THE STASH JULY 2, 2009
My item from earlier this week about Treasury and PPIP elicited some mixed reactions, so I wanted to post a quick follow-up clarifying what I think the Treasury official I quoted meant. To review, the official was commenting on how most of his colleagues haven't been too disappointed to see PPIP scaled back because their overarching goal--recapitalizing banks--has partly been accomplished without it. (His comments mostly speak for themselves, but different people have had different interpretations.):
I think there was a broad appreciation within Treasury that, even if [the big banks] were not insolvent, that capital was central. That it wasn’t just liquidity. If you were to caricature--the Paul Krugman caricature--there was a set of people who said we thought it was all liquidity, that there was free magic to be had. That if you get rid of the illiquid equilibrium and get to a good one, you'd fix things. ...
If you had asked--I don’t want to speak for the secretary--what’s problem number one? I think he'd say capital. Problem two? Capital. Problem three? Capital. Everything was in the service of that view. The legacy loans program was meant to help clean balance sheets. It was not an independent good in itself. It was seen as friendly to equity raising. Now people say the legacy loans thing is not gaining as much traction, so is that a failure? But because we had a good outcome in terms of raising equity, they [the banks] were able to raise equity without shedding assets ... you should be okay with that.
My take-away from the conversation was: The hope when conceiving PPIP was that removing toxic assets from balance sheets would make it easier for banks to raise capital privately, and that, in the process, PPIP might also bid up the price of the assets somewhat, which would reduce the size of their capital hole. The government would then step in and fill the hole that remained--that was the idea behind pairing the stress tests with the promise of additional capital.
What Treasury wasn't thinking was that the hole would disappear entirely or even mostly if they just provided liquidity. That's where they think they were caricatured. And it's also why they're not especially upset to see PPIP get scaled back a little. So long as banks are raising capital privately, they're not as concerned that the market for the toxic assets is still illiquid. (Though they'd certainly prefer it to be more rather than less liquid.)