Will Geithner and Summers Succeed in Raiding the FDIC and Fed?
Geithner and Summers have now announced their plan to raid the Federal Deposit Insurance Corporation (FDIC) and Federal Reserve (Fed) to subsidize investors to buy toxic assets from the banks at inflated prices. If carried out, the result will be a massive transfer of wealth -- of perhaps hundreds of billions of dollars -- to bank shareholders from the taxpayers (who will absorb losses at the FDIC and Fed). Soaring bank share prices on the morning of the announcement, and in the week of leaks and hints that preceded it, are an indication of the mass bailout at work. There are much fairer and more effective ways to accomplish the goal of cleaning the bank balance sheets.
A major part of the plan works as follows. One or more giant investment funds will be created to buy up toxic assets from the commercial banks. The investment funds will have the following balance sheet. For every $1 of toxic assets that they buy from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the remaining balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the toxic assets purchased by private investors fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the toxic assets.
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.
With a little arithmetic, we can calculate the size of that transfer. In this scenario, the private investors (who manage the investment fund) will actually be willing to bid $636 billion for the $360 billion of real market value of the toxic assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders! Here's why.
Under the rule of the Geithner-Summers Plan, the investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion. The FDIC will loan $546 billion. (All numbers are rounded). If the toxic assets actually pay out the full $1 trillion, there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.
Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP's expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.
The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the toxic assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is "underwater" (holding more in FDIC debt than in payouts on the toxic assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.
Soaring bank stock prices during the last week, and then again on the day of the announcement, demonstrate the bailout in action. From March 9 to March 20, the KBW bank index rose by 33 percent, while the overall Dow Industrials rose by only 11 percent, indicating how the rumors were especially good for the banks. This morning, bank shares across the board soared in value. Citibank has tripled in value since its low in early March. The value of the bailout dwarfs the AIG and Merrill bonuses, but since the bailout is much less obvious than the bonuses, the public's reactions have been muted, at least at the start.
The plan should not go forward on such unfair terms. Under the law, Congress should apply the Federal Credit Reform Act of 1990, which requires budget appropriations to cover expected losses on government loans programs, which would presumably include the expected losses on FDIC and Treasury loans under the Geithner-Summers Plan. With proper credit accounting, the entire operation in our little illustration would require a budget appropriation of $276 billion, equal to the expected losses of the FDIC and Treasury. If the Administration goes to Congress for such an appropriation it will be shot out of the water. The public will not accept overpaying for the toxic assets at taxpayers' expense. Thus, it is very likely that the Administration will attempt to avoid Congressional oversight of the plan, and to count on confusion and the evident "good news" of soaring stock market prices to justify their actions.
The Geithner-Summers plans for the FDIC are not the only off-budget transfers to bank shareholders taking place. Other parts of the plan support subsidized loans from the Treasury and, even more, from the Fed. The Fed is already buying up hundreds of billions of dollars of toxic assets with little if any oversight or offsetting appropriations. Since the Federal Reserve profits and losses eventually show up on the budget, the Fed's purchases of toxic assets also should fall under the Federal Credit Reform Act and should be explicitly budgeted.
There are countless preferable and more transparent courses of action. The toxic assets could be sold at market prices, not inflated prices, making the bank shareholders bear the costs of the losses of the toxic assets. If the banks then need more capital, the government could invest directly into bank shares. This would bail out the banking system without bailing out the bank shareholders. The process would be much fairer, less costly, and more transparent to the taxpayer.
Banks that are already insolvent should be intervened directly by the FDIC, that is, temporarily taken into receivership. The shareholder value would be wiped out, except perhaps for some residual claims in the event that the toxic assets vastly outperform their current market expectations. As I've written before, the allocation of bank shares between the taxpayers and the current bank shareholders could be make contingent on the eventual value of the toxic assets (http://www.huffingtonpost.com/jeffrey-sachs/a-proposal-on-how-to-clea_b_166303.html), ensuring fairness between the shareholders and the taxpayers.
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Jeffrey Sachs is completely right that this investment scheme is really a sleight of hand, designed to transfer huge subsidies to the banks. And I'm sure that it will be even less of a gamble for the banks than the article portaits. I can allready see them repackaging and reselling the remaining downside risk.
But were I disagree, is that I don't think that there is any other way that would save substantial amounts of money.(Relatively speaking - what's a 20 billion) . The simple example given was carefully chosen by Mr. Sachs to reflect actual conditions. And lo and behold - 60 to 70 cents on the dollar is what the banks need to sell off without going bancrupt. If the banks were to be nationalized they would need the same amount of money. With all the bruhaha that nationalisation would be accompanied with, chances are that the housing market would do worse in that case. And then it would cost the government even more. The downside of subsidizing the bank shareholders is a relatively minor problem, given how far the stocks have allready fallen.
Silly people! This is the Plan(tm). The financial criminals pulling the strings (and who purchased Obama during the campaign with huge donations and who owned Bush/Cheney before and Clinton before, etc) intend to break the bank of the government. The whole purpose of this is for the "assets" to be worth less than paid for so the Wall Street criminals will reap all the rewards, the taxpayers will be (suddenly) have the previously "off book" debt from the Treasury heaped upon them, and, naturally, the "only answer" is to murder Social Security and Medicare and Studen Loans and Public Schools, etc, etc. The Plan(tm) is to eliminate all the safety net programs and other public programs that makes life livable by the Peons.
We will then be expected to sit tight in our tent cities waiting the next crust of bread from the rich elite who come and ask for the lowest bidder on a job to mow their lawns, serve their food, wipe their asses, etc. We will then be left to fight amongst ourselves for the "right" to debase ourselves before our masters.
Keep the eye on the ball people. We need to be ever ready to scream bloody murder and an absolute "NO!" to any attempts by the feudal overlords to take away Social Security, Medicare, Foodstamps, and all the other basic, just, and necessary safety net programs put in place by men FAR better than they.
The more of follow this plan the worse it sounds. The Federal Reserve has already expanded its role well beyond its traditional one, as has Treasury. If the FDIC is really going to suffer these losses they should be borne not by the tax payers but by the member banks. Make that part of the plan. I want to hear what healthy small banks have to say about bailing out Citi and BOA.
The more of follow this plan the worse it sounds. The Federal Resrve has already expanded its role well beyond its traditional one, as has Treasury. If the FDIC is really going to suffer these losses they should be borne not by the tax payers but by the member banks. Make that part of the plan. I want to hear what healthy small banks have to say about bailing out Citi and BOA.
Mr. Sachs, I'm sorry but there really is nothing else that could REALLY--as opposed to eutopian dreams of people who are not responsible for actually DOING the job--be done to fix this economy that Mr. Geithner and Mr. Bernanke are not doing. Watching their testimony yesterday on the Hill made me understand that.
Lead, follow, or get out of the way because being an armchair critic is NOT helpful right now.
lgreene,
You obviously choose to not believe the assertion the author makes that there are better ways to deal with this problem. The difficulty with your complaint is that it does not acknowledge the likelihood that Mr. Geithner's plan has motives that are incompatible with the public interest.
One way to describe those motives that is perhaps overly generous to Mr. Geithner is the idea that "he is so imbued with wall street thinking that he can only conceive of a solution that is in wall street's interests". This is generous because it suggests that if his plan abuses taxpayers and unfairly enriches undeserving people.... it does so through some kind of innocent interpretation that does not understand the unfairness.
Another way to describe those motives is that .... as one of the greedy hoard from wall street (that feels entitled to multi-million dollar incomes no matter what) .... he is just taking care of his own.
Neither interpretation results in a fair shake for the taxpayer.
The U.S. is in the middle of a monetary financial derivative debt based global economic collapse. How can Geithner, Bernanke and Summers talk about investing/buying in this crisis? These institutions can be protected in bankruptcy proceedings. Instead we are to invest in cancerous and corruptly run institutions without even a regime change: Entangling the U.S. government and the population in a usurious scheme. The American public is both terrorized and distracted by the latest "plan"; there is no mention of the population's well-being, health and prosperity. Embedded in this plan is a economic and population contraction policy. This moment in time is the result of a long range plan started by Greenspan during the Reagan admin. Everybody got stoked on home buying mortgage financing, tax write-off investments, free-trade, globalism, cheap labor, out sourcing industry and jobs. Get rid of the middle class. The Nation and the world will be controlled by a group of private central bankers.
This is irregular warfare. Financial warfare. Geithner, Bernanke, and Summers are going to deliver the financial coup d' tat. Stop the bailouts. Get rid of the Three. Put the Fed in bankruptcy. Create the U.S. National Bank.
So many troubling aspects of this program! No oversight, almost all downside to the taxpayer, off the books accounting (which is part of what caused the meltdown in the first place).
I agree with the proposal of mark to market accounting and then help the banks with infusion of needed cash (provided the banks assisted would be able to function with a reasonable infusion).
I'm also not sure why the government - if it insists on buying toxic assets - wouldn't pay the current "market" price, and then sell the assets later, sharing any profits with the bank. So an asset that is worth now 30 cents on the dollar is bought by Geithner at that price. When the Feds sell later at 60 cents, it gives half of the profit, 15 cents to the bank. If the asset later sells for only 15 cents, the government takes a hit. I assume that buying at a low "market" price would reduce the likelihood of further downside (but it wouldn't prevent it entirely).
This gives the banks money in hand; it could take off the most toxic assets; the banks could choose what assets to keep; and an "estimated value" of the ultimate profits could be carried on the banks' books until the final sale by the government of the toxic assets.
Probably the government doesn't have enough staffing to do this; but apparently it doesn't have enough staffing to monitor the trillion dollar bailout announced yesterday. What a nightmare.
This is too much math! The bottom line is-- why are we buying up toxic assets without reforming the system that creates toxic assets? There's a hole in our bucket.
In my opinion, he already has.....and will continue to do so.
The biggest disappointment in the O administration. He makes me question Mr. O in general because it seems we can all see it, but he doesn't?
"These toxic assets could be sold at market prices"
That's where you lost me. If these banks could sell these assets at market price then WE WOULDN'T BE IN THIS MESS. I absolutely love how you, Krugman , and Huffington act as though we can just get the assets off these banks books when no one will buy these assets at market price. Or have you not been paying attention. And what exactly is market price? Who determines that, Congress, Treasury?
Certainly we can sell these assets at market price. The problem is not that the assets have no market value, it is that the market value is far below the amount the bank paid for it.
The market value is what the market (you and I) would be prepared to pay for an asset. For example, houses on the outskirts of Washington DC that once sold for nearly 400k are now selling for 40k in public auction. The bank that held the asset lost 90% of its investment on the deal.
In other words, if toxic assets were to be evaluated on an open market the banks would be insolvent.
Jeffrey, I respectfully agree and disagree with you.... I have the same concerns about the auction of the toxic assets and a raid on the FDIC... However, GAME THEORY comes to play here, if The Auction is set up correctly according to GAME THEORY (our beloved cuuk John Nash), then it really is a win/win with relatively low downside for the government..
Our Great and Brilliant Leaders will have thought of this because this might be the only way to win the 2010 and 2012 elections. If GAME THEORY is not applied, then we are totally toast and give the country to the republicans again (my worst nightmare)....
I still believed raising taxes on the rich is the only way to repair the overall fabric of our society.....Millionaires paying 17% in taxes while 2.4 million people were thrown out of their houses... and the BANKERS will say the Mortgagees were too smart for them which means that the BANKERS ARE TOO STUPID and should not be keeping all the ill gotten gains of the last 5 years... Also FREE LUNCH came out before this Bailout mess started, so look for David Kay Johnson's new book and read BAD MONEY by Kevin Phillips in addition to the Theocracy book which discusses the rise of Wall Street and Debt... (anything by Phillips is 5 star).
