The Geithner Plan

The 24-hour corporate media has been blasting a lot of hate Sec. Geithner's way. Every story needs a villain and Mr. Geithner's charisma problem may have ensured it was his head on the chopping block. It's unfair and lazy, but since when has that mattered much.

There are essentially three options.

1. "Nationalization" - this isn't really an option, you can't do it, the job is just too big. The US banking system is too centralized; the twenty largest banks in the US hold something like 90% of all deposits. It would take thousands of FDIC bureaucrats to take over just a fraction of those banks; it's just not realistic, at least not now. If it happened, it would probably go like this, Friday the bank is taken over, not just one bank but all, you have to do them all at one time because if you do it one-by-one the ensuing panic on other banks would be disastrous. So you close down and put them into receivership, all the good parts you would sell immediately and the bad parts you would place into a asset fund managed by professionals who sell the "toxic assets" piece-by-piece and try to get the best price possible. This is what happened with the savings and loan crisis in the 1980s and 1990s. A Resolution Trust Corporation was created to handle the resulting "bad assets" and they were sold off piece-by-piece. The problem is one of scale, this is problem is too big, we're talking the ENTIRE US BANKING SYSTEM, or close enough to that to make "nationalization" fundamentally untenable. Something similar also happened in Japan and Scandinavia in the 1990s. Japan did a piecemeal capital infusion program that kept insolvent banks alive which prevented consumer and investor confidence from returning and created "zombie banks" that were no longer really alive without their infusions from the Japanese government. Scandinavia did a temporary nationalization that worked very effectively, and if the American economy was the size of the Swedish economy we might be able to do that now, but it's not, so we can't.

2. "Let 'em Fail" - Again, an option that isn't really an option. You can't let them fail, we would cease to have an economy, literally.

3. "Something Else" - The only real choice. Keep the banks alive, at least the ones that cannot fail because we can't effectively manage their "nationalization" or bankruptcy. The FDIC has been closing and selling banks dozens of times over the last few months, but we can't do that with Citi or Bank of America. Like I said earlier, you'd have to do it at one time to prevent a panic and then you'd have to hope there is enough private capital to buy the banks and enough bureaucrats to do it. We've effectively kept the banks alive by providing direct capital infusions. There are a lot of problems in doing this, too many to really list, but needless to say this cannot be the sole solution mainly because it does nothing to address the true anchor on the banks balance sheets, toxic assets. No one wants to deal with a bank that has an unknowable balance sheet. The market for housing went illiquid, meaning you cannot sell into the market, so a house that was worth $200,000 now appears to be worth only $100,000 because no one is buying. A loss of 50% of a banks assets (mortgages, mortgage backed securities, etc.) or even 20% can destroy a bank, making it insolvent. So, in addition to preventing failure by increasing capital ($250 Billion from TARP and a whole bunch more from the Federal Reserve) you have to do something about the toxic assets, but what? If you nationalized you would just hold on to them until the market improved, but we cannot nationalize on a scale that would make this effective, so we need to do something else. We need to remove them from the balance sheets of banks, you need to buy them. The problem is in determining their worth. How much is it all worth? No one knows. The banks, mostly because they have to, argues the assets are close to 100% of their previous value, however, the market disagrees. So, the biggest debate is how much to pay. If you pay the market value, the banks will lose too much and stay insolvent, accomplishing nothing. So, you need to get the other money in the economy (private asset management firms) to get to buy the assets at a high enough value to keep the banks solvent, but low enough to ensure a they make money (so they'll actually buy them).

So, that is what the Geithner Plan does. It ensures the purchase, guaranteeing that a private asset management firm that purchases these toxic assets cannot lose more than their initial investment, any further loses are the taxpayers. Any profit belongs to the firm. It could work. Those, like Dr. Krugman and others, that disagree think that banks won't sell the assets at a low enough value to ensure that firms can buy them and sell them at a profit, meaning the tax payers will have to bail out the firms and not really solving anything. Or, the banks just won't sell, again, not solving anything. Those who favor a Swedish "nationalization" need to acknowledge that it's a hard lift and has as many unknowns as the Geithner Plan. That being said, if the auction does not work (the Geithner Plan calls for an auction to sell off the toxic assets) the "Swedish" plan can go forward.

Another fact to consider is that to enact the "Swedish" plan we would need to determine which banks need to be placed into receivership ("stress-test") and we need to staff up to take over the banks (which takes a few months). So, if we were to enact a Swedish model, we wouldn't tell anyone and we would have to "pretend" we were going with another option that removes the assets.

So, in closing, the Geithner Plan does a good job, it addresses the toxic assets in a way that gets private asset management firms to bite, and hopefully bite hard enough to get banks to sell. That is the big "IF" of the plan, it can work, but only "IF" private firms buy high enough for the banks and low enough to sell off for a profit. The risk of the firms buying too low (so low the banks don't sell or if they do the firms cannot sell) means we are at a great risk of ensuring undercapitalized banks, maybe even insolvent, "zombie banks". However, the shadow banking system (FDIC) might be preparing in an undisclosed location for the kind of massive intervention that a "Swedish" solution would require.

Be Brave. Be Wise. Be Compassionate.