"Economists Laid End To End": Judging The Geithner Plan
"If all economists were laid end to end, they would not reach a conclusion" -- George Bernard Shaw
Disagreements among the cadre of economists critical of the Obama administration's economic strategies have made it difficult to assess the viability of the recent bank-bailout proposals announced by the President and Treasury Secretary Timothy Geithner.
When, for example, Treasury Secretary Geithner on March 23 announced a new "Public-Private Investment Program" -- the latest variation of the Obama administration's bailout plan -- the normally reliable gang of critics split into two camps.
One faction, exemplified by Nobel Laureates Paul Krugman and Joseph Stiglitz, remained firmly pessimistic, arguing that the new policy would at best slow a steady march toward the cliff's edge.
"The Geithner plan is very badly flawed," Stiglitz told Reuters. "Quite frankly, this amounts to robbery of the American people."
Other concerned economists, including Nouriel "Dr. Doom" Roubini (who has often proved disconcertingly right) and Brad DeLong, Berkeley professor and former deputy assistant secretary of the Treasury under Clinton, argue that the proposal might do some real good, although their commentary is packed with caveats.
"For the economy to be viable, the financial system must be healthy. For this to occur, the system needs to be cleansed of its poorly-performing loans and so-called toxic securities backed by loans," Roubini and fellow NYU Business School Professor Matthew Richardson wrote on March 25 in a New York Daily News op-ed. "Secretary Timothy Geithner's new toxic asset plan is a serious step in the right direction."
In their Daily News piece, Roubini and Richardson warned that "[t]he government bears the risk if and when the investors take a bath on the taxpayer-provided loans. If the economy gets worse, it could get very ugly, very quickly."
On his own blog, Roubini added a crucial warning: "the Geithner plan is not an alternative to nationalization: insolvent banks should be nationalized and the Geithner plan should not apply to them. But solvent banks still need to have their toxic assets disposed of; and for these banks the Geithner plan provides a solution that - all in all - is better than the alternative."
Markets initially endorsed the Geithner plan, with the Dow gaining 497.48 points, or 6.84 percent on March 23. As is well known, however, markets in periods of crisis can be volatile: after the Great Depression began, the stock market saw sporadic, but very large hikes which quickly disappeared, including a 12.34 percent rise on Oct. 30, 1929, a 14.87 percent gain on Oct. 6, 1931, and the largest one-day gain in the Dow's history, 15.34 percent on March 15, 1933.
The March 23 rally following Geithner's "Public-Private Investment" announcement resulted, in part, from the fact that the plan eliminated much of the risk -- or gamble -- in buying banks' toxic assets. Folks buying and selling stock saw that the Geithner plan increased the likelihood of profits for investors. The announcement of the program declared that "nonrecourse loans will be made available to investors to fund purchases."
A non-recourse loan is one "in which the lender cannot claim more than the collateral as repayment in the event that payments on the loan are stopped. Thus, a group of investors may purchase an asset with a down payment and the proceeds from a nonrecourse loan. In the event that the investment turns sour, the investors are not apt to lose more than the down payment and payments already made on the loan. The unpaid balance on the loan will be absorbed by the lender."
The Geithner plan has the effect of making the purchase of toxic assets far more attractive than would be the case in a marketplace without subsidies.
Let's examine an example as described by the Treasury itself:
"Sample Investment Under the Legacy [Read Toxic] Loans Program"
"Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector - in this example, $84* - would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis - using asset managers approved and subject to oversight by the FDIC."
This may seem like a huge leap, but let's see if we can compare Geithner's new March 23 "Public-Private Investment Program" to a poker game - something people are more familiar with than the offloading of toxic assets:
Normally, a poker player has to pay full value for every chip, $1 for a $1 chip, $100 for a $100 chip, and so forth. In the Geithner game, the rules are different. A player acquiring $84 worth of "chips" only puts up $6. Of the remaining $78 which S/he owes, the FDIC would provide - in the form of a nonrecourse loan --- $72, and the US Treasury would put up $6.
Let's say the player has a good night, and makes $200 over and above his/her original $84 "investment" with a total stack of $284 (his/her $200 profit and his/her initial $84 buy-in). Our happy camper then takes $84 off the top out of which s/he pays $72 back to the FDIC, and $6 dollars back to the Treasury. S/he would pocket the original $6 investment.
The remaining $200 would then be split between our talented player and US Treasury, each getting $100, good news for one and all. There are no limits on the upside: if the player has an extraordinary night and makes $10,000, s/he will get $5,000, all from an original investment of $6.
If, however, our player has a terrible night, and loses the initial stake of $84, the downside is just $6. S/he gets to gamble $84 with the worst possible outcome being the loss of $6 -- not a bad deal. If Donald Trump could offer that, his Entertainment Resorts would not have filed for bankruptcy on February 18 of this year.
