Why The Treasury Plan Will Fail

The recent economic plan endorsed by Treasury Secretary Geithner will not succeed for two reasons. I will not discuss the complexities of the proposal, but rather point to its inadequacy. The first pitfall of the plan is that it’s based on massive subsidies for economic agents participating in it. Subsidies by their very nature cause distortions in the price mechanism. So while the objective of the Treasury plan is to augment the price discovery process for opaque financial instruments, the government handouts will prevent this from taking place in full measure. Recognizing they have the support of the government (who presumably represent the taxpayers), bidding firms will overpay for the assets. Therefore the situation will create the environment where the latter will reap potentially unlimited rewards but cap its losses in a worst-case scenario. In essence, the government is writing an enormous call option for potential investors. Buyers and sellers will benefit. Assuming no additional regulatory burdens to investors arising for participating in the plan, the cost of the subsidies incurred by government will exceed the benefits for buyers and sellers—a characteristic of all subsidies. The notion that there is such a thing as an optimal subsidy concedes that a committee of economic advisors is superior to private parties interacting in an unhampered market.

The second issue relates to the continued distress banks’ balance sheet will experience, in particular to loan deterioration. The current crisis has dealt primarily with the trading side of financial institutions. The next phase will take place in the so-call banking book, which makes up the non-tradable assets (e.g. loans). Consider the ratio of Net Loan Charge Offs-to-Total Loans at commercial banks: It has climbed significantly since 2006, where it stood just below .2 to the current figure of .95. This same pattern is exhibited for all data series presented in this missive since the aforementioned period. But during the late 1980s/early 1990s, the ratio peaked at around 1.8 (see here). Another key statistic is the Loan Loss Reserves-to-Total Loans ratio, which is lower today (2.30) in comparison to where its peak in 1993 (2.75). But this hides the fact that for commercial banks with assets whose assets fall between $1 billion to $15 billion the gap is much larger. The ratio currently stands at 1.89, significantly lower than its peak of 2.90 registered in 1992 (see here). Those banks with average assets exceeding $15 billion, the ratio is currently 2.53 vis-à-vis approximately 4.70 in 1987 (see here). As can be expected given the severity of the economic crisis, these ratios will increase.

Considering Net Loan Losses-to-Average Total Loans for banks resemble the same behavior. For all banks, the ratio currently reported is of 1.33 compared to its peak of approximately 1.6. For banks with average assets of $1 billion to $15 billion, the ratio currently stands just below 1.2, much lower than the peak amount of about 1.8 in 1991 (see here). For institutions exceeding the $15 billion average assets threshold, the figures are equally abysmal: The ratio currently stands at 1.5, which is much lower than the amount of 2.3 reported in 1990 (see here). But what evidently demonstrates that more difficulty awaits the banking industry, consider the ratio of Non-Performing Loans-to-Total Loans. Non-performing loans constitute past-due principal and interest in excess of 90 days. These are bank assets that will most likely turn toxic. At its peak for all commercial banks, the ratio stood at 4.88, which is much higher than the current figure of 1.70 (see here). The same ominous gap is present for all banks exceeding $1 billion in average assets (see here, here, and here).

Therefore, we can assess that banks’ balance sheets will continue to get worse. Non-performing loans will increase. Many of these loans will be charged-off. Loan loss reserves, which buffer against defaults, is not sufficient to cover the potential losses. Banks starving for capital will be forced to increase this amount and reduce lending to risky borrowers. All this points to more bailouts and failures ahead. The Treasury plan does not address any of these looming troubles.