 3X, the banks' asking price. So, transactions will take place at 3X which will be then become the new market price.

What's in there for private fund managers?

They are effectively being financed to buy call options on toxic assets with limited downside and substantial upside. They are playing mostly with taxpayers money without having to worry about paying them back should they lose it all. That's why shares of certain fund management shares lit up like fireworks on New Year's Eve.

Will the banks become more active again after they get rid of those assets at bloated prices? Maybe, but maybe not. We still to this day do not know how bad a shape the banks are in though we suspect a few of the majors are technically bankrupt.

Given insufficient transparency, it is uncertain that the credit market would become robust again even after the toxic assets are taken off the banks' books.

All this does not even begin to touch on the political implications of this Geithner plan as if democratic principles no long matter.

What if the toxic assets are substantially above $1 trillion? What if they cannot be resold at a profit resulting in heavy government losses?

What if banks continue to remain risk adverse to corporate or individual credits by slowing down the rate of lending and, by so doing, defeating the principal objective of this Geithner plan?

The Geithner plan has put Obama's presidency of less than 100 days old to a major economic and political test it does not need.

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