For fun read a Road through History (Ina Caro) or European Dream....
Please.........I'm begging you..........
Shout this information at the top of your lungs..........to anyone who will listen.
This is the biggest scam in the history of mankind.
Brought to us by Barack Obama.
Actually, it was brought to you by GW Bush.
Yes you are correct, except now Obama is furthering the exact same bamboozle that Bush and Paulson started. This is NOT change we can believe in!
Your assumptions are fundamentally flawed. You assume here that the current market price of these assets reflect their accurate value- on the other hand most analysts believe they reflect fear and are grossly undervalued. 85% of folks still they pay their mortgage, and more will if the economy stabilizes. Moreover, the private investors dont automatically have to walk away from the fund if they go underwater, they can stay in till it recovers- and if the banks do well, and the economy shows signs of recovering why will they walk away?
In any case, if the banks do well, the taxpayer also will be doing well, since we well own most of the banks now: 40% of citi, and quite a chunk of others. It is high time we consider that each time we speak of nationalization, the banks are already partially owned by us anyway- and we will be wiping ourselves out if we wipe them clean: and we will simultaneously make FDIC go broke, create panic in the system on lehman like proportion that will be hard to reverse. Cutting your nose to spite your face.
Even if 85% of people can afford to pay their mortgage, when they come due to renew or refinance, if their home has lost value, if they are underwater, they will be unable to renew or refinance... A lender will not lend them more money at renewal than their house is worth, even if they can afford to pay the monthly payments.
At that point, your argument fails.
And you seemed to have missed the point of the article: if the plan for saving the banking system is again to privatize the profits and nationalize the losses, it will not sell.
The idea is to raise prices for homes sooner through this resolution of the toxic asset portfolio. Consider that the system reacts to inputs and guess what will happen.
It is very clear that you do not know much about this issue. Nationalization is only a boogeyman; the correct term is receivership. Insolvent corporations are taken into receivership.
Too much regurgitating conjecture and not enough reasoned thought.
Can you name one economist who feels Geithner's plan is a good idea?
Bernanke.
Larry Summers [cheeky, I know...]
Actually your assumptions show you have no idea what really is the issue at hand. If the auction process was conducted sans manipulation several of the big banks would go under. You need to stop blindly following the media and do some research.
Goldman Sachs put out a report last week on the carrying values of various assets by the major banks. Citi is carrying most of their loans at 99% to 100%. That is a fantasy world and if it was up to me I would put some executives AND auditors in prison.
The pundits also love to cry that this problem was created, or at least exacerbated, by the application of MTM accounting. The reality is many banks ARE NOT MARKING ANYTHING TO MARKET!!!!!!! Jamie Dimon even said last Friday that any change related to MTM would have very little affect on JPM. The banks don't want to value the assets at their true value so they move them to Level 3 or claim they will be held to maturity so they do not have to write them down when that is not their intention in many cases. Level 3 assets at the banks have continued to grow even as Hank Paulson continuously said otherwise. Now why do you think that is the case?
It's only a matter of time before they raid FDIC...
Probably close to the 2012 election...they'll go along for a few.
Right now people are saving and more people are aware and wary of sub-prime loans. Some of the decline in lending is people saying "thanks but no thanks."
They're going to get theirs and they're just letting the coffers load up.
You'll be barred from withdrawing when the s h i t hits the fan. And Geithner's buddies are going to suck it all up like a vaccum cleaner.
When Obama terms out, Geithner and Summers will return to the boards of banks.
What are you talking about? If the banks go into receivership the FDIC will be out of cash period. Not in loan guarantees but in cash.
One was a rant about the current loan situation...
Followed by a separate rant about deposits no longer being insured.
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