Geithner's financial-rescue plan, take two

by Frank James

If at first you don't succeed quelling global investor doubts with your financial-rescue outline, wait a month and then deliver a much more detailed plan.

That's the strategy being followed by Treasury Secretary Tim Geithner who will take his second cut at solving the nation's banking crisis by unveiling details of his financial-rescue plan. It comes a month after he made a speech that was universally panned for lacking specifics about a way forward in dealing with the toxic assets on bank balance sheets.

The Obama Administration hopes to entice private sector types like hedge funds and other investors now sitting on huge piles of cash to purchase real-estate loans that are sitting on banks books. Doubts about the value of those loans has essentially frozen the credit markets, making it difficult for many companies and consumers to obtain loans.

As an inducement get the private sector involved, the federal government, meaning taxpayers, will assume most of the risks connected to the assets and low-interest loans.

But Wall Street may be in a mood to wash its hands of participation in federal financial-rescue programs after being turned into villains by Washington policymakers over the AIG bonuses and other matters.

Geithner spelled out his plan with a Wall Street Journal op-ed piece today:

Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity. Our new Public-Private Investment Program will set up funds to provide a market for the legacy loans and securities that currently burden the financial system.

The Public-Private Investment Program will purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate.

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

This program to address legacy loans and securities is part of an overall strategy to resolve the crisis as quickly and effectively as possible at least cost to the taxpayer. The Public-Private Investment Program is better for the taxpayer than having the government alone directly purchase the assets from banks that are still operating and assume a larger share of the losses. Our approach shares risk with the private sector, efficiently leverages taxpayer dollars, and deploys private-sector competition to determine market prices for currently illiquid assets. Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience.

While the Asian financial markets appear buoyed by Geithner's plan, some of the nation's most respected economists aren't.

Paul Krugman, the Nobel laureate and New York Times columnist, hates it. An excerpt from his op-ed column from the weekend:

Over the weekend The Times and other newspapers reported leaked details about the Obama administration's bank rescue plan, which is to be officially released this week. If the reports are correct, Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy -- specifically, the "cash for trash" plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.

This is more than disappointing. In fact, it fills me with a sense of despair.

After all, we've just been through the firestorm over the A.I.G. bonuses, during which administration officials claimed that they knew nothing, couldn't do anything, and anyway it was someone else's fault. Meanwhile, the administration has failed to quell the public's doubts about what banks are doing with taxpayer money.

And now 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. And by the time Mr. Obama realizes that he needs to change course, his political capital may be gone.

Simon Johnson, a Massachusetts Institute of Technology economics professor who runs the popular Baseline Scenario blog, doesn't think much it either:

An excerpt:

My problem with Monday's expected announcement from Mr Geithner doesn't have much to do with the details of the public-private partnership. I doubt this will work, because I don't see the incentive for banks to sell assets at less than the value currently on their books. Right now, they have the government right where they want it - look at the body language and words of leading CEOs.

The government feels that it cannot take over large banks, there is no bankruptcy-type procedure that would work, and only deference to the CEOs of major financial institutions can get us out of this mess. This is a conscious strategy decision from the very highest levels.

I'd like to say: OK, but this is absolutely the last time we will try for a solution to our banking problems involving a private sector-led approach. Of course this would not be credible and bank CEOs know this...

Johnson thinks the power of the big banks needs to be broken with tougher regulation. For instance, he advocates limiting the size of banks to try and reverse the too-big-to-fail problem.

The Obama Administration is obviously nowhere near making that kind of radical change. Instead, it has basically decided to refine the plan Bush Administration Treasury Secretary Henry Paulson first proposed before he ditched it because of the complexities involved and the immediate needs the banks had last fall for cash.