Wall Street and Main Street must work together

By Professor Fariborz Moshirian  Friday, 27 March 2009  Opinion Pieces

Professor Fariborz Moshirian, from Banking and Finance at the Australian School of Business argues in an opinion piece in the Australian Financial Review that the recent US plan to purchase bad banks assets requires the full participation and support of the private sector.

The US Treasury Secretary, Timothy Geithner has provided his long awaited details on the program to buy the troubled US bank assets. The initial reaction of the market was positive. There is no question that an effective plan to get rid of toxic assets will be an essential part of any sustained economic recovery in the US and the rest of the world. The current plan is designed to induce private investors to participate as partners with the US government. The US government is willing to provide both equity as a co-investor and loans to special funds that are designed to purchase toxic securities.

Furthermore private investors could provide half of the required equity for a pool of residential mortgages and the government will supply the other half ( based on a 6 to 1 debt-to-equity ratio). At the same time, the Federal Deposit Insurance Corporation (FDIC) will provide a guarantee for about 85 percent of the investment in residential mortgages. Although the Program appears to be generous enough to entice the private sector into a partnership with the government, particularly with respect to purchasing residential mortgages, the question will remain as to whether private investors are willing to invest in such a program, even if, in the long run, it is possible that the value of these bad assets recover, leading to large profits.

One can only assess the effectiveness of this program of public and private partnership over the long term. In the meantime, one should consider a number of issues:

The first one is whether large banks will be willing to sell off their bad assets at low price, knowing that if they wait, the value of some of these assets could increase. Furthermore, Bank of America and Citigroup which have the US government's guarantee against their future losses, may have even less incentive to participate in this program, hoping that the participation of other banks in this program could increase the value of their bad assets anyway.

The second one is to what extent the US Treasury will be willing to recapitalise those banks that fully disclose the size of their bad assets as a way of off-loading them. The indications are that the US authorities believe that some of these banks could be declared insolvent if this program proves to be effective. According to the IMF's latest figure, toxic assets on the US banks balance sheets is about $2.2 trillion, whereas the current plan has an initial US$500 billion funding with the possibility of increase to US$1 trillion if the program is successful. However the US Treasury will have to go to Congress for extra funding, as the US government is currently relying on the balance sheets of the FDIC and the Federal Reserve System to finance a number of programs.

Third, it is not clear whether once some of the bank balance sheets are cleared, bank lending will resume fully. This is because the US and other economies are now suffering from an absence of risk takers, as the current global financial crisis has led private investors to see the future as more uncertain. This means that the process of unclogging the lending market should be backed by other national and global policies that restore both national and global confidence. The outcry over the bonuses for AIG executives has also created a major rift between Wall Street and Main Street that should not be underestimated, although the US authorities are trying hard to assure Wall Street that investors in this partnership program will not be penalised for future excess profits or salaries over time.

Fourth, the current experience has shown that the recent US Treasury plan to increase consumer lending under the "Term Asset-backed Securities Loan Facility" ( TALF) has not attracted many private investors. The original idea was that the US Treasury would provide US$200 billion and then extend it to $1 trillion by encouraging private investors to borrow from the TALF and invest in securitisation of consumer loans such as auto-loans, credit cards and Student loans. Due to lack of support from the private sector for the TALF, the US Federal Reserve recently decided to enter the market and directly purchase US Treasury notes. Given the slow response of the private sector to the TALF, one must wait and see how the private sector will respond to the current private and public investment partnership as a way of buying bad banks assets.
After months of the Obama Administration and others criticising Wall Street, there has been strong lobbying by the US Treasury Secretary and other US Officials to encourage the key players in Wall Street to support this new private and public partnership. What is clear is that the US government has to ensure that there is a balance between Main Street and Wall Street when it comes to efficiency, partnership and cooperation. While it could be true that access to government funding is a privilege, as President Obama and Timothy Geithner have stated, inducing the private sector to participate in a partnership with the government may also become a privilege in the current global financial environment.

With an effective policy that encourages Wall Street to participate in the US government schemes and with Wall Street acknowledging the effects of the current global financial crisis on Main Street and on those affected by it, it would make the private and public partnership to purchase bad bank assets more effective, as for this program to succeed, it requires genuine respect and cooperation on the part of both Wall Street and Main Street in the US.