At least the Obama administration understands that ultimately private investment is the key to strengthening financial institutions.
The Bush administration never got around to this realization. In its early interventions, it sought to punish shareholders, as a deterrent to others taking imprudent risks.
It was too late for that. The financial system already was suffused with imprudent risks. And the Bush administration spent the rest of its days bouncing from one ad hoc first-aid idea to another.
Unfortunately, the new plan announced Tuesday by Treasury Secretary Tim Geithner indicates that, while the Obama administration may understand the need to attract private capital, it hasn’t figured out how to make it happen.
To engage, private investors need to know what they are buying. They need to know they are buying into a relatively stable regulatory environment, that the federal government isn’t going to radically change the rules of the game on them.
And they won’t buy into a situation in which the federal government is, in essence, their senior partner.
Geithner’s plan, however, adds uncertainty and regulatory risk, rather than reducing them.
He said that the federal government would be conducting a “stress test” on regulated financial institutions. This stress test would be “forward looking.”
In other words, not based upon current conditions, but conditions regulators think could possibly exist in the future. The idea is to see how financial institutions might hold up if economic circumstances become even worse.
The implication is that the federal government will do something to institutions that fail this stress test about imagined future events. But what the federal government will do is unclear.
What private investor would commit a dime to any financial institution until these stress tests are performed, and the results and the federal government’s response known?
Part of the uncertainty discouraging private investment in financial institutions has to do with the value of their collateralized debt obligations, particularly mortgage-backed securities.
These are often labeled “toxic assets.” But they are toxic only because of the way they have to be valued for accounting and capital requirement purposes.
The assets have value. Nationally, 90 percent of mortgages still are performing. Even two-thirds of subprime mortgages are performing. These so-called toxic assets still are producing income of a known quantity.
But they cannot be valued, according to the federal rules, based upon their projected cash flow with loss reserves. They have to be valued based upon what comparable assets are selling for on the market. But there is no market.
One of the reasons there is no market is because the federal government cannot decide whether it is going to be a big buyer of such assets. No private investor is going to want to compete against the federal government.
Geithner prolonged this uncertainty. He suggested the federal government would enter into some highly vague joint venture with private investors to purchase these assets. So, their value remains uncertain and potential private investors remain frozen.
Moreover, Geithner said financial institutions receiving additional federal assistance would be subject to additional federal requirements regarding lending, executive compensation and dividends.
No private investor is going to want to commit capital to an enterprise in which politicians and bureaucrats ultimately call the shots.
Private investors need some certainty about the value of existing capital in financial institutions. They need to know that the federal government will unwind its management role and not radically change the regulatory environment.
And given how much uncertainty both the Bush and Obama administrations have created, they probably also need a significant tax incentive to run the financial, political and regulatory risks involved – say, an exemption from capital gains taxation.
The alternative is more government control, more uncertainty, more taxpayer risk and a further debased currency.
That’s the road we’re on.
Robert Robb, an Arizona Republic columnist, writes about public policy and politics in Arizona. E-mail: firstname.lastname@example.org