Is Tim Geithner’s toxic asset plan toxic?

Markets reacted quickly — and positively — to U.S. Treasury Secretary Tim Geithner’s announcement detailing a public-private investment program to absorb toxic assets, once and for all, from financial institutions’ books. "I am very confident this scheme dominates all the alternatives for trying to find that balance," Geithner said about the plan.

Not everyone is so optimistic. To be sure, there is a long, difficult road ahead. Throughout the day, Foreign Policy gathered the reactions of economists and practitioners as they come to terms with the plan. Stay tuned for updates and further contributions tonight and tomorrow. 

Dean Baker: 

The Geithner plan is yet another effort to avoid acknowledging the obvious: the major banks are insolvent. The hope is that expensive government subsidies can raise the selling price for these assets to a level that will be high enough that Citigroup, Bank of America and other major holders of bad assets can be kept insolvent.

This plan will allow for some large windfalls for investors who would have purchased some of these assets anyhow but were waiting for a big government subsidy. It will also lead to some large losses for the government as the lender to investors who bet and lose. There will also be incidents of fraud since there is not sufficient oversight capacity.

However, at the end of the day, this plan is not likely to buy up enough bad assets to maintain the solvency of the banks, so we will need yet another bailout package or the banks will have to finally be pushed into receivership.”

Roger Craine:

Lights, Camera, Action, Take One. In a rushed, poorly thought-out, one page memo to Congress in Sept. 2008, Hank Paulson outlined the Troubled Asset Relief Program (TARP) which proposed that the Treasury (i.e. taxpayers) buy toxic assets (mostly underwater real estate loans and securities backed by real estate loans) from the banks to cleanse their balance sheets and provide them with badly needed capital. It didn’t take a Nobel Prize winner to figure out that the Treasury can’t provide banks with more capital without overpaying (a taxpayer subsidy to banks) for the toxic assets. Still, when Paul Krugman, the 2008 Nobel Prize winner in economics, pointed out the obvious logical fallacy in the New York Times, it became even more embarrassing.

Lights, Camera, Action Take Five. On Mar. 23, 2009, Tim Geithner announced TARP Take Five which is a sophisticated (sneaky?) redo of TARP Take One. In TARP Take Five — relabled as the "Public Private Partnership Investment Program" — private investors instead of the Treasury buy the toxic assets. Of course, as Krugman noted, the banks won’t get more capital unless the private investors overpay for the toxic assets. To increase the value of the toxic assets, the FDIC (taxpayers) threw in a valuable insurance policy. The insurance limits investors’ losses to 15 percent of the value of their purchase. The insured toxic assets are worth more than the uninsured toxic assets and the investors will pay a premium. Taxpayers provide the insurance, but they don’t get the premiums. The premiums go to the banks. Underneath the bells and whistles, TARP remains a cleverly disguised vehicle for taxpayers to subsidize the banks without getting compensated through partial ownership.

Mark Thoma:

There were three plans to choose from: the original Paulson plan in which the government buys bad paper directly, the Geithner plan in which the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, and outright nationalization.

So which plan is best? Any plan that does two things — removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner — has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has the two necessary features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. This option also comes with its own set of political problems — problems that will worsen if the loans to private sector "partners" turn out to be as bad as some fear. Finally, the plan for nationalization also includes these two features, but it suffers from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives (though not everyone agrees with this assertion).

I am not wedded to a particular plan. Each has its good and bad points. Sure, some seem better than others, but none is so off the mark that I am filled with despair because we are following a particular course of action.

Thus, I am willing to get behind this plan and to try to make it work. It wasn’t my first choice; I still think nationalization is better overall. But trying to change the plan now would delay the rescue for too long, and more delay is not something we dare risk at this point.

— Mark Thoma is professor of economics at the University of Oregon. He blogs at Economist’s View.

Phil Levy:

With today’s announcement of Public-Private Investment Funds, the Obama Administration finally begins to grapple with the core issue of the economic crisis — a deeply-troubled financial sector. The new program is not the best that we can do. It may be the best that we can do conditional on:  not going to Congress and seeking more funds and not allowing any major financial institution to fail.

The underlying premise seems to be that we are in a Sleeping Beauty crisis. An evil spell has been cast on the financial markets. Now we just need the kiss of a handsome prince and the markets will spring back to life. The kiss comes in the form of private investor incentives to partner with the government and bid for troubled bank assets. The bidding is supposed to relieve bank balance sheets of bad assets and bring in enough money to restore banks’ health.

