Two weeks after being introduced, Timothy Geithner's bank rescue plan is facing a new round of withering criticism from economists who say the proposal is likely to produce major losses for taxpayers as banks and investors game the system.
In public writings and interviews with the Huffington Post, some of the same figures that issued early warnings about the current financial crisis now say that Geithner's designs for alleviating toxic assets from the nation's banks are inherently flawed. As evidence, they point to the massive amount of federal funding, in the form of FDIC backing, being offered to prospective buyers of toxic assets. It is the "closest thing to risk-free investing -- with leverage! -- around," wrote Andrew Ross-Sorkin of the New York Times.
More specifically, they have highlighted the seeming ease with which a bank could effectively drive up the price on an asset it already owns by creating subsidiary entities to bid on those assets. "The amount of potential rip-off in the Geithner-Summers plan is unconscionably large," said Columbia University's Jeffrey Sachs.
These critiques have produced a Washington rarity: the re-sparking of a debate that, in the wake of positive reviews from Wall Street, had largely subsided. Just as Geithner seemed to be finding his political footing, the spotlight has been placed right back on his cornerstone proposal, with critics calling into question both his projections and past testimony on the matter.
Geithner has long insisted that his hybrid plan -- which supplements private investors with large amounts of public funding as a way to create a market for toxic assets -- is the best way to clean the banks at minimal taxpayer risk. Indeed, during a relatively overlooked portion of Capitol Hill testimony on February 10, he insisted that the government would not be guaranteeing any portion of the private investor's purchase:
SENATOR CRAPO: So there will not be any aspect of the federal guarantee of the asset purchase?
GEITHNER: Not as we envision it in this proposal. In fact, part of the virtue of this proposal, again, is to try to bring a structure that allows a market mechanism to help catalyze market solutions to clean up these legacy assets.
CRAPO: .... But would simply the financing that you're talking about -- do you believe that that would have an impact on the purchase price, in terms of the federal government being involved in some way of subsidizing the price?
GEITHNER: Well, I wouldn't think it requires a subsidy. I think you're absolutely right. In a solution where the government is either purchasing or providing insurance or capping losses on a portfolio of assets, then you're acutely vulnerable to the risk that the government is taking risks that it can't understand, cannot manage, may get wrong, may end up providing a level of subsidy to the institution that is not appropriate. We're trying to avoid that risk by using this kind of structure. And, again, by providing financing alongside private capital with private asset managers, we think we're going to -- likely to put ourselves in a better position to avoid that risk, very important to try to avoid that risk.
The testimony largely pacified members of Congress at the time. Senator Crapo's office declined to comment for this story. Looking back now, however, several economists take umbrage with Geithner's remarks, saying they were either too rosy or vague. "At the very least he is engaging in double talk," said Dean Baker, co-director of the Center for Economic and Policy Research. "Obviously this proposal limits the downside risk, since the investor can get an upside gain on an amount that is seven times their investment, whereas they can't lose more than their investment on the downside."
To be sure, others note that Geithner was technically correct: there is no 100 percent "guarantee" in his proposal. Investors using mostly federal money to purchase a toxic asset could still lose the money they themselves put in, a Treasury official confirmed. But in conversations with several leading progressive economists, the consensus seems to be that this is a distinction without much difference.
The downside they see in the Geithner plan is the same problem that led to trouble in the housing market: it is a system of far-to-excessive purchasing leverage. Buyers get highly favorable loans to, in essence, bet on the future of a specific asset. This allows the lender to either profit greatly or get stuck on the hook.
Mark Thoma, an economics professor at the University of Oregon, offers the following example:
The buyer of the toxic asset worth $100 today puts up $10 of his own money and borrows $90 to purchase toxic assets. The toxic assets are collateral against the loan... On the day the loan is due, the borrower can (1) pay the loan... or, (2) exercise the put option (default on the loan). The owner of the asset always has, in essence, the option of selling the asset back to the government and walking away. Now suppose, for example, that the price of the asset falls from $100 to $30. The owner can simply give up the asset to the government, and walk away. This is the put option. The government can then sell it, and reduce losses to $60 [the difference between the $90 initially put up for the asset and the $30 sale].
... The buyer gives up the asset of $30 in return for being forgiven the loan of $90. So it's not that any of the initial $10 is protected, it's losses over and above that that are eliminated. It does limit losses. It's just like putting a 10% down payment on a house. If you walk away, you lose the value of the house, but that is less than you'd lose by paying off the loan.
Taking the hypothetical a step further, University of Texas Professor James Galbraith, who raised some of the earliest critiques of Geithner's plan, notes:
The buyer [of a toxic asset] will need to pay the loan back to the government. Now if the asset is worth less than 90 dollars that he was loaned, then he has a choice: he can continue to pay his loan, but he has taken the loss on himself... or he can stop paying a loan, in which case the asset defaults to the government. In that situation, the economical thing to do would be to default... Otherwise he is holding on to an asset worth 30 dollars in cash and still owes 90 dollars.
In short: if the toxic assets prove to be worth less than current face value, the likelihood is high that the government will end up with a bunch of defaulted loans (on top of owning those bad assets).
To be certain, Sheila Blair, chair of the FDIC, has insisted that such a money-wasting scenario won't happen. "We project no losses," she told Ross-Sorkin, saying that assets purchases won't be backed unless they are deemed profitable. "Our accountants have signed off on no net losses." Others, meanwhile, have argued that the prospects for profit are great enough that private investors won't bolt.
"If the fund does well over the next five years - returns profits of 9% per year -private investors get a market rate of return on their very risky equity investment and the equivalent of an "annual management fee" equal to 2% of assets under management," wrote economist Brad DeLong, "If the portfolio does less well - profits of 4% per year - the managers still get a healthy but sub-market return of 10% per year on their equity. And if the portfolio does badly - loses 1% per year - they lose roughly 70% of their investment. Those are attractive odds."
But for many economists, the invitation for risk inherent in Geithner's plan is simply too great. Indeed a second critique being forcefully raised by economists is that the system Treasury is putting in place can easily be gamed.
In his Monday column, Sachs outlined this very prospect: Citibank, theoretically, has a toxic asset on its books with a face value of $1 million but no probability of payout. The bank sets up a Public-Private Investment Fund (PPIF) to bid the full $1 million for that worthless asset. That PPIF borrows $850,000 from the FDIC, gets an additional $75,000 from Treasury, and puts up $75,000 of is own money to make up the bid. In the end, Citi gets a profit of $925,000 (the $1 million it receives of the bid minus the $75k its related entity had to put up).
Such a scenario is indicative of the flaws in the Geithner plan, argued former senior Clinton commerce official Rob Shapiro. There is, in fact, a guarantee.
"The Feds guarantee the 5/6 leverage used to buy the assets," he said, "so if the assets tank and the buyer defaults on the loan (no $ to pay it back, since the assets really were worthless), the feds (taxpayers) make it up to the lender."