*
There are a number of folks with expertise in economics who share this way of looking at the Geithner plan.
Columbia economist Jeffrey Sachs, an outspoken critic, took the poker image one step further, telling the Huffington Post: "It's as if the taxpayers, banks, and hedge funds are playing poker, but the hedge funds get to use the taxpayer's chips."
The banks, in Sachs' scenario, are the big winners:
"To understand the essence of the giveaway to bank shareholders, it's useful to use a numerical illustration. Consider a portfolio of toxic assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The market value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, which sums to $360 billion. The assets therefore currently trade at 36 percent of face value.
Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC loan. The FDIC is giving a 'heads you win, tails the taxpayer loses' offer to the private investors.Specifically, the FDIC is lending money at a low interest rate and on a non-recourse basis even though the FDIC is likely to experience a massive default on its loans to the investment funds. The FDIC subsidy shows up as a bid price for the toxic assets that is far above $360 billion. In essence, the FDIC is transferring hundreds of billions of dollars of taxpayer wealth to the banks."
Henry Blodgett, editor of BusinessInsider.com, shares that view, declaring more succinctly: "the plan is yet another massive, ineffective gift to banks and Wall Street. Taxpayers, of course, will take the hit."
Along a different, but parallel tack, Daniel Gross of Slate wrote:
"Where the hell are the capitalists? Where are all the people who are willing to put their own money and that of people willing to lend them cash, at risk in pursuit of profit? Why are Wall Street's tough guys such a bunch of girly men? The Geithner plan assumes that Wall Street's bravest investors won't spend a penny or borrow unless the government is willing to cover losses, make loans, and give away extra profits. It assumes, in short, that these great businesspeople are afraid to do business."
A colleague of Sachs at Columbia, economist Massimo Morelli, told the Huffington Post that despite the massive transfer of taxpayer money to the troubled banks, he was less critical than Sachs and others, because he thinks the outcome may justify the costs:
"On average, the taxpayers lose in the sense that the Fed and the Treasury accumulate losses, while banks certainly win....[But] the injection of money into the banks may well be necessary,
and if it is, then the Geithner plan is one of the best ways to do it one can think of, because it really could stimulate private actions on multiple sides: (1) bank stocks will go up and hence the legacy loan program and the legacy security program may not need to last long; (2) the management of the private public investment funds will perhaps bring back to action some key asset managers who are now standing on the side lines; (3) the injection of federal money reduces as a side effect all kinds of interest rates and eliminates the risk of further deflation, hence the housing market starts rebounding. In summary, I think Geithner's plan seems to be aimed to maximize the probability of a significant impact on the lending and investment activities, at the cost of an initial big sacrifice in fairness." [emphasis added]
Even more supportive of the Geithner proposal is Brad DeLong, who told the Huffington Post that "from my perspective, this is an entirely reasonable way of using $100B of TARP money."
But, DeLong stressed, "The problem is that it is only about 1/8 the scale of what we need to do."
In a New York Times blog, DeLong said the goal of the plan is to boost asset prices so as to "make it easier for businesses to obtain financing on terms that will allow them to expand and hire..... When assets are seen as less risky, their prices rise. And when there are fewer assets to be held their prices rise too: supply and demand. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms."
Former New York State Commissioner of Taxation and Finance, and former deputy chief of the U.S. Congress Joint Committee on Taxation, James W. Wetzler, contended that the debate over whether the Geithner proposal gives too much to the banks, hedge funds and private equity investors misses the larger picture:
"The big issue is whether the program will have a meaningful impact in improving the economy. If so, it'll be a very good deal for the taxpayers. If not, the government will have to try something else and will have to figure out how to develop political support for that something else, raising the question of whether this program's design will adversely affect the prospects of developing political support for the something else. I think those are the right questions to ask."
Wetzler, who is now a director in Deloitte Tax LLP's Multistate Tax Controversy practice, added, in comments to the Huffington Post:
"It seems to me that one can't make informed judgments about what to do about the large banks without knowing information about their finances that relatively few people know. That hasn't stopped numerous pundits from making very strong recommendations (see Paul Krugman as an egregious example and from making sharp criticisms of the recommendations made by the people who do have the relevant information. The cacophony of criticism then undermines the success of the programs, which to a large extent depend on the restoration of confidence."
With this range of disagreement, Nassim Nicholas Taleb, the Distinguished Professor of Risk Engineering at NYU-Polytechnic Institute, wrote to the Huffington Post that the way to deal with a lack of consensus is to recognize that: "Economists always disagree ... on the wrong problems."
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First Posted: 03-30-09 10:40 PM | Updated: 04-30-09 05:12 AM