There are potential problems with the plan itself. For example, it is not clear that buyers and sellers will even agree on prices for the assets.

More fundamentally, though, what if our problems are more deep-seated than just a temporary market funk? What if many of these loans really have gone bad and the assets are toxic? Then we’re squandering scarce funds in a scattershot way and may still end up with an undercapitalized financial sector dragging down the economy. 

 — Phil Levy is resident scholar at the American Enterprise Institute.

Michael Pomerleano:

In a Mar. 4, 2009 article, "Promising signs of progress in the ‘Bad Bank’ Plan," I wrote that the approach sketched by the U.S. Secretary of the Treasury deserves consideration and support from the policy making and financial communities for the following reasons:

1) This design ensures that troubled assets are worked out in the private sector. The government bureaucracy does not have the expertise or the motivation to make decisive decisions in the resolution of troubled assets.

2) The proposed approach secures private equity capital, while providing government working capital. The program further ensures that the incentives of the managers are aligned with the public interest since the managers’ own money is at risk.

3) The program creates capacity and competition in the private sector to deal with the mammoth impaired assets problem.

However, that program presented by the Treasury today is exceedingly generous to the private sector. The Treasury is acting as a rock bottom "discount" hedge fund; it offers assets to the private sector for a minimal amount of equity capital (5-7 percent), and non-recourse financing at subsidized government interest rates.  The program will end up as a massive wealth transfer to Wall Street. It would have been desirable to see a far more robust risk sharing program.  

A final observation is that the program is not a "magic bullet" — it will take time to implement.

— Michael Pomerleano is advisor on financial stability at the Bank of Israel. He is on external service from the World Bank.

 Roger G. Noll:

Thankfully, the federal government is finally taking an action that has some hope of fixing financial markets.  For about a year, there have been only two viable choices. The first is some variant of the Swedish plan (take over a financial institution when it is about to become insolvent, recapitalize it to enable it to get through the crisis, then re-privatize when financial markets stabilize). The second is to take the toxic assets off the balance sheets of troubled financial institutions by subsidizing their acquisition by others. The Obama Administration has chosen a defensible version of the latter.

Several criticisms of the plan are based on incomplete analysis and so should not be taken seriously. At the top of the list is the complaint that taxpayers should not have to bear the risk that the true value of troubled assets is at or near zero. In fact, taxpayers are bearing that risk already — the risk of bank failure causing deposit insurance to kick in and that the failure of financial markets will plunge us deeper into recession or even depression, wiping out much of the other half of asset values that remains after the plunge in real estate and stock prices. The issue is how to minimize the sum of all the risks, not to minimize only one portion.

Another complaint is that the government should go straight to option No. 1 and take over all financial institutions for which their book value (using mark-to-market accounting) is negative. The financial institutions believe that their toxic assets have more long-term value than the current market price, and that if the current storm can be weathered — financial markets thaw, the recession ends, investment picks up, housing prices turn around — the market price of these assets will increase enough to eliminate the current negative book value of stockholder equity.  This argument is not silly; if assets were over-valued during the period from 2003 to 2007, they could be under-valued now.  It does make sense to see if this argument is true by creating a solid market in toxic assets, letting financial institutions sell enough of these assets to keep them going, and see if things improve a year or so down the road.  At that point, if it turns out these assets are as bad as their current market values imply, we can always opt for the very expensive option No. 1 then.

The third category of criticism is about the formula: the debt equity ratio is wrong; the equity sharing ratio is wrong, etc. These are just quibbles. The fact is that until we gain more experience, no one can argue that any particular set of numbers for these parameters is optimal. 

Two key features of the plan to bear in mind are as follows:

First, the government is assuming only the deeply downside risk that the auction will over-value the assets.  Even the direct loan purchase program, with its six to one debt/equity ratio, will cause trouble for taxpayers only if investors are excessively bullish over home mortgages to the tune of 15 percent. For this to be true, financial institutions not only must be wrong that these assets are under-valued; they must also have the sign wrong. This seems implausible unless the nation lunges into a deep depression.  But if that happens, the blame will fall on Congress for failing to pass a recovery program. And if that happens, we are toast anyway.

Second, unlike the bailouts that have gone before, this plan aligns the incentives of investors with the interest of citizens. If the assets are under-priced, both investors and taxpayers will win, the FDIC will not have to pay claims on its debt insurance, and financial markets will recover.  The real story behind the Merrill Lynch and AIG bonuses is the failure of the bailout approach to align public and private interest, which was understood at the time the only really bad decision in this saga was made — the decision to attack the problem by giving money to the institutions that caused the problem.