When Secretary Geithner first announced the Public-Private Investment Partnership, it was generally well received by the public. Many important commentators endorsed the program. PIMCO supported the program because it was effectively a stealthy government assistance for banks at a time when nationalization was not politically feasible. Ironically, banks, who were at first seen as the greatest benefactors, were eventually the greatest hindrance.
The PPIP has been completely marginalized since when it was announced. First, in early June, the FDIC cancelled a pilot sale of toxic assets that would have served as a test run. Then, it was revealed the program would continue but at 1/10th the size at only $30bn. This clearly indicates the Treasury no longer sees the PPIP as a necessary program. To account for this change, it is helpful to look at what has changed since the PPIP was announced.
The PPIP was announced in the middle of March, close to the low points of financial markets and investor expectations. Four months later, markets have rallied and outlook has improved. This could be an example of what George Soros called "reflexivity", where investor bias reinforce market trends and change perceptions of fundamentals. The PPIP created the idea that toxic assets would soon be removed from banks. Even though they were never removed, simply the idea that this would occur restored confidence. As one Goldman Exec described it in the WSJ, the PPIP was "the greatest program that never occurred... (because it) created confidence in the markets so banks can raise equity capital." The New Republic had a story on the PPIP that quoted a source from inside the Treasury:
I think there was a broad appreciation within Treasury that, even if [the big banks] were not insolvent, that capital was central. That it wasn’t just liquidity. If you were to caricature--the Paul Krugman caricature--there was a set of people who said we thought it was all liquidity, that there was free magic to be had. That if you get rid of the illiquid equilibrium and get to a good one, you'd fix things. ...
If you had asked--I don’t want to speak for the secretary--what’s problem number one? I think he'd say capital. Problem two? Capital. Problem three? Capital. Everything was in the service of that view. The legacy loans program was meant to help clean balance sheets. It was not an independent good in itself. It was seen as friendly to equity raising. Now people say the legacy loans thing is not gaining as much traction, so is that a failure? But because we had a good outcome in terms of raising equity, they [the banks] were able to raise equity without shedding assets ... you should be okay with that.
From this it seems evident the government's way of addressing banks' toxic assets is to have them earn their way out of their losses, as the PPIP will not take any significant portion of toxic assets off balance sheets. From a bank's perspective, ever since the FASB adjusted its guidance on fair value accounting a few months back (though after the announcment of the PPIP), it has been better not to participate in the PPIP. Selling only some assets to the PPIP would cause banks to have to write down many other related assets. As long banks can use mark-to-model to keep book values up, banks can recognize losses over the next few years while earning record profits due to monetary and regulatory forebearance.
(For this reason, I consider banks with few toxic assets, like JPM or Goldman, as strong buys. Regulatory and monetary forebearance will favor these firms as much as those who still bear the burden of toxic assets. These banks will benefit even more as capital market transactions continue at record rates. The kicker is these capital market fees will stay sky-high as long as large lenders like BofA and Citi carry toxic assets. These large lenders will not lend at their fullest as long as they carry toxic assets, especially as their capital ratios will be constantly scrutinized. This lack of lending will force companies to turn to capital markets and, therefore, GS, MS, and JPM investment bankers.)
As I mentioned earlier, a Goldman exec is quoted in the WSJ as describing the PPIP as "the greatest program that never occurred." It is obvious why a Goldman executive might have that opinion. However, a different approach, such as actually implementing the PPIP, might have been better for the economy, though maybe not as good for Goldman, Sachs.
Consider another time the Government chose forebearance before addressing toxic assets directly--the 80s Latin American debt crisis. During the Latin American debt crisis, American regulators allowed banks to postpone losses on their debt. This had the effect of stiffling capital flows into Latin America, causing their "lost decade." The toxic assets were finally addressed nearly a decade later through the creation of Brady Bonds. Recall also that the more famous "lost decade"--that of the Japanese during the 90s--was also caused by zombie banks holding toxic assets. Choosing forebearance over the PPIP does not mean the US necessarily faces a lost decade, but it greatly increases the risk. James Kwak from the Baseline Scenario writes, "as long as Banks can raise capital, everything is fine, no matter how many toxic assets they hold." However, if confidence and markets fall to March lows, we may regret passing over the PPIP when we had the chance.
