The Geithner Plan
Reaction to the Geithner plan seems evenly divided between bitterly critical (Dean Baker, James Galbraith, Paul Krugman, Jeffrey Sachs, Yves Smith, Joseph Stiglitz) and cautiously optimistic (Brad DeLong, Joe Nocera, Nouriel Roubini, James Surowiecki, Mark Thoma, Michael Spence). I’m finding myself in the latter category.
There are three parts to the plan: (1) Expansion of the TALF (Term Asset-Backed Secure Lending Facility), a lending program of the Federal Reserve and the Treasury, to include hundreds of billions of dollars of non-recourse financing for purchases of mortgage-backed securities. (2) Partnerships between the Treasury and five or so investment management firms, with the equity contributions split evenly between them, to purchase mortgage-backed securities. And (3) the “Legacy Loans Program” in which the FDIC provides six-to-one (or about 85 percent) non-recourse financing to investors (individuals, mutual funds, hedge funds, pension plans, private equity firms, etc.) to purchase “toxic” loans from banks, with the remaining equity capital contributed equally by the investor and the Treasury.
The third part, the FDIC portion, has been the most controversial owing to the non-recourse loans (although the TALF portion also involves non-recourse loans). Since the loans are non-recourse, the investor repays the loan only if the investment has a positive return (to be split evenly between the investor and the government). If the investment has a negative return, the government gets the toxic asset as collateral, while the investor loses just the seven and a-half cents per dollar of the purchase price that the investor contributed. The government is then out 92.5 percent of the asset price, though it gets whatever minimal gains can be salvaged from the toxic asset it now possesses.
This is a bailout, so there are two key questions: (a) Will it work? And (b) is it fair?
My answers are “not sure” and “no.” Nevertheless I conclude that given the political constraints within which the Obama administration is working, the Geithner plan may actually be the best step forward at this time.
Let’s take a “toxic” asset with a face value of $10,000, that’s believed to have a 30 percent chance of paying off in full and a 70 percent chance of paying $2,500. The expected value would be $4,750 ($10,000 x 0.3 + $2,500 x 0.7). Banks, however, would be unable to sell such assets at the their expected or market values, since to do so would be to book losses that would mean they no longer exist as financial institutions. The bid price in this case, with the government subsidy and the limited downside risk, would be $7,407 (see formula below). And the hope is (a) that many such assets exist, i.e., that with the help of government largesse investors will determine bid prices that are well above expected values, and (b) that banks will accept these prices.
[Mathematical note: The investor’s bid price, x, i.e., the highest price the investor would willingly pay for the asset, will be such that the investor’s equity contribution (7.5 percent of the bid price, or 0.075x) is equal to the expected return to the investor. To calculate the expected return, take the full payout of $10,000, subtract from that the FDIC loan (which is 85 percent of the bid price x, or 0.85x), multiply the result by the probability of a full payout r, and then divide by 2, since the government gets half the profit and the investor gets half. Thus:
[($10,000 – 0.85x)r]/2 = 0.075x (1)
so that
x = ($10,000r)/(0.15 + 0.85r) (2)
Note that it makes no difference to the determination of the bid price what the equity split is between the Treasury and the investor. For example, if the investor’s equity contribution is one-third, so that the right-hand side of (1) is 0.05x, the denominator of the left-hand side would be 3 rather than two, since the investor would retain a third of the profit rather than half. This is equivalent to multiplying both sides of (1) by 2/3.]
In the diagram toxicity (1 – r) decreases from left to right, toxicity being the opposite of the probability of a full payout. The plan thus creates a window—an area of elevation of bid price above expected value—in which it’s conceivable that buyers and sellers will find prices they can agree upon. Any price between the red and blue lines (a) will have positive expected profitability for the investor, and (b) should encourage banks to sell, since the price will be above the current market price. Where the bid price is highest relative to the expected value—as at relatively high but not extreme levels of toxicity—there should be the best chance of success, since it’s is in that range (from a roughly 0.2 to a 0.4 probability of full payout) that the banks stand to gain most by selling.
(It should be noted that this assumes that the quality of the assets is transparent to all parties. There could be a problem of adverse selection if banks, who know their assets best, obfuscate their true quality or try to sell only the worst ones. Investors will be onto this and will lower their bid prices, and the government will wind up paying larger subsidies and owning a lot of bad assets. So transparency is crucial.)
The caveat is that the Geithner plan can only succeed to the extent that the problem is a liquidity problem and not a solvency problem. Most likely it’s a combination of the two. That is, it’s plausible that many of these assets really are undervalued because of risk aversion gripping the investor community. To that extent it’s a liquidity problem. And the solution would be to unfreeze the markets for assets that are temporarily illiquid because investors are—wrongly—fearful about holding them. The administration’s hope appears to be that the fiscal stimulus and the mortgage modification program will stem the tide of defaults and foreclosures, making the assets less toxic than people currently think they are.
But we also must remember that it was the bursting of a massive housing bubble that got us into this mess. Such a decimation of asset value can potentially make holders of toxic assets insolvent, pure and simple, with no possibility of offloading them at any price that would reveal the holders of these assets to be solvent after all. The only solution in such cases is nationalization or receivership (or whatever), i.e., government seizure of banks, separation of bad assets from good, re-capitalization, and re-privatization once a bank is again functional.
