Some Positive Comments on the Geithner Toxic Plan

[ProSense]

March 23, 2009

Which Bailout Plan is Best?

Which plan is best, the original Paulson plan where the government buys bad paper directly, the Geithner plan where the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, or straight up nationalization?

Last March, before Paulson had announced his plan, I said that I thought it was time for the government to begin aggressively purchasing toxic assets to solve this problem once and for all:

I’m starting to think that the Fed should drop the term part of the TSLF and instead trade permanently for risky assets (with the haircut sufficient to provide some compensation for the risk), bonds for MBS, money for MBS, or whatever, and don’t limit trades to banks.

The Fed would act as “risk absorber of last resort.” Why should it do this? There has been an unexpected earthquake of risk, a financial disaster on the scale of a natural disaster like Katrina, and the government can step in and sop some of it up by trading non-risky assets (money, bonds, etc.) for risky assets at an attractive risk-adjusted price. ...

I still think that this would have worked then, I called the government a "risk absorber of last resort," and the prices of the assets at that time were high enough to keep banks solvent. But it would have involved a massive transfer to the banks without giving taxpayers any share of the upside. In addition, as time has passed and prices have fallen, solvency issues have come to the forefront - the balance sheet problems are no longer hidden by overpriced assets - and the solvency problems must be addressed directly. That means that if there is no separate program to provide an infusion of capital, simply removing the toxic assets from the balance sheets through government purchases at current prices - prices so low that the banks are insolvent - won't be resolve the problem.

So if it was to work, the Paulson plan had to be amended, it needed to both get assets off the banks' books somehow, and it also needed to provide recapitalization in a way that is politically acceptable (which means no giveaways - the asset purchase plan I proposed above would have been a giveaway without some sort of redistributive mechanism attached to the plan).

So which plan is best? Any plan that does these two things, removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has these two features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. The plan for nationalization most certainly has these features, but it has political problems as well.

So I do not take a binary (or, I suppose, trinary), either/or approach to the proposals where I think one plan will work and the others will fail miserably. All three plans have their pluses and minuses. The politics of the Paulson plan make it a non-starter, I have no quarrel with the view that it constitutes a giveaway that is not justified, so the only way the Paulson plan will work is if we can convince people that equity stakes or some other mechanism makes the plan sufficiently equitable. I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear. So all three plans do the requisite things - get assets off the books and provide recapitalization - and each comes with its own set of political worries.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none - to me - is so off the mark that I am filled with despair because we are following a particular course of action.

The post quoted above was from over a year ago, and we had been aware of growing problems in the financial sector for some time before that. There were programs in place, but nothing of sufficient scale to get the bad paper off the books, so we've been at this for a long time without any big, decisive, effective policy action. What's important to me is that we do something, that we adopt a reasonable plan that has a decent shot at working and that satisfies the political test it must pass (though the administration could certainly do more to sell the plan to the public and help with this part, so passing the test is partly a reflection of the effort that is put into selling it). We've been spinning our wheels for too long, and it's time to get this done. We can't wait any longer.

So I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

Some Positive Comments on the Geithner Toxic Plan

by CalculatedRisk on 3/23/2009 05:27:00 PM

<...>

I tend to agree with Mark on this. The Geithner plan is suboptimal, but it is probably the best we can get in the current environment. I'd add a caveat: this plan is easy for the banks to game or arb - and if a bank is caught gaming this plan, the AIG bonus flap will seem like a light Summer breeze.

<...>

From Matt Padilla: Economists mostly bullish on $500 billion toxic asset plan

An excerpt:

“My gut reaction is that this is an excellent plan. This plan will go a long way toward getting banks in better position to lend more aggressively and break the deleveraging feedback loop that is now in place."
Scott Anderson, senior economist, Wells Fargo

I think this is a myth that banks will lend "more aggressively" once the toxic assets are off their balance sheets. To whom? Perhaps Anderson is making the moral hazard argument here - maybe he is saying since the banks (and their investors) are being bailed out with above market prices for toxic assets that they will once again engage in risky lending. I hope that isn't his argument.

The key problem with the Geithner plan is that it incentivizes investors to pay more than market value for toxic assets by providing a non-recourse loan and with below market interest rates. (See Krugman on the price impact of a non-recourse loan). The investors do not receive this incentive, the banks do. And the taxpayers pay it, so this is a transfer of wealth from taxpayers to the shareholders of the banks.

This can be thought of as a European style put option - it can only be exercised at expiration. The taxpayers will pay the price of the option in the future, the investors receive any future benefit, and the banks receive the current value of the option in cash. Geithner apparently believes the future value will be zero, and that is a possibility. If so, this is a great plan - if not, the taxpayers will pay that future value (and it could be significant).

