Geithner's Folly: The Bank Rescue Plan Is a Disaster in the Making

The financial bailout plan unveiled by Treasury Secretary Timothy Geithner yesterday reminded me of the time my cousin Jethro Billy Rex Reed came over to my house and offered to pay me $50 for the privilege of scraping roadkill off my street.

"Well gee," I said to Jethro.  "What are you going to do with all that roadkill?"

"I'm gonna sell it for eatin'," he said proudly.  "The market for grilled flattened squirrel is booming right now!"

"But Jethro, there ain't no sane person out there that'll pay any price for crushed squirrel meat!" I said.  "What's going to happen if no one buys it?"

"That's the best part," he said.  "I figure that if no one buys, then my dad will pay me at least $100 to clean all the roadkill out before it stinks up our basement."

Much like Jethro's stock of roadkill, toxic mortgage-backed securities are now stinking up our financial system and Geithner seems to be willing to pay a premium to just get rid of them.  A key part of the plan he unveiled is to have the government create a public-private investment fund that will use government dollars to insure private investors against losses they could suffer from purchasing those bad assets if the economy keeps heading south. 

Geithner says that letting private investors bid on these assets -- with government guarantees against large losses -- will allow the market to define concrete prices for them and thus "avoid a program that has government overpaying for a bunch of financial assets."

The trouble with this, of course, is that many of these assets will never be worth what the banks will accept for them. Economist Dean Baker, co-director of the Center for Economic and Policy Research, told me that the worst of these assets "have lost value because they rest primarily on underwater mortgages."  The only way these assets will ever regain the value they've lost over the past few years, says Baker, is in the unlikely event that the housing bubble makes a comeback.

Economist James K. Galbraith told me that the government is simply in denial if it thinks it can ever recoup the losses it will inevitably take by paying insurance for those "toxic" assets. Instead of trying to sell them off in an attempt to hide the depth of the banks' losses, Galbraith says that the government should instead acknowledge that they are insolvent.

"If someone within the Government Accountability Office does their due diligence on these assets, they'll find that they're not marketable for a reason," he told me.  "Many of these securities were backed by mortgages that had sloppy and inadequate documentation."

Another problem with Geithner's plan is that it leaves bank executives and shareholders relatively unscathed. If government dollars are used to prop up bad asset values and thus protect shareholders from being wiped out, then future banks will have more incentive to invest in risky assets, safe in the knowledge that the government will help pick up the tab and leave their executives intact when the next bubble pops.

"This is the issue of moral hazard," says Hale Stewart, a tax attorney and former bond broker who writes frequently about economics at the Huffington Post. "By bailing out banks, the government is rewarding bad behavior. The alternative is to let the banks go broke and probably take the country down with them."

But although letting the banks completely fail is an unacceptable outcome, alternatives to the Geithner plan do exist. While there is no happy solution to a massive financial crisis, many economists have concluded that the United States will have to nationalize its insolvent banks. While that initially involves a government takeover of the banks, Baker points out that it's actually a more market-oriented solution than artificially propping up the value of bad assets and shielding bank shareholders from losses.

Baker adds that the government takeover of the banks isn't permanent: rather, the government removes the bad assets from the bank before reorganizing it and then selling it to the private sector as a healthy bank.

"The normal way to deal with a bad bank is to wipe out the shareholders, fire most of the executives, reorganize it, soak up the assets that are nonperforming and sell them over time," says Stirling Newberry, an economics writer at the Agonist. The end goal of any bank reorganization plan, he notes, should be to eventually "merge the bank with a healthier bank."

Nouriel Roubini, the New York University economist who correctly predicted the current financial crisis long before many economists saw it as a serious threat, recently endorsed nationalizing banks while responding to reader questions over at the Financial Times' Web site.

"Nationalization may be a more market-friendly solution," wrote Roubini, who also noted that the nationalization model was successfully used by Sweden during its banking crisis in the early '90s. "It creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and … it provides a fair upside to the taxpayer."

The biggest danger in not nationalizing banks, Roubini continues, is that many of the banks will become "zombies" that are insolvent but are still being animated by taxpayer money. Without restructuring, these zombie banks would continue to be run poorly, and frozen credit markets would be unlikely to thaw.

So if the nationalization solution presents a better alternative to the Geithner plan, why isn't it being employed? 

There are two plausible explanations, and both are depressing. The first explanation is the most cynical one: that Geithner is protecting his friends within the banking industry from suffering the consequences of their poor decision-making. Baker sums up this argument succinctly: "Bankers are powerful supporters of the Democratic Party, and therefore [they think] it is good to help them."

The other explanation is that the Obama administration is so determined to transcend traditional partisan politics that it has bought into the false notion that America is an intractably "center-right" nation that will not tolerate massive government intervention into private institutions. President Barack Obama gave credence to this explanation during a recent interview with ABC News.

"Obviously, Sweden has a different set of cultures in terms of how the government relates to markets, and America's different," said Obama, explaining why the U.S. was not following the Swedish model for financial rescues.  "What we've tried to do is to apply some of the tough love that's going to be necessary, but do it in a way that's also recognizing we've got big private capital markets, and ultimately that's going to be the key to getting credit flowing again."

A week earlier, Geithner was even clearer about the administration's priorities when he said: "We have a financial system that is run by private shareholders, managed by private institutions, and we'd like to do our best to preserve that system."

If Obama is sincere about this, then this is indeed a discouraging development. The president who once promised that he'd bypass ideology in favor of "what works" is sacrificing a solution that has worked in the past on the altar of "center-right" ideology.