| By Robert J. Samuelson Call it Uncle Sam's hedge fund. The rescue
of the American financial system proposed by Treasury Secretary Timothy Geithner is, in
all but name, a gigantic hedge fund. The government would lend vast sums to private
investors to enable them to buy loss-ridden assets at discounts from banks with the
prospect of making sizable profits. If that's not a hedge fund, what would be? The hope is
that the $14 trillion U.S. banking system would expand lending if it could get rid of many
of the lousy securities and loans already on its books.
Almost everyone thinks that a healthier banking system is necessary for a sustained
economic recovery. Can the Geithner plan work? Maybe, though obstacles abound. One is
political. Private investors may balk at participating because they fear populist wrath.
If the plan succeeds, many wealthy people will become even wealthier. Congress could
subject them (or their firms) to humiliating hearings or punitive taxes. Why bother?
Another problem: Investors and banks may be unable to agree on prices at which assets
would be bought. (Article continued below...)
But succeed or fail, Geithner's plan illuminates a fascinating irony. "Leverage"
— borrowing — helped create this mess. Now it's expected to get us out. How can
this be? It's not as crazy as it sounds. Start with the basics on how leverage affects
investment returns.
Suppose you bought a stock or bond for $100 in cash. If the price rises to $110, you make
10 percent. Not bad. Now, assume that you borrowed $90 of the purchase price at a 5
percent interest rate. Over a year, the stock or bond still increases to $110, but now
you've made more than 50 percent. You pay $4.50 in interest and pocket a $5.50 gain on
your $10 investment. Note, however, that if the price fell to $95, you'd be virtually
wiped out ($4.50 in interest paid plus $5 lost on the security).
Economist John Geanakoplos of Yale University argues that the economy regularly
experiences "leverage cycles." When credit is easy, down payment terms are
loose. Investors or homeowners can borrow much of the purchase price of houses and
securities. Prices of assets (stocks, bonds, real estate) rise, often to artificial levels
because investment returns are so attractive. But when credit tightens—government
policy shifts or lenders get nervous — the process reverses. Prices crash. Leveraged
investors sell to repay loans. New borrowers face stiff down payment terms.
To Geanakoplos, we're suffering the harshest leverage cycle since World War II. Three
years ago, he says, homebuyers could put down 5 percent or less. Now they've got to
advance 20 percent or more. Hedge funds, private equity funds and investment banks could
often borrow 90 percent of security purchases; now borrowing can be 10 percent or less.
"Deleveraging" has caused prices to plunge to lows that may be as unrealistic as
previous highs.
Grasping this, you can understand the idea behind Geithner's hedge fund. It is to inject
more leverage into the economy — not to previous giddy levels but enough to reverse
the panic-driven price collapse. Details remain unsettled, but the plan would allow 6-1
leverage ratios in some cases. Here's an example. Private investors put up $5; the
Treasury matches that with another $5. This equity investment could then be expanded by
$60 of government-guaranteed loans. The entire $70 could be used to buy assets from banks.
Sounds simple. In practice, it won't be. Given all the deleveraging — a record 15
percent of hedge funds closed last year — the market prices of many securities have
been driven well below prices that seem justified by long-term cash flows. Geanakoplos
mentions one mortgage bond whose market value has dropped by roughly 40 percent even
though all promised payments have been made and, based on the performance of the
underlying mortgage borrowers, seem likely to continue.
If banks sold this and similar credits at today's market prices, they would have to record
huge losses. ("Banks Face Big Writedowns in Toxic Asset Plan," headlined the
Financial Times.) Their capital would be depleted, and they'd have to raise more or
request more from the government. Presumably, the government-supplied leverage would
enable investors to pay higher prices. After all, that's the purpose. Still, whether
sellers and buyers ultimately agree on prices is unclear.
If they can't, Geithner's hedge fund will remain puny. Cautious banks will continue to
constrict credit. But success also poses problems. Money managers talk about making huge
annual returns of 20 percent or more from a scheme in which government puts up most of the
funds and takes most of the risk. A political backlash might squash the project before it
starts. Geithner treads a narrow line between financial paralysis and populist resentment.
|