Still I agree with Mark Thoma:

(T)his is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

more

Edited to fix link.

[Arkana]

1. Shhhhhh! Positive comments aren't allowed.

[Cha]

2. Rec'd!

Thanks for putting this together, PS~

[GeorgeGist]

3. Only a professional clown ...

would see profits in toxic assets.

[Aloha Spirit]

4. Well, with the government subsidizing, yes, it becomes profitable.

That's the whole point of the public-private partnership, right?

[ProSense]

5. Comparing three plans

Government Intervention in the Market for Toxic Cars:

So how could the government fix the problem?

1. Government purchases of toxic cars

<...>

One danger in this plan is that if you overpay for the cars, e.g. give $7,500 when the breakeven price was, say, actually $5,000, then you have given the owner of the car lot $250,000 more than the cars were actually worth (this will be the loss to taxpayers). The dealer may need this money to stay solvent and stay in business, but, nevertheless, it is a windfall.

There are a lot of uncertainties here, and lots of ways to lose money. But it's possible to make money too.

2. Subsidies and Public-Private partnerships

<...>

And I should note that it doesn't have to be a subsidy. That's one way to do this - as a giveaway - but another way is through a no recourse loan (what is being called a partnership). Suppose that the government gives (up to) a $3,500 loan to a private sector buyer to purchase the car for $7,500. If it's a good car and the value rises above $7,500, say to $15,000, then government will get paid back (with interest) since the asset can be sold profitably (another option is for the government to demand a share of this profit through warrants or other means). But if it's a bad car, the price falls to zero and the loan is forgiven - it does not need to be repaid. So the private sector agents only have to put up a fraction of the price to control the asset, and their losses are limited to the amount they put up while the gains are potentially large.

This is, in essence, the Geithner Plan. If many of the loans are not repaid, or if the subsidy is too large, it could lose a lot of money, but it could also make money too.

3. Nationalization

Now for the Saab story. Another option is for the government to simply take over the car dealership. The dealership is essential to the economy of the town, without it people will struggle, and the government - for that reason - might consider temporarily taking over the dealership to prevent failure. In doing so, it would make an evaluation of the company's assets, pay off the people who loaned the business money up to this amount, which may require having them take a haircut, i.e. accept some percentage of what they are owed on the bad loans they made, and the owner would simply be wiped out (which is a benefit since the business is insolvent and this allows the owner to escape the loans that cannot be paid through liquidation).

After taking over, the government would stress test the cars it now owns, put the bad ones in the junk pile, and sell the rest back to the public. So long as it didn't pay the creditors too much when it took over, i.e. the haircut is sufficiently large, it ought to make money on the deal. But it could lose money here too.

The Point

But, and I want to stress this, the point of these plans is not to make money, the point is to keep the economy of the town going, to keep people employed. If people place a large value on security, then even if the government takes a loss on paper, it may not be an economic loss. That is, we must put a value on the jobs that are saved and the security it brings (simply imagine that the utility function has risk as one of its arguments - by lowering the risk of job loss and the associated household disruption, you have made the agent better off, and this must be counted against any loss from any of the programs above). There is value in economic stability and security over and above whatever the government makes (or loses) on the actual financial transactions, and this must be factored into the evaluation of the policy.

[Phx_Dem]

6. Uh oh. You mean there are economists who disagree with St. Paul?

Yeah, I already knew that and enjoyed reading these viewpoints. Thanks for sharing.

[ProSense]

7. This needs more exposure. n/t

[firedupdem]

8. Thanks ProSense.

I appreciate your informative posts. I don't truly understand all aspects of these plans, and your information is a lot more explanatory and less divisive. Appreciate it!

[HopeOverFear]

9. can't rec, but I can kick n/m

[jonestonesusa]

10. I appreciate your contribution to the debate.

And while I take with a grain of salt opinions from economists working within the banking industry (i.e. Wells Fargo) who stand to gain from significant public sector guarantees behind the effort to buy bad debt, I would prefer for the plan to work as well.

Even on your link from Calculated Risk, Mark Thoma's support for the Geithner plan over nationalization is based more on the political difficulty of getting nationalization done, not on the specific merits of the Geithner plan. To my mind, that argues for a stronger effort by the administration to look at all options. More public information as to what "nationalization" is would help, but the Obama economic team seems summarily against that approach, preferring to keep bad assets bundled, exposing public dollars to greater risk and perhaps making it less likely that credit will loosen. I think the headline from the ever-reliable Orange County Register is a bit deceiving.

Thanks, though!

[ProSense]

11. Thanks. Here is more on nationalization

here and here.