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The Geithner rally: Rome wasn’t burned in a day

Geithner flashes his trademark perma-smirk.
Geithner flashes his trademark perma-smirk.

Have you heard? The stock market has rallied and everything’s going to be all right. That’s the consensus of some of the best-dressed cheerleaders in America after yesterday’s announcement of the Geithner cash-for-trash plan spurred a 6.8 percent increase in the Dow and a 7.1 percent gain in the S&P 500. “Obama and company started paying attention to the stock market,” the chief investment officer at Chicago’s Harris Private Bank told Bloomberg News. “They knew they had one shot at this, they took a big swing and I think they hit the ball out of the park.” In the words of another money manager, “Maybe practice makes perfect. Another few days like this and [Geithner]’ll be a great hero on Wall Street.”

There’s even talk of a new bull market in the offing, which some of the more sober analysts–killjoys!–are dubbing “premature.” “Loony” might be a better word. Why wouldn’t major market players like the Geithner plan? It’s an invitation to a fresh round of speculative activity. Private investors are in a near-risk-free position; the government is willing to front them about 95 percent of the purchase price of banks’ most dicey assets. And if buying up those assets proves to be a bad bet, the losses on those government loans will be footed by taxpayers.

The premise of the Geithner plan, and of the Obama administration’s whole bailout strategy, is that the financial crisis is all just a big misunderstanding–a classic market panic, and not the collapse of a huge asset bubble. The banks are not really broke as a result of years of insane lending. Their assets are not really over-valued; in fact they’re undervalued. All it will really take to restore the good old days is a great big shot of confidence.

But if we are experiencing the collapse of a bubble, as most economists now believe, then the Geithner plan is simply an effort to reinflate it. And the real problem–a few trillion dollars worth of bad debt that needs to be expunged from balance sheets–goes largely untouched even as we throw staggering sums of good money after bad.

Simon Johnson and James Kwak, the co-founders of the Baseline Scenario blog, have an essay in today’s LA Times that splashes cold water on the Geithner plan:

First, the subsidy may not be sweet enough to close the deal. According to one analysis, a specific mortgage-backed security was held on a bank’s books at 97 cents, while its market price was about 38 cents. Even if you limit the buyer’s potential loss to the capital he put in, it’s unlikely he will raise his bid from 38 cents to anything near 97 cents.

Second, there is a “lemons” problem, also known as adverse selection. Even with a reasonable degree of disclosure, the selling banks will still know more about their assets than the buyers. The banks will be trying to dump their most toxic assets (their lemons); the buyers, fearing exactly this behavior, will reduce all their bids accordingly. This will make it harder for buyers and sellers to meet.

Third, there are political pressures, which have multiplied recently. For this plan to succeed, it has to offer private investors both upfront subsidies (cheap loans) and the long-term prospect of high returns. Both of these will be broadly unpopular with the public, especially given general attitudes toward hedge funds and private equity firms. Any attempt to limit the upside for the private sector has, apparently, been vetoed by potential investors. And that will make it look and feel like a taxpayer shakedown.

Johnson and Kwak favor the solution that V.V. Chari discussed here last week: bankruptcy reorganization for the big banks. In other words, deal with their problems by writing the bad loans off the liabilities side of the ledger rather than injecting endless quantities of cash on the assets side.

While Wall Street was exulting yesterday, what was happening in the world outside the trading floors? 

China was broaching the subject of supplanting the dollar as the world’s reserve currency. Europe was continuing to balk at stimulus spending. The Obama administration was watching its political capital for undertaking future bailout measures drop to dangerously low levels. And U.S. commercial real estate was showing further signs of following residential real estate down the toilet.

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Comments (7)

  1. Submitted by Glenn Mesaros on 03/24/2009 - 09:31 am.

    The “Public Private Partnership Investment Program” (PPPIP) introduced today by Treasury Secretary Tim Geithner is nothing more than a continuation of the greatest swindle in world history, in which money from the U.S. taxpayers is being stolen to bail out the bankrupt banking system. Under the PPPIP, the government will loan money to hedge funds and other speculators to buy toxic waste from the banks, with the provision that the loans will not have to be paid back if the deals are not profitable.

    The government’s problem is simple: to bail out the banks, it must dramatically overpay them for the worthless loans and securities they now carry on their books. At the same time, for political reasons, it must keep up the pretense that it is protecting the taxpayers, who are actually being stolen blind. Therefore, the government will set up phony mechanisms to allow it to pretend that the “market” is setting the price, when in fact the whole thing is a government operation.

