The Geithner Plan Won't Work

by James K. Galbraith

Why not? Because it fails the president's own test: It won't get
credit flowing again.

What is the Geithner plan? In briefest summary, it is the TARP—the
Troubled Assets Relief Program—Bush Treasury Secretary Henry Paulson’s
original plan to repurchase subprime and alt-A mortgage-backed
securities from the banking system—dressed up to engage the interest
of hedge funds and private-equity investors.

Under the plan, 7.5 percent of the purchase price would come from
private sources as equity. The same would come from TARP—that is, from
the Treasury—also as equity. Eighty-five percent would come from the
FDIC, as a low-interest, non-recourse loan, meaning that if the loans
default, the FDIC gets the assets but nothing else.

If the assets prosper, then public-private partners make money and the
FDIC gets paid. If the assets default at high rates, then Treasury and
the private investors are together wiped out. The FDIC would get the
securities and sell them; its losses would depend on the price it can
get. In this game, the banks benefit from a high price, the FDIC from
a low one, in the initial sale.

The Geithner plan’s real design is thus not to help the market but to
steer it. It is not to discover a price but to create a new one, based
on rules the Treasury is just now making up.

In principle, an auction will decide what the price will be. But since
participation is voluntary, only assets that meet the banks’ selling
price will actually sell. We’re told the banks do not wish to sell for
less than 60 percent of face value—to take a deeper loss might expose
them as insolvent. Private investors will not buy for more than 30
percent, because they think the assets are trash. This disagreement
explains why there is no market now.

Secretary of the Treasury Timothy Geithner’s idea is that his plan can
help make a price, acceptable to both parties, somewhere between the
ask and the bid. Council of Economic Advisers Chairwoman Christina
Romer was explicit about this on Sunday: “We are trying to help the
taxpayer by using the expertise of the market by trying to set the
price for these toxic assets.” National Economic Council Chairman
Larry Summers, responding to Paul Krugman, made the same argument: “I
don't know of any economist who doesn't believe that better
functioning capital markets in which assets can be traded are a good
idea.”

But, obviously, the plan gives the banks the whip hand. If the price
doesn’t meet their minimum, they don’t sell, or anyway not much, and
that’s the end of the story. It won’t take more than an auction or two
to find out.

The Geithner plan’s real design is thus not to help the market but to
steer it. It is not to discover a price but to create a new one, based
on rules the Treasury is just now making up. It is, in effect, to
create a new asset, a derivative, that can sell where the existing,
underlying security (also a derivative) does not. The new
rules—especially the leverage and the non-recourse feature—create in
effect a new kind of bond, with a very high expected return,
accessible to those who take the toxic assets from the banks.

Thanks to the FDIC’s loan guarantee, there is a big upside if the
assets do well. That upside is there to lure the rich guys in. That is
why the big funds were happy; that is why the stock market went up.
For the high rollers, this casino could be very attractive.

And what happens if the assets really are trash? Well, first of all,
you’ve now put the residential-mortgage-backed securities in the hands
of some pretty aggressive investors. Are they likely to be forgiving
of the poor home buyers in trouble? And cooperative with foreclosure
relief? It’s doubtful, I’d say.

Second, when the assets default, the investors are out 7.5 cents on
the dollar. Treasury is out the same. And the FDIC is out the
difference between 85 cents and the ultimate sale price of the assets.
Which could be anything between 85 cents (or percent of the auction
price) and zero. The banks, meanwhile, are in the money no matter
what. As is helpfully pointed out here, it’s easy to construct mixed
examples—with some of the assets going bad and the others staying
good, where the investors make money. But the FDIC always loses and
the banks always win.

How much will the FDIC lose? From IndyMac’s experience, just
announced, it appears that the alt-A residential-mortgage-backed
securities are being written down about 80 percent in resolution. We
don’t know if other banks were as bad. But when the ratings agency
Fitch examined the loan tapes for a small sample of highly rated RMBS
(Residential Mortgage-Backed Security) in 2007, they found
“misrepresentation or fraud in practically every file.” Geithner’s
plan states that the FDIC “will employ contractors to analyze the
pools” against which it will issue loan guarantees. One wonders
whether this analysis includes a scrupulous examination of the
underlying loan tapes, with public disclosure of the extent of missing
documentation, misrepresentation, and fraud.

If not, it would seem that these assets could only be sold, at 60
cents, to gamblers—to investors who are willing to guess at what the
assets will eventually yield. Possibly there are enough gamblers out
there, to pay the prices that the banks require. But it seems hard to
believe.

Then again, there’s another possibility. Suppose some “interested”
party—say a banker’s brother-in-law—came in on the buyer’s side.
Suppose they were to bid up that initial price, meeting or nearly
meeting the expectations of the banks? In that case—miracle of
miracles!—the assets would sell. The Treasury and FDIC funds would get
engaged. And the mortgage-backed assets would fly off the books of the
banks.

At first glance, in that case, the plan would look like a big success.
Geithner would be a hero. Paul Krugman and I would have to shut up.
Until, after a bit, it became clear that the assets were not actually
worth 60cents on the dollar, but only 30 cents, or nothing. Then the
FDIC would take its losses. But the banks would be home free.

Isn’t there an open invitation here, for the banks to bail themselves
out? They have a huge interest. For a small inducement—the exposure of
a credit-default swap—they can get a dollar of bad assets off their
own books. Ultimately, thanks to leverage and non-recourse, the loss
falls on the FDIC, and is recouped (if at all) by higher insurance
premiums on all banks—not just the big ones, which have a lot of
liabilities that are not insured deposits—but the small ones, too, who
mostly avoided the subprime mess, and mostly fund themselves mainly
through FDIC-insured accounts.

What’s not to like about that, if you’re a big bank?

The ultimate objective, and in President Obama’s own words, the test
of this plan, is whether it will “get credit flowing again.” (I have
dealt with that elsewhere.) Short answer: It won’t. Once rescued,
banks will sit quietly on the sidelines, biding their time, until
borrowers start to reappear. From 1989 to 1994, that took five years.
From 1929 to 1935—you get the picture.

So why rescue them? The cost has to fall somewhere: As Milton
Friedman, no less, liked to say, there is no free lunch. Let’s not
forget: Behind all of this are mortgages and derivatives, which were
called “liars’ loans,” “neutron loans,” and “toxic waste” by the
people who issued them. There was fraud in the inducement, fraud in
the conveyance, and fraud in the ratings process. The incumbent top
management of the biggest banks either did this, or is complicit, or
is complacent. And they all did very well, while the money was good.

And the reality is, if the subprime securities are truly trash, most
of the big banks are troubled and some are insolvent. The FDIC should
put them through receivership, get clean audits, install new
management, and begin the necessary shrinkage of the banking system
with the big guys, not the small ones. It should not encumber the
banking system we need with failed institutions. And it should not be
giving CPR to a market for toxic mortgages that never should have been
issued, and certainly never securitized, in the first place.