Sunday, March 22, 2009

The Geithner Plan: One Big Problem, One Big Question

Uh oh. It's that time of the financial crisis again. A new plan is about to be rolled out to save the U.S. banking industry. Sketchy details have been leaked in advance of course. (The New York Times summary is here.)

Much of the blogosphere commentariat has been withering in its criticism. Paul Krugman hates the plan, as it currently appears to be constituted. Yves Smith hates it.

Superficially, the plan appears to take a giant step in the right direction. The government would partner with sharp-witted private investors to buy toxic assets that are weighing down the balance sheets of the country's major banks. The Wall Street guys would be the brains: they figure out how much the toxic dreck is really worth, then bid against each other for it. The U.S. government would be the money: taxpayers fund most of the purchase price, then ideally scoop up a nice profit at the end of the day.

Sounds good. What's wrong with this picture?

The one big problem:

Since the Geