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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But were I disagree, is that I don't think that there is any other way that would save substantia
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
Lead, follow, or get out of the way because being an armchair critic is NOT helpful right now.
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 acknowledg
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"
Another way to describe those motives is that .... as one of the greedy hoard from wall street (that feels entitled to multi-mill
Neither interpreta
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
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.
The biggest disappoint
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?
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.
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 republican
I still believed raising taxes on the rich is the only way to repair the overall fabric of our society...
For fun read a Road through History (Ina Caro) or European Dream....
Shout this informatio
This is the biggest scam in the history of mankind.
Brought to us by Barack Obama.
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 nationaliz
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 nationaliz
Too much regurgitat
Can you name one economist who feels Geithner's plan is a good idea?
Probably close to the 2012 election..
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 withdrawin
When Obama terms out, Geithner and Summers will return to the boards of banks.
Followed by a separate rant about deposits no longer being insured.