It is inconceivable that Geithner, Summers, Bernanke, Romer, etc.—all regarded as bright and competent—are unaware of this possibility, even if they’ve been mum about it publicly, presumably for political reasons or to avoid unsettling the markets. Critics of the Geithner plan seem to assume that it encompasses the administration’s entire strategy for dealing with the problem. Yet almost certainly it does not.
Last week the administration began its push for comprehensive regulatory reform, including expansion of the FDIC’s resolution authority to cover not just banks, but also “any nonbank financial firm whose disorderly liquidation would have serious adverse effects on the financial system or the U.S. economy.” Though the proposal is couched as a way of preventing “another AIG,” the scope of the proposal seems broader. Geithner listed the institutions to be covered as “bank and thrift holding companies and holding companies that control broker-dealers, insurance companies, and futures commission merchants, or any other financial firm posing substantial risk to our economy.” But the thing is, Bank of America, Citigroup and J.P. Morgan Chase are “holding companies that control broker-dealers.” The language of Geithner’s testimony, in other words, suggests that the administration believes it either currently lacks the legal authority to nationalize “large complex financial institutions” like these or, if it tried to nationalize them, would get into a legal battle over the definition of the word “bank.” Thus nationalization or receivership would still seem a live option—one for which the administration appears to be laying the groundwork, in a way that won’t saddle it with too much legal or political flack, should it be necessary.
So legal considerations may be one reason nationalization is off the table. But there are others. There’s the sheer magnitude of the undertaking, which would make a typical FDIC resolution seem like play-acting. And trumping everything else are probably political concerns. Since nationalization would require money, the administration would need to go to Congress, which might well refuse to appropriate any additional bailout money. Indeed, the 60 votes needed in the Senate reportedly aren’t there. (According to Brad DeLong, the sixtieth vote that would need to be there, but isn’t, is Voinovich.) So for all these reasons it’s just not very surprising that nationalization isn’t the Obama administration’s first choice for how to deal with the problem.
In this context, the Geithner plan makes strategic sense as a first, exploratory, step that (a) could solve part of problem by removing some toxic assets from banks’ balance sheets, and (b) should, along with the stress tests, reveal much about the true state of banks and their assets, preparatory to more dramatic action, should it be necessary. If banks can’t sell their toxic assets even at the inflated prices likely to materialize in the FDIC auctions, that surely means they cannot be saved by any possible “market solution.” Nationalization would then be the next logical step. And with the threat of nationalization hanging over their heads, the banks will surely have an added incentive to settle with investors.
Is It Fair?
It’s impossible to look at this diagram and think it’s fair. The graph depicts the expected government subsidy [r(0.075)($10,000) + (1 – r)($2,500 - 0.925x)], at different levels of toxicity, of our hypothetical asset, the one that pays $10,000 if all goes well and $2,500 if all doesn’t go well. (Again, toxicity decreases from left to right.) Since current market prices for toxic assets are about 30 cents per dollar of face value, most of the toxic assets are somewhat like our hypothetical asset at the very lowest levels of probability of full payout, i.e., around 0.1 or 0.2. If we assume a probability of full payout of 0.2, the effective government subsidy should be about 62 percent of the expected value, or $2,475. This is probably a worst-case scenario, but plausibly the government could wind up covering about 50 percent of the expected value of the toxic assets sold through the Geithner plan. Since the administration anticipates that toxic asset sales from this program will range from $500 billion to $1 trillion, that could mean a government subsidy of $250 to $500 billion. (These are extremely rough numbers, but that’s all we have at this point.)
So it’s a massive bailout. And who’s being bailed out? The last people on earth who deserve it: banks and their shareholders, the people who caused our woes by making irrational bets that house prices would rise forever. (And to top it off, we’re also giving massive subsidies to hedge funds and private equity firms.) If capitalism means anything, it surely means that people who make bad bets should suffer the consequences. Supposedly that’s the secret of its success.
But that only works if the consequences of bad decisions are borne by those who made them, rather than spread like a contaminant to the rest of society and the world. Unemployment is now officially 8.5 percent, up three percentage points from a year ago. And that can only get worse as long as toxic assets remain on banks’ balance sheets. As deleveraging continues, pressure on asset prices will be downward and pressure on interest rates will be upward. Businesses that want to expand and hire won't get the credit needed to do so. Businesses that merely want to stay afloat will be unable to renew existing lines of credit. (And when the latter starts to occur widely, more and more businesses will fail, and the credit crisis will really hit home.)
The Obama administration clearly hopes that the stimulus will improve the economy enough to stem the tide of defaults and foreclosures, thus making the toxic assets less toxic than people believe they are. The troubled assets problem might then really be a liquidity problem after all, addressable by the Geithner plan. But that’s a slim reed on which to pin one’s hopes. It’s encouraging, at least, that the administration seems (and I emphasize “seems”) to be putting nationalization in its back pocket, should all else fail.
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