Fleshing out Geithner’s plan

April 2, 2009

Business Week proposes five ways that it can be gamed.

So the administration now has floated a concrete plan, but gets a couple weeks to let everyone help flesh out the potential pitfalls before writing the fine print.  That can only be good.

I like the plan.  And the two criticisms I often hear don’t make much sense to me:

It’s a giveaway to Wall Street

Well isn’t it better to entice new players with profits (while exposing them to losses) than giving the bad actors hundreds of billions outright as we have been doing?  But most importantly, any profits will be shared by taxpayers and private investors dollar for dollar.  If next year there is a AIG-style populist fracas over a hedge fund making 10 billion in profits, at least the administration can point to the 10 billion we also made on the deal.  This is brilliant.

The taxpayer is taking 93% of the risk

Technically this is true, but it gives people the impression that if the plan doesn’t work we will pay the full 93%.  This is not so.  Even if the plan fails, and assets wind up being worth less than investors priced them, the chances they will go to zero or even close to zero is negligible.

It’s like saying that your life insurance company is exposed to 10 billion in losses if all its policy holders die all of a sudden.  Well that’s just not going to happen.  Or more technically there is a 0.0000000000001% chance it will.

Even if the plan fails miserably assets will be worth something, say 50%-80% of the purchase price (which is itself already a fraction of the original price on the banks’ books). So the FDIC (which holds the securities as collateral) would only lose 20% to 50% on the loans, and taxpayers’ (worst case) total exposure is more like 50%

Also, the government is actually protected because the losses are borne disproportionately by the private investor at the top end:  Private investors will always have to lose all of their 7% share (along with treasury’s 7%) before the FDIC loses a cent on the other 85%

How it’s likely to play out

Some banks probably won’t want to sell.  I think there is a good chance the administration will require some or all (bailed out) banks to sell a portion, and then more, over time.

This is where stress tests come in:  Simulate a fall of another 30% in home prices over the next two years, and price assets in balance sheet based on that… bankrupt?  well then we order you to dump some of them now, even if that means taking a (not quite as bad) hit right now.

And like that Geithner will have achieved creating an artificial market with true natural price discovery.

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