THE BLOG
03/23/2009 10:28 am ET Updated May 25, 2011

The Geithner Plan

From the WSJ:

However, the financial system as a whole is still working against recovery. Many banks, still burdened by bad lending decisions, are holding back on providing credit. Market prices for many assets held by financial institutions -- so-called legacy assets -- are either uncertain or depressed. With these pressures at work on bank balance sheets, credit remains a scarce commodity, and credit that is available carries a high cost for borrowers.

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Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity. Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

This program to address legacy loans and securities is part of an overall strategy to resolve the crisis as quickly and effectively as possible at least cost to the taxpayer. The Public-Private Investment Program is better for the taxpayer than having the government alone directly purchase the assets from banks that are still operating and assume a larger share of the losses. Our approach shares risk with the private sector, efficiently leverages taxpayer dollars, and deploys private-sector competition to determine market prices for currently illiquid assets. Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience.

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We cannot solve this crisis without making it possible for investors to take risks. While this crisis was caused by banks taking too much risk, the danger now is that they will take too little. In working with Congress to put in place strong conditions to prevent misuse of taxpayer assistance, we need to be very careful not to discourage those investments the economy needs to recover from recession. The rule of law gives responsible entrepreneurs and investors the confidence to invest and create jobs in our nation. Our nation's commitment to pursue economic policies that promote confidence and stability dates back to the very first secretary of the Treasury, Alexander Hamilton, who first made it clear that when our government gives its word we mean it.

Let's move through this paragraph by paragraph:

1.) First -- I like the term "legacy assets". It's a nice and polite way of saying, "we're stuck with some really old garbage".

Now -- let me back up a bit further and provide a bit of a history lesson here. Securitization -- the process of taking single loans, pooling them with other loans of similar qualities (same interest rate, maturity date etc..) has been around for about 30 years now. For anyone who wants to really delve into this process, read any of the fixed income books by Frank Fabozzi. In other words, the problem hasn't been the system of securitization. Instead the problem has been the "lend to securitize" market of mortgage lenders that sprung up over the last 15 years like weeds. These lenders had no incentive to make quality loans because they sold the loans off faster then the loans would go bad.

These are essentially mortgage related assets who's value is depressed right now thanks to the housing market. There are a lot of questions related to these assets. Let's start with the big one: what are they worth? The problem is most of these assets are "thinly traded" -- meaning there aren't enough trades to determine an "average price". And therein lies the real problem with most of these bonds -- we can't figure out what they are worth.

Secondly, is their price unrealistically low right now because of the problems in the housing market? That is, are prices unrealistically depressed? There is no answer to this question. Most owners would say yes -- which explains why they are arguing for a relaxing of the mark to market rules. In general I would agree with this sentiment, but only by adding this very important caveat: prices are depressed if the owner's intention is to hold the asset to maturity. Finally, will these assets increase in value over time to where a profit can be made? No one really knows the answer to this question either, although assuming the maturity date is far away enough (say 10+ years) the answer is probably yes.

Here are the underlying principles:

Three Basic Principles: Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets - with the potential to expand to $1 trillion over time. The Public-Private Investment Program will be designed around three basic principles:

* Maximizing the Impact of Each Taxpayer Dollar: First, by using government financing in partnership with the FDIC and Federal Reserve and co-investment with private sector investors, substantial purchasing power will be created, making the most of taxpayer resources.

* Shared Risk and Profits With Private Sector Participants: Second, the Public-Private Investment Program ensures that private sector participants invest alongside the taxpayer, with the private sector investors standing to lose their entire investment in a downside scenario and the taxpayer sharing in profitable returns.

* Private Sector Price Discovery: Third, to reduce the likelihood that the government will overpay for these assets, private sector investors competing with one another will establish the price of the loans and securities purchased under the program.

Here are the advertised merits:

The Merits of This Approach: This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases - along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets.

So -- the government provides some funding, to be matched by the private sector. The plan states this will "maximize the impact of each taxpayer dollar" and "share the risk", both of which are fundamentally true assuming, of course, there is a desire by the private sector to participate. Assuming that is true, then the two propositions are true.

Here's how it would work:

* Banks Identify the Assets They Wish to Sell: To start the process, banks will decide which assets - usually a pool of loans - they would like to sell. The FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee. Leverage will not exceed a 6-to-1 debt-to-equity ratio. Assets eligible for purchase will be determined by the participating banks, their primary regulators, the FDIC and Treasury. Financial institutions of all sizes will be eligible to sell assets.

* Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.

* Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.

* Private Sector Partners Manage the Assets: Once the assets have been sold, private fund managers will control and manage the assets until final liquidation, subject to strict FDIC oversight.

All of this hinges on two points:

1.) The banks wanting to sell an asset, and

2.) Private bidders arriving at a price the banks are willing to take.

These two points are critical. There is nothing forcing banks to participate in the program. And that is the real problem. And there is a big reason keeping the banks from participating: finding out that various assets aren't worth anything.

However, assuming banks are willing to play this isn't bad. I would change a few things -- the most important being the government provided leverage. I think the private sector should pony up a whole lot more. But that's just my opinion which is completely unsolicited.

In addition, no plan is perfect. There are no guaranteed solutions to any of our problems right now. Specifically, nationalization has a ton of problems associated with it. However, overall I think this is workable.