That Geithner Plan Again

Joe Stiglitz has an excellent and simple description of the economics of Geithner’s toxic assets buy out plan in today’s New York Times: Op-Ed Contributor – Obama’s Ersatz Capitalism

As you know I remain opposed to the plan. It has two flaws both of which are fatal from my point of view:

First: As Stiglitz demonstrates the plan fails its own test. It is supposedly designed to surface market prices for toxic assets so that they can be traded at ‘fair value’. The problem up until now has been that the market has failed to price these assets reliably and so they cannot be moved off of bank balance sheets and housed in more appropriate places like private equity funds where both capital and risk appetites are abundant. So getting the price right is seen as crucial to freeing up the market.

But Geithner’s plan doesn’t actually achieve this.

Instead is allows the market to determine prices for the implicit option attaching to the asset. This is very different. Because the government is insuring the private investors in the plan from most of the downside loss, those investors will focus primarily on the value of the gain they can achieve. Once the downside is virtually eliminated from the calculation the price an investor is willing to pay will be much higher than a price that takes into account a potential loss.

As a result the prices that Geithner’s plan will elicit from the bids by investors is necessarily skewed upward. The ‘true’ value of the toxic assets will still not be revealed.

So who benefits from this?

The banks. They will be able to take advantage of the skewed prices and dump toxic assets at prices well above true value. The investors. They will be able to bid aggressively knowing that the gains and losses will accrue from their bids will be heavily asymmetrically weighted towards gains.

So who loses from the plan?

You and me. The taxpayers. We stand to make gains on some of the assets, but our return on equity pales in comparison to that achieved by the private investors. And when the toxic assets turn out to be toxic we lose big time.

So the plan fails in its stated goal: it does not price toxic assets, it only prices the implicit option on those assets. And it amounts to a heavy subsidy of both the investors and the banks.

This subsidy is augmented further by the ‘adverse selection’ problem Stiglitz mentions. Adverse selection is a situation when the selection process has a bias towards a negative result. In this case the bias is negative because the banks will be able to select the worst assets for sale. They will be able to keep any assets that they feel have a chance of coming good. Since the market knows this the investors will be inclined to bid lower in order to cover their own losses [they still have the potential to lose their equity stake] but the selection bias almost certainly condemns the taxpayers to losing money – there will be far fewer ‘good’ toxic assets sold so the upside is severely limited.

The second flaw in Geithner’s plan is far more important. It simply doesn’t address the continuing undercapitalization of the major banks. This lack of capital is the reason that lending will take a while to pick up speed. Until the banks are flush with capital they will have to avoid making new loans that might go bad. Since we in a deep recession that means pretty much all loans. Hence, at the moment, a wise bank makes no loans. Especially if its capital is limited.

So.

The Geithner plan has all the hallmarks of something put together by people who have limited imagination, little courage, and limited resources.

It sets us on course for a Japanese style economy for years to come.

And that’s what annoys me most.