    The banks like the plan because they get to dump their worthless assets on the taxpayers. The government likes the plan because it provides some modicum of political cover to its complicity in this theft. What remains unclear at this early point, is who would want to buy this toxic waste, and why. No matter what any of the parties involved claim, the buyers must significantly overpay for what they buy, and even though the government will pick up most of the cost, the private buyers will still have to put in a few pennies on the dollar, which they presumably will lose, unless other arrangements such as fees for managing the assets are made.

    BANKRUPTCY PROCEEDINGS NOW! TAKE OVER CITIBANK, WELLS FARGO, JP MORGAN, AND DOA (BANK OF AMERICA). FIRE AND REPLACE ALL EXECUTIVES.

  2. Submitted by Steve Titterud on 03/24/2009 - 11:05 am.

    It seems the single result of this chicanery, if it works, is that it would relieve the banks of the bad mortgage assets, improving their balance sheets.

    What worries me is that these same banks have not yet disclosed all the “side bets” they’ve made in exotic derivative transactions, and the true sum of their potential exposure. These were unregulated and unreported. If they are still playing hide-and-seek with these, then this program is pointless.

    I agree with Mr. Mesaros and many others that if the slate were wiped clean in a bankruptcy, at least then we’d know where we’re at, insofar as the real liabilities of these banks. Another low-brow benefit is we’d get to know what transactions they’ve been hiding.

    The matter of the Chinese currency becoming a replacement for the dollar in foreign exchange settlements has been brewing for a while, a little at a time. See http://bbs.chinadaily.com.cn/redirect.php?gid=2&fid=33&tid=623385&goto=nextnewset from September, and http://english.cri.cn/6826/2009/02/19/168s455479.htm from a month ago.

    I am scratching my head wondering what THIS means for our dollar and our economy!

  3. Submitted by Susan Lesch on 03/24/2009 - 11:06 am.

    Cheer up! Bill Gross said it is “perhaps the first win-win-win policy” and that PIMCO will participate.

  4. Submitted by Paul Scott on 03/24/2009 - 12:24 pm.

    Best headline I’ve read in a long time.

  5. Submitted by Bernice Vetsch on 03/24/2009 - 12:46 pm.

    And that ain’t all. Should there actually be profits, the government and the “investor” who put in 5 percent with share them 50-50.

    Congress MUST kill this deal. Has Mr. Chari spoken before any committees?

  6. Submitted by Richard Schulze on 03/25/2009 - 07:59 pm.

    We have to anticipate the likelihood that some banks will resist selling their loans and securities…We may then have to start asking, “Why keep insolvent banks afloat?” And having asked that, we will have to search for ways to manage the ensuing systemic risk.

    Either way, once the plan is fully implemented, we will be entering a new phase of the financial crisis. The water is choppy. Let’s hope we are strong swimmers.

  7. Submitted by Richard Schulze on 03/25/2009 - 08:06 pm.

    There are lingering questions about how to deal with insolvent banks and how to capitalize the rest of them, and TARP funding is nearly spent. The public, however, is bail-out weary and angry, and the Congress is unwilling to legislate in the face of that anger, and is further constrained by institutional bottlenecks.

    The goal, then, is to take steps toward resolving the banking problem with the limited resources available, without doing anything too crazy that risks digging the economic hole deeper. (I know some economists are of the opinion that the riskiest thing to do is to leave insolvent banks afloat for another six months, but I think they’ll agree that the cost of six more months’ worth of zombies is far lower than the cost of another Lehman.) In light of all that, Mr Geithner’s plan looks quite reasonable.

    Here’s what we’ll know in a few months time. We’ll know which banks opted to participate in the plan and which banks did not. We’ll know a good deal more than we do now about where some of the toxic assets out there should be marked, and those prices will have the ratification of the government and the private auction participants. As a result, we’ll have a much better idea who is clearly, irresolvably insolvent—a judgment that will likewise be ratified by both the government and the private market participants. And the Obama administration wil be able to take those judgments to the Congress and say, “We have no choice but to do something about these banks in violation of their charters. Give us the tools we need so that we don’t have to liquidate the banks and send the economy spiralling down all over again”. And of course, in a few months we’ll also have a better sense of which trajectory the economy has chosen to follow.

    Of course, a lot has to go right to get to that point in one piece, some of which is within the control of the Treasury (which is hopefully employing teams of lawyers and economists to sniff out potential avenues for abuse), and some of which isn’t. It would be wise to be devising backup plans to their backup plans. I don’t see another option out there that clearly performs better than this plan on: 1) cleaning up balance sheets, 2) working with available resources, and 3) avoiding serious risks to the financial system. So the Geithner plan it is.

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