Three Scenarios for the Geithner Plan

The very premise behind Geithner's plan is flawed. We insist on saving the banks, and refuse to admit most of them are impaired beyond hope.
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Three scenarios are possible for the new Geithner plan:

1. The toxic assets will attract only few bidders, while most investors decide they are not a good investment at any price, even with Treasury's inducements, since those asset are not just illiquid but actually hopeless.

2.The Geithner plan will attract only few banks, because they fear their assets will receive only very low bids, forcing banks to take further write downs and thus eroding their capital even more. This will tear the mask from the banks' balance sheets and spell their doom. Because of that risk, many banks may choose not to participate. This scenario also renders the plan ineffective.

3.The plan's participants buy most assets from the banks at prices that leave the banks solvent. In this case, the plan works well but would amount to effectively subsidizing the failing banks, transferring their losses and risk to the taxpayers via the Fed's balance sheet.

None of the above scenarios is very promising; none leads to a good denouement. And what bothers me most is that we bet our financial system and the economic recovery on this plan, hailed as a panacea. It is never a good idea to bet the house on any grand scheme. Any system as complex and reflexive as the US economy is by definition unpredictable, and nobody could be confident this plan will work. If it fails, shattering the high hopes of so many, the price of disappointment will be immense. We will be with our back to the wall, facing another wave of panic.

The very premise behind the plan is flawed. We insist on saving the banks, and refuse to admit most of them are impaired beyond hope. We prefer to sweep their problems under the carpet, but the day of reckoning is here and it is always better to deal with our problems than pretend they are not there. We can handle the truth, although we may not be able to postpone it much longer.

What we should do instead is have the Treasury offer to match the capital of new community banks to be formed by the private sector. Entrepreneurs will have strong incentive to launch these new banks because of the federal matching, which will double their capital overnight. These new banks, unburdened by past mistakes, will have clean balance sheets and will be eager to lend, replacing the old failing banks and rejuvenating the credit system. Because most banks operate with loans at least ten times their equity capital, the amount of new credit will be at least 20 times the capital allocated by the government, so the multiplier effect will be very substantial.

And the banks that engaged in wretched excess and can't survive without federal funding do not deserve our help.

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