Will the Geithner Plan Work?

This debate at the New York Times is worth reading and following. It gives an insight into the way that some top economists are viewing the problems that ail the banking system, and the likelihood of the Geithner plan solving those problems. The participants are Krugman, DeLong, Thoma, and Johnson, all of whom maintain solid relationships with the Obama administration. Will the Geithner Plan Work? – Room for Debate Blog

The central issue from my point of view is the effectiveness of the Geithner plan and its cost, versus other plans that could provide a solution.

First up: the Geithner plan offers only $500 billion of money whereas there are an estimated $4 trillion of toxic assets accumulated throughout the system. The administration hopes that by injecting $500 billion it can ease pricing on the remaining assets and encourage private investors outside of the plan to step in and buy them. We should all remember that it is highly likely that some if not most of these assets have some value. Not dollar for dollar, but there is residual value. Every real estate bust of the last few decades has left behind a few very wealthy investors who took a risk and stepped in to help clean up assets. By holding those ‘bad’ assets for a long time, in some cases all through to maturity, those investors were able to more than recoup their money. Many made fortunes.

The key is that because of accounting rules for banks, the assets may have more value off the banks balance sheets rather than on. So where the banks may show a loss while retaining the ‘bad’ assets a private investor may show a profit.

Second: The Geithner plan does not directly recapitalize the banks. Presumably that is to come via another TARP like program. What Geithner is trying to do is simply to create a market for ‘bad’ assets and allow the market to determine their worth. One of the biggest barriers to moving the assets around to private investors is that no one has any idea of what a good price is. This is partly because the credit markets are frozen – out of fear of buying ‘bad’ assets that are truly ‘bad’ rather than being ‘good’ but ‘misunderstood’ – but it is also partly because so many of the ‘bad’ assets form part of larger pieces of Mortgage Backed Securities and other derivatives. The problem with these derivative assets is that they are so far removed from their origin and may even be sliced up that several organizations may have pieces of the same mortgage. Threading all the information back together is a big task in normal market conditions, doing so when the market is dysfunctional is even harder.

Traditional economic theory argues that an asset’s price conveys all the information and investor needs to know in order to make an informed purchase. However so much information is lost during the derivative construction process that I find this argument invalid. The increase in uncertainty fostered by substitution of the old ‘originate and hold’ strategy for mortgage lending with the new ‘originate and sell’ strategy of the 1990’s and 2000’s eliminates the effectiveness of pricing as the sole source of actionable information. Investors therefore need to be encouraged to offset this increased uncertainty – risk of loss due to something they had no idea of – by being given other incentives. In the case of the Geithner plan that incentive is ‘non-recourse loans’ from the government. This amounts to a subsidy and gives investors a big upside gain at little cost.

This all sounds a little technical, and indeed the debate surrounding the Geithner plan seems to have become very technical quickly.

But at its heart is the issue I have raised before: is this crisis a simple panic? In which case the assets are essentially good but temporarily undervalued because the market is having a snit. Or is the crisis one of an over supply of truly bad assets resulting from faulty economic modeling and wrong headed lending by the banks? In which case the assets are toxic and have little value even in a good economy.

The policy responses to these two scenarios are radically different.

In the first you do what Geithner is trying: slap the market back to life by pumping in cash and calming investor nerves.

In the second you find ways to eliminate bad banks from the system so that they no longer clog up lending and prevent the credit system from springing back to life.

I think it is the second scenario that we are looking at. Geithner thinks it is the first.

So will the Geithner plan work?

If he is right about the fundamental problems of the economy, yes it will. At some cost to taxpayers, but it will work. If he is wrong about the fundamentals, no it won’t work, and we will still be discussing bank bailouts in a few months.