The new Geithner plan is a flop

So writes Chicago Booth School economist Luigi Zingales. For an opposing view on banks financial condition see Richard Bove: hysteria about banks’ financial condition.

On Monday, the market rallied 7% at the announcement of Treasury Secretary’s Timothy Geithner’s plan to deal with banks’ toxic assets. Should taxpayers celebrate as well? The answer is a resounding no. Geithner’s plan is just a more risky and cagey version of the original plan by his predecessor, Henry Paulson: to buy toxic assets. Not only is it as likely to fail as his predecessor’s, but it is also likely to create major political unrest.

The premise underlying both plans was that banks were facing a temporary liquidity problem: Many mortgages and related securities allegedly were trading below their long-term values, making banks appear insolvent. According to this view, it would be enough to inject liquidity into this market to make valuation return to its “fundamental” level, restoring the health of banks. Hence the idea to pump the government’s money into this market to fix the problem.

As banks know well, however, no debtor on the verge of bankruptcy would ever admit to being insolvent; he will always perceive his own problem as a temporary liquidity one. The credibility of this position depends on the duration of the “liquidity” problem and on the existence of legitimate reasons to think that the long-term value has not dropped.

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Jeff Sachs doesn’t like the Geithner plan either: Obama’s bank plan could rob the taxpayer.

…The plan’s essence is to use government off-budget money to overpay for banks’ toxic assets, perhaps by a factor of two or more. This is done by creating a one-way bet for private-sector bidders for the toxic assets, then cynically calling it “private sector price discovery”. Consider a simple example: a toxic asset with face value of $1m pays off fully with probability of 20 per cent and pays off $200,000 with probability of 80 per cent. A risk-neutral investor would pay $360,000 for this asset.


Along comes the government and says it will finance 90 per cent of the investor’s purchase and, moreover, do so as a non-recourse loan. Non-recourse means the government’s loan is backed only by the collateral value of the toxic asset itself. If the pay-out is low, the loan is defaulted and the government ends up with the low pay-out rather than full repayment of the loan.


Now the investor is prepared to bid $714,000 (with rounding) for the same asset. The investor uses $71,000 of his/her own money and $643,000 of the government loan. If the asset pays off in full, the investor repays the loan, with a profit of $357,000. This happens 20 per cent of the time, so brings an expected profit of $71,000. The other 80 per cent of the time the investor defaults on the loan, and the government ends up with $200,000. The investor just breaks even by bidding $714,000, as we would expect in a competitive auction.


Of course, the investor has systematically overpaid by $354,000 (the bid price of $714,000 minus the market value of $360,000), reflecting the investor’s right to default on the loan in the event of a poor pay-out of the toxic asset. The overpayment equals the expected loss of the government loan. After all, 80 per cent of the time (in this example) the government loses $443,000 (the $643,000 loan minus the $200,000 repayment). The expected loss is 80 per cent of $443,000, equal to $354,000.


The idea of “private sector price discovery” is therefore flim-flam. There would be price discovery if the government’s loan had to be repaid whether or not the asset paid off in full. In that case, the investor would bid $360,000. But under the Geithner-Summers plan the loan is precisely designed to be a one-way bet, for the purpose of overpricing the toxic asset in order to bail out the bank’s shareholders at hidden cost to the taxpayers.

But what if Richard Bove is correct – and the CDOs and MBSs on the books are in fact worth a lot more than $.30?