Wednesday, April 1, 2009

Leverage & the hair of the dog

The aspect of leverage in the Geithner plan that I previously found puzzling enough to call the paradox of leverage, may be just what we need. So argues Robert Samuelson Over at Real Clear Politics:

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.
He goes on to argue that what we are seeing is a contraction in leverage resulting in prices of assets being unrealistically low, the inverse of a bubble. The Geithner plan, which Samuelson calls Uncle Sam's hedge fund, is an attempt to increase leverage. This will then entice buyers to purchase assets that they wouldn't otherwise.

Samuelson thinks that the biggest obstacle to Geithner's plan succeeding is whether or not buyers and sellers will be able to agree on prices. I am not sure this is an insurmountable problem. After all, buyers would put up only a fraction of the purchase price and then borrow much of the rest on favorable terms. But the really sweet part of the deal is that if the assets turn out to be worth less than the purchase price, they don't have to pay the loan back. US taxpayers will take care of that.

Coming to agreement on a price may not be a cakewalk, but buyers are faced with a quantifiable risk, their initial cash investment, and the potential for a huge payoff if the assets do turn out to have value.

Samuelson's discussion seems to hinge on the assumption that what we have is a liquidity* problem, not a capitalization problem. He is in the majority of opinion-holders in this respect, but that doesn't necessarily mean he is right. But then he goes on to note this:
Presumably, the government-supplied leverage would enable investors to pay higher prices.
That is to say, the government guaranteed low interest loan is in fact a subsidy for these purchases, which will drive prices up. No one doubts that this will push prices above what buyers are offering today, that is the whole point of the plan. However, this contradicts the fact that in describing the plan, Secretary Geithner has made a point of saying it uses the market to correctly price these assets, something the government can't do well in his estimation.

So excessive leverage helped create this mess by fueling an unrealistic run-up of asset prices. Now Geithner wants to try a controlled bubble to move assets off of bank balance sheets in order to get lending going. Please insert your own comparison to catching lightning in a bottle, a tiger by the tail, etc.etc. here. In any case, it sounds risky, but the alternatives may be worse.
For a discussion of the liquidity vs. capitalization question, click here.

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