Geithner’s Bank Plan Made Simple: Probably a Rip-Off

The heart of the issue remains pricing. No matter how they structure the financing of any plan to buy up all those “toxic securities” on the books of a few big financial institutions — and clearly they’re trying to use as little tax-payer cash up front as possible — they’re still protecting investors against losses that are likely inevitable. Or, at the very least, they’re taking on a lot of risk -- on behalf of you and I and the tax-payers we know -- in order to protect investors from the potential for steep losses. The nub of it is this, via the WaPo:

The program provides capital for new investment funds, matched with by private investors such as hedge funds. The Federal Deposit Insurance Corp. will guarantee debt issued by those private funds, meaning that lenders probably would view them to be as nearly as safe as lending to the U.S. government.

It works like this, according to a Treasury Department fact sheet: Imagine that a bank wants to sell mortgage loans with a $100 million face value. The FDIC would auction the loans to private bidders. Suppose the winning bidder offered $84 million. The private investor would put up $6 million, Treasury would put up $6 million, and the FDIC would guarantee $72 million worth of loans.

OK, so the treasury and private investors are in for a 50-50 split up front, an they share in the eventual profits if the underlying assets regain value and the loans are repaid or losses if they continue to go South. They're trying to create a market for a "shitpile" nobody wants to buy without protection. So far, so good.

If investors select assets wisely, and the assets prove to have good value over the long run, the loans will be repaid, and the hedge fund and Treasury Department split the remaining profits in proportion to their original investment. If the investors choose poorly, or the assets fall significantly in value, the government shares in the initial loss and potentially is required to spend additional money to cover the loan guarantees.

The idea is to get those assets off the books of banks and onto the books of long-term investors who could lose money without causing broader economic damage.

Let’s translate that. The idea is to make sure that investors get into the market by minimizing their potential losses, while making sure that they have some “skin in the game” — that they face some risk. And I think it’s fair to say that this might not be a terrible approach if the housing market — and let’s keep in mind that we’re also talking about commercial credit, consumer credit and other debt-based securities — were stable, or somewhere near a bottom. And there’s the rub — it doesn’t appear to be anywhere in the neighborhood, as Hale Stewart (among others) noted a couple of weeks ago (also, see Dean Baker on the “shadow housing inventory” that’s likely to drag the housing crisis on for a while). Anyway, this is a plan that allows investors to put 6 percent cash down on whatever assets they choose to snatch up — presumably the most attractive in the “shitpile” — and only stand to lose that 6 percent no matter how hard the assets drop. Uncle Sam will pick up the remainder. And that’s in a period of plummeting asset values. Baker again (from February 25):

The data in the December Case-Shiller 20-City index indicate that the rate of housing price decline is continuing to accelerate. The data show that house prices in the 20 cities fell at a rate of 2.0 percent in the month of December and were falling at a 21.3 percent annual rate in the last quarter of 2008.

It is important to remember that these data reflect sale prices in the three month period from October to December. Since there is typically a 6-8 week period between contracts and closing, these data reflect contracts in a period centered on October. This means that the data is already somewhat dated when it is released. If the recent rate of price decline has persisted, prices are already 8 percent lower on average than the data indicate.

For the fourth consecutive month, prices declined in all twenty cities in the index. While prices continue to decline rapidly in former bubble markets, there were also sharp drops in some markets that had been less affected by the bubble. For example, prices in Minneapolis fell 4.1 percent in December and have fallen at a 31.5 percent annual rate over the last quarter. Prices in Atlanta fell 2.0 percent in December and have fallen at a 21.5 percent rate over the quarter.

If we’re not near the bottom in housing — and the larger debt crisis — than this plan is addressing a crisis which at heart is about a debt-ridden economy suddenly deleveraging by offering investors a chance to buy assets on a taxpayer-backed margin account. Bad policy. And, as the WaPo notes, one that may not even have the desired impact. "One particularly treacherous hurdle for the plan," according to the report, "is persuading the private investors to come to the table -- a key to its success." PS: it's also pretty much the definition of "moral hazard."