Treasury Secretary Tim Geithner today announced a new plan that will allegedly help stabilize the financial markets, restore institutions’ balance sheets, and thus ease the credit crunch with all its attendant ripple effects. It’s an unwieldy construct with multiple parts, but ultimately a lot of it comes down to using taxpayer money to help purchase “toxic assets.” (E.g., CDOs backed by MBSs, the stuff hedged by all those CDSs. Isn’t it fun to play with the new lingo we’ve all learned these last few months?)

The stock market seems to love the plan, seeing as how it surged several hundred points today. But does that mean it’s a good thing? 

Paul Krugman certainly doesn’t think so, and wasted no time explaining why in today’s New York Times

Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.

It’s as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street.

…The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.

…But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.

One of the underlying premises of the Summers/Geithner approach to things (continued, as Krugman accurately notes, from Paulson) is that the biggest institutions aren’t “really” insolvent, appearances to the contrary notwithstanding, because the assets underlying their CDOs and whatnot have a “hold to maturity” value that’s higher than the currently very low “mark to market” value per current accounting. (In metaphorical terms: the banks aren’t really zombies, they’re just malnourished.) The concept here, therefore, is that facilitating liquidity will encourage investors to take a (subsidized) risk on those assets, and everyone will come out fine once the “real” value has a chance to shine through.

I’ve been at best cautiously skeptical about this line of thinking since September —it’s been a learning process—but what it comes down to is that it’s just not very credible any more. (Nor does the investing class believe it, obviously… or the MTM value wouldn’t be so low in the first place. Besides, there’s just something hypocritical about saying MTM was a perfectly fine basis for everyone’s balance sheets when things were on the upswing, but it’s not reliable now that they’re on the downswing.)

It’s been six months. To the extent that there’s been actual forensic investigation into the underlying value of some of these assets, the results have not been encouraging: they really are mostly “trash.” (As should have been obvious two years ago to those paying attention.) Meanwhile, the crashing Main Street economy (job losses, business closings, foreclosures, etc.) makes it even less likely that the remaining pools of assets (i.e., other people’s debts, remember!) will actually turn out to be valuable, since fewer debtors are in a position to repay them.

This plan, like the many variants that have come before, relies on the crucial assumptions that we need to buy time; that when everything comes out in the wash, there’s real underlying value here; and that meantime, the people in charge of these institutions have meaningful expertise and should be kept in place. (That’s certainly a big part of what the AIG bailout was all about, as Matt Taibbi described in detail in his recent no-holds-barred, names-named Rolling Stone piece:  pumping capital in so that AIG could make good on its CDS obligations to places like Goldman, who had used those CDSs to hedge what it knew were risky holdings… thus helping Goldman keeps its own books balanced. Of course, this implicitly validates the whole highly overleveraged business model in which both sides were engaged, which isn’t really especially sane.)

What Krugman, James Galbraith and other critics are saying (and have been) is that these premises aren’t sound. The emperor has no clothes. The people atop these institutions didn’t know what they were doing, and didn’t properly account for risk, and don’t actually hold anything that retains enough value (even long-term) to consider them solvent… and thus that they need not to be patched up and kept intact, as is clearly the plan here, but instead put into receivership, restructured, broken up, and sold off, making the old shareholders and management bear the burden of their recklessness, and letting new ones start over with clean slates. To reiterate a metaphor I’ve used elsewhere, a quick amputation beats a long, slow wasting disease.

Most importantly, there’s a strong case that this plan just won’t work. It’s clearly an attempt at market-making and price discovery, which in ordinary times (or if this were merely a liquidity crisis) would make sense… but as the Telegraph (UK) notes,

…wade through the pages and pages of press releases, fact sheets and frequently asked question guides released by the US Treasury today, and on not one will you find any reference to how these assets will be valued.

Since the core problem to date in removing assets from bank’s balance sheets has been valuation, you’d think the plan might address that? …

In reality, the private investors who get involved in the [plan] will want not to want pay top-dollar for these assets, far from it. If banks, which have already been forced to heavily write down the value of these assets due to strict mark-to-market accountancy rules, are not offered decent bids when it comes to auctioning assets, they will withdraw, for fear of being forced to take further multi-billion dollar write-downs, and the scheme will fail.

For the sake of fairness and thoroughness, though, it’s worth pointing out that this isn’t a universally held view. That Wall Street likes it is no surprise; its players benefit directly regardless of larger effects. But UC Berkeley economist Brad DeLong (no right-wing market fundamentalist!) has also posted a detailed argument today on why he thinks this plan is a good thing, for both the economy and the taxpayers. Even he acknowledges that it’s more of a stopgap measure than a full solution… but he does agree with the premise that the “risk discounts” on the assets in question are excessive right now, and proceeds from there.

DeLong makes an interesting case, but not an entirely persuasive one. Obama’s approach to short-term stimulus and long-term budget priorities have been smart and admirable, but his approach to the financial sector, specifically, risks becoming a real problem. This was predictable right from the start with Larry Summers, obviously (hell, he helped shred Glass-Steagal back in the ’90s), but I’d harbored higher hopes for Geithner. Those hopes have been disappointed.

And finding out who’s right is not merely an academic exercise:  as Krugman observes, “by the time Mr. Obama realizes that he needs to change course, his political capital may be gone.” This is not an outcome any of us should want to see. There are more worthwhile projects on deck which need that political capital.

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7 Responses to “Geithner’s latest plan for the banking sector”
  1. Yeah. Not a question about the overtures toward Iran, either—Obama had to bring it up himself at the end. But everyone seems Deeply Concerned about budget deficits… despite the incredible short-sightedness of that in times like these. Methinks there may be another post in there somewhere…

  2. phil from new york says:

    It’s interesting that at Obama’s press conference Tuesday night, not one question was asked about the bank bailout plan. I guess that means the Village media like it because Wall Street likes it. (But the reporters DO NOT, and I mean DO NOT!! like the impending budget deficits in the out years. And at least one reporter seemed to be upset that Americans aren’t suffering enough in the greatest economic downturn since the ’30s. You can make this stuff up. It’s not called the Village for nothing.)

  3. I think that last point is a key one. When you’ve had even the likes of Alan Greenspan and Lindsey Graham pointing to the need to nationalize zombie banks, it’s become something that goes beyond the traditional political spectrum. When left and right agree on the economics, how is the middle of the road something different? Summers and Geithner’s passionate dedication to restoring the finance system as it was, rather than engaging in a little creative destruction, is hard to fathom in terms either political or economic.

    That said… I think the “no second chances” analysis is a worst-case scenario. It’s politically understandable (if regrettable) that Obama doesn’t want to dump his guy and his guy’s plan only two months in. So he gives it a chance to succeed or fail… but if/when it fails, what will be the obvious effects? Yes, time will be lost as lending continues to be overcautious (bad), and thus real businesses in the real economy will have cash-flow problems (also bad)… but these are all indirect effects. The thing people will see up on the surface is that bankers and investors refused to cooperate with a plan that bent over backward to accommodate them. Blame falls on them, and Obama moves on to the next thing. And it’ll at least bolster an argument for even stronger, tougher regulation moving forward. Heck, even Geithner’s testimony in today’s news lays the groundwork for that.

  4. michael says:

    Phil,

    You read Krugman—and lots of other sensible economists—right: there will be no second chance. All the more reason Obama’s reliance on Geithner and Summers is troubling; this may be his Katrina moment, as it were.

    Keep in mind that 1) the Democrats should have been able to win the White House running a ham sandwich, so we should not be too impressed that an affable, articulate, intelligent fellow like Obama won; 2) his campaign was run by people far better at their jobs than his economic team is at theirs, people who vehemently disagree with this team’s current approach; 3) the trouble with Obama’s economic policy is not that it is too middle of the road but that it is simply bad economics.

  5. phil from new york says:

    Chris and Michael,

    I’m with you guys on this thing, so I’m preaching to the choir here. I share Krugman’s views on what needs to be done (along with his fellow Nobel winner Joseph Stiglitz). Krugman has been pretty dead on about the economy since Bush was put into office. Why should he start being wrong now?

    However, some people, I think, are arguing that The Shrill One doesn’t appreciate the political problem the administration is facing here. Thus, the argument seems to go, the Geitner plan is a moderate approach. If it works, everybody’s happy, credit loosens up, the economy starts to recover, and we can avoid the big GOP and media freak-out about SOCIALISM!!! If the plan doesn’t work, then, Obama can say he tried it Wall Street’s way and that didn’t work, so now we have to put several big banks into “receivership” — because he can’t use the dreaded “N” word, “nationalization.” If I read Krugman right, he doesn’t believe Obama will get a second chance. So who knows?

    But two things on Obama: (1) I underestimated him all through the presidential campaign, so what do I know? And as far as the public is concerned, polls coming out yesterday appear not to hold him responsible for the AIG bonus mess. I would argue that the public support for him now is an argument for him to be more aggressive than he has been, but, as I said, what do I know? (2) I keep reminding myself that Obama is an establishment Democrat, not the Super Liberal the far right would have us believe. So why should I be surprised when he takes a middle-of-the-road action?

  6. Part of an interesting commentary from Simon Johnson at Baseline Scenario (following on from an earlier ruthless analysis of Treasury’s current approach):

    “If Secretary Geithner’s scheme works, we draw the lesson that our banks became too big and we aim to make them smaller relative to the economy moving forward. The regulatory agenda currently in progress – including for discussion at the G20 next week – would do essentially nothing to reduce the political power of big banks. We need simple caps on bank size, leverage relative to the economy and – this is harder – measures of interconnected tail risk (i.e., is everyone making the same kind of crazy loans?). Design a system with this in mind: regulators get captured and super-regulators get super-captured.

    “If the scheme doesn’t work, we draw the exact same lesson.”

  7. michael says:

    DeLong is very generous in his account of the plan. He makes it sound like private investors are doing the rest of us a favor by participating, and merit consideration as a result. This is nonsense. If they have to be enticed, let’s do without them: take over the banks, clean up the toxic assets at auction, and sell stakes in the healthy businesses at a handsome profit, retaining sizable positions so as to exercise voting rights and share in longer-term appreciation. This is a much more effective use of the FDIC that does not risk its other functions in the bargain. And send Geithner back to Wall Street, where he clearly feels at home.

  8.  
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