The Geithner plan: what is it, and will it work?

Wall Street and and the ASX have rallied hard in approval of US Treasury Secretary Timothy Geithner’s bank rescue plan. In this post I am going to examine the Geithner plan, try and describe and explain what it is, and then ask whether it will work. First things first – here is the actual plan, known officially as the “Public-Private Investment Plan: $500 billion to $1 trillion plan to purchase legacy assets.” (As the old joke goes, $500 billion here, $500 billion there – pretty soon you’re talking real money). As Geithner’s White Paper goes on to explain,

The two key elements of the plan are: 

• Legacy Loans Program: a program to combine an FDIC guarantee of debt financing with equity capital from the private sector and the Treasury to support the purchase of troubled loans from insured depository institutions.

 • Legacy Securities Program: a program to combine financing from the Federal Reserve and Treasury through the Term Asset-Backed Securities Loan Facility (“TALF”) with equity capital from the private sector and the Treasury to address the problem of troubled securities.

Okay, so what does all this mean exactly? The best description-by-analogy I’ve seen is Economist’s View’s toxic car analogy, which begins like this:

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars – the engines blow up and the cars are then worthless – and this will happen just after purchase. The other half are perfectly fine. Unfortunately, there is no way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the assets on the car dealer’s “balance sheet” – the cars on its lot – are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.    

The Geithner plan works in the following way: the government offers a subsidy to private sector buyers. Depending on what the sellers of these toxic assets are prepared to sell them for, the government will have to top up the amount that purchasers are willing to pay by an extra amount. As EV notes (WARNING: a supply-and-demand curve follows):

the government will not know if it is getting this right or not. Suppose it offers a $1,000 subsidy thinking that is generous enough. In this example, that won’t bridge the gap between the highest offer of $6,000, and the reservation price of $7,500. Thus, the subsidy would be too small to restart the market and the plan would fail. So the answer is to make the subsidy large enough to encourage buyers, but the problem is that if it is too large, the government will be giving money away unnecessarily.    

And there’s another problem. If there’s a large gap between what people are willing to pay and what dealers are willing to accept(the gap between $6,000 and $7,500 in the example), this would be problematic politically since it would require subsidies that are unacceptably large.

And I should note that it doesn’t have to be a subsidy. That’s one way to do this – as a giveaway – but another way is through a no recourse loan (what is being called a partnership). Suppose that the government gives (up to) a $3,500 loan to a private sector buyer to purchase the car for $7,500. If it’s a good car and the value rises above $7,500, say to $15,000, then government will get paid back (with interest) since the asset can be sold profitably (another option is for the government to demand a share of this profit through warrants or other means). But if it’s a bad car, the price falls to zero and the loan is forgiven – it does not need to be repaid. So the private sector agents only have to put up a fraction of the price to control the asset, and their losses are limited to the amount they put up while the gains are potentially large.

This is, in essence, the Geithner Plan. If many of the loans are not repaid, or if the subsidy is too large, it could lose a lot of money, but it could also make money too.

Okay, back to the real world for those of you who find supply and demand curves just a little bit fake. As Paul Krugman notes, the real issue here is how toxic these assets are.  The substance of the Geithner plan is that hese assets are not really toxic, but merely mispriced. Which means that by re-financing the banks, they can eventually sell these assets and the crisis will pass. As Krugman points out, 

early on in this crisis, it was possible to argue that it was mainly a panic. But at this point, that’s an indefensible position. Banks and other highly leveraged institutions collectively made a huge bet that the normal rules for house prices and sustainable levels of consumer debt no longer applied; they were wrong.     

Atrios via Kevin Drum makes the same point (as does Naked Capitalism):

Aside from setting up an overly complicated plan to try to disguise what they’re really doing, the utility of the Geithner plan rests (or pretends to rest, not sure) on one fundamental premise: that Big Shitpile is greatly undervalued by “the market” and that these mortgage securities really have expected revenues which justify higher prices. One could have reasonably believed this months ago, I have no idea why anyone would believe this now. The housing bubble burst, and now recession is here. There’s a lot of shit to be eaten, the question is who will eat it? Timmeh wants to make sure it’s not the banksters.      

Drum makes the point elsewhere that the crticism of the liberal bloggers is fairly simple:

banks aren’t willing to sell their mortgage-backed assets at market prices because they think the market is panicked and only willing to buy at fire sale prices. And fire sale prices will ruin them. But if the government buys at the price banks value this stuff at, they’re almost certainly paying too much. It might rescue the banks, but only by essentially giving away lots of free money.     

Not everyone is anti-Geithner, of course. Cautious supporters of the plan include conservatives like Gregory Mankiw and venerable liberal economist Brad DeLong, who argues that 

I think the private-sector players in financial markets right now are highly risk averse–hence assets are undervalued from the perspective of a society or a government that is less risk averse. Paul judges that assets have low values beceuse they are unlikely to pay out much cash.     

Okay – so – will it work? That depends, of course, on how toxic these assets really are.

If they are actually worth something in the long term – as surely some of them must be – then, with time and more government liquidity, the institutions can eventually sell them, round out their losses, refinance their balance sheets and begin to lend money again. The massive extra liquidity sloshing around the world will then move slowly (or perhaps rapidly) back out of defensive plays and into wealth-generating assets, US consumers will regain confidence and start spending again, and economic growth in the rich world may restart. Even so, we will have experienced a very nasty recession indeed.

But if enough of the assets are truly toxic, eg. worth nothing, then institutions like Citi, AIG, RBS et al are truly insolvent (which, given how much US government money they have all accepted, is not a long bow to draw).  In this case, Krugman is right: many of the pillars of global finance are in fact zombie banks. And zombie banks which do not die can limp on for years, soaking up liquidity and not lending it out to anyone. See: Japan in the 1990′s.  In which case the global credit squeeze will continue in the medium term, and economic growth in rich countries will continue to stagnate. And, in any case, consumers in much of the rich world will have to repair their balance sheets after decades of under-saving.

Which is why I think the current equities rally is just a bear market or “suckers” rally, and will soon be eclipsed by more market pessimism.