The Geithner Plan: Take 1

Some negative reactions to the Geithner plan: Krugman, more Krugman, Calculated Risk, Yves Smith, James K. Galbraith, Henry Blodget, Noam Scheiber. Brad DeLong, on the other hand, likes it, and whether you agree with him or not, he’s made the strongest case I can think of for it, and it’s absolutely worth reading, as is Krugman’s response. All of these people actually know what they’re talking about. I, on the other hand, do not: I’m just a reasonably informed non-economist like, I assume, most of you. Take what follows in that light, and if your time is short and you have to choose between reading me and reading, say, Krugman or DeLong, choose the latter. Also, if I get anything wrong, please let me know.

That said, several problems with this plan, and specifically with Geithner’s proposal to create public/private partnerships which will bid against one another to buy various toxic assets, just leap out at me. For one thing, it might not work at all. From the NYT:

“Risk-taking institutional investors, like hedge funds and private equity funds, have refused to pay more than about 30 cents on the dollar for many bundles of mortgages, even if most of the borrowers are still current. But banks holding those mortgages, not wanting to book huge losses on their holdings, have often refused to sell for less than 60 cents on the dollar.”

How, one might wonder, will holding an auction help here? If the banks are not willing to sell below 60 cents on the dollar, then absent nationalization or something similarly drastic, we can’t force them to. If potential buyers are not willing to pay the price banks insist on, then the auction will simply fail, the assets will remain on the banks’ books, and nothing will have been accomplished. And if the NYT is right about the gap between the price at which banks are willing to sell and what buyers are willing to pay, then the only way for an auction to work is if it somehow persuades one group to change its mind.

As it happens, some of the auctions Geithner plans to propose will do just that. From the WSJ:

“To target troubled securities, such as mortgage-backed securities, the government will create several investment funds. Treasury will act as a co-investor, in most cases contributing $1 for every $1 contributed by the private sector and sharing in the first-loss position.

To target troubled loans, the government will create a Disposition Finance Program with the FDIC. In that case, the government will be a co-investor, but could also agree in some cases to contribute 80% of the financing, with the government putting up $4 for every $1 in private financing. As part of that program, the FDIC would provide guarantees against losses on a pool of loans that a bank wants to sell. The program could guarantee as much as $500 billion in loan investments.”

In the first sort of auction, we share the risk with private investors. In the second, however, we assume it all. Obviously, buyers will be willing to pay more for otherwise risky assets if the government guarantees any losses they might suffer. Why? Because any investment is worth more if you don’t have to worry about losing money. As Ezra says:

“A private auction will not price the assets. It will price the potential upside of the assets given that taxpayers will assume the brunt of the losses. As illustration, imagine an art auction. Now imagine an art auction where Sotheby’s loans money to the participants and promises to pay the losses if the paintings fall in value. Think the pricing will be the same?”

This means several things. First, one of the things you might think that an auction would do would be to help us to figure out what these assets are really worth. But while the auctions of troubled securities might do that, the auctions of troubled loans will not. They will, at best, help us to figure out what those loans would be worth if they had no downside risk. That’s a different thing entirely. And it means that this auction will be useless for figuring out what those loans are actually worth.

Second, buyers will presumably pay more for these loans than they would have done had they had to assume their risks along with their potential gains. This might help overcome the gap between what buyers are willing to pay and what sellers are willing to accept. But it does so by artificially inflating the price of risky loans. Since we, along with the private investors, will be paying these artificially inflated prices, this is a subsidy to the banks, and should be recognized as such.

Third, it’s worth reemphasizing this point: we, the taxpayers, assume a lot of the risks under this plan. This is one reason why, as Paul Krugman says, it’s a huge gamble on the proposition that the assets in question are undervalued, and will regain their value as soon as the economy returns to normal. If that’s true, then we will probably get our money back, though we won’t do as well as we would have done had we paid market prices. But if it’s not, then we will be left holding the bag. And it’s a very, very big bag.