05/08/2009 05:12 am ET Updated May 25, 2011

Summers/Geithner Plan: Bank Heist One More Time

Obama's economics guru, White House chief economic advisor Larry Summers, has been a walking career controversy and his latest activities are more of the same.

His scheme, with Federal Reserve Chair Tim Geithner, was recently unveiled and is designed to bail out the banks, through a highly-leveraged investment protocol.

The idea is that private investors can put up 7.5% of the cost of buying toxic bank assets with the bank putting up the same and taxpayers 85% in the hopes that values will improve. If they do, all three prosper, if not the bank's dumped worthless assets onto taxpayer laps and not their shareholders and bondholders.

Not surprisingly, this scheme is being roundly criticized by some very smart people. I think it's more of the same: highly leveraged risk-taking shenanigans facilitated by a naive government and tax dollars.

What's wrong with it

Here are three critics of the plan, starting with Columbia University's Jeff Sachs:

"Insiders can easily game the system created by Geithner and Summers to cost up to a trillion dollars or more to the taxpayers."

Nobel Prize winning economist Joseph Stiglitz dissed the scheme in the New York Times last week: "The proposal has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win -- and taxpayers lose."

Also critical was financial expert Peyton Young who wrote in the Financial Times: "People who outbid others in auctions sometimes pay too much, a phenomenon known as the winner's curse. Yet the plan outlined last week by Tim Geithner, US Treasury secretary, for pricing the toxic assets clogging up the financial system, provides private investors with an unusually strong incentive to overpay: the government is proposing to pick up most of the tab if the assets turn out to be worth much less than was spent on them. Indeed, the more aggressively investors compete in bidding for these assets, the worse off the taxpayers will be."

Pro or con

The argument in favor of the Summers-Geithner policy is that eventually the asset may be valuable and private-sector participation will reduce the pain and help turn around values.
Cynics say Geithner was part of the problem because he didn't see what was going on in banking as Federal Reserve New York City Chair and that Summers drank hedge fund Kool Aid when he made millions on Wall Street from late 2006 to late 2008.

Professor Summers certainly enjoyed close and lucrative ties with Nation Hedge Fund after his stint as President of Harvard University came to an end following an impolitic remark about females and mathematical aptitude.

Summers then taught at Harvard part-time, but made speeches and a cool US$5.2 million working one day a week in two years for D.E. Shaw & Company, a hedge fund managing US$30 billion in assets. That's a daily rate of US$25,000.

Summers gets a bail out

The fund was successful and Summers also made money as one of its investors. Even better, and because he had to divest to go to the White House, he was able to cash in his stake even though D.E. Shaw imposed a redemption ban in the fall on all the other investors.
Summers maintains that his experience has been beneficial to helping reshape America's financial sector.

"I have a better sense of how market participants sort of think and react to things from sort of listening to the conversations and listening to the way the traders at D. E. Shaw thought," he said.

Not everyone agrees.

Sachs says that Summers and Geithner are ignoring suggestions that cannot be gamed, such as the division of banks into good and bad banks. Such restructuring would allow the bad assets time to improve or worsen without dragging down the good bank assets or operations.
Is it a grab for tax dollars to save bank shareholders and bondholders or is it, as these two Wall Street denizens maintain, the only viable option?

Diane Francis blogs at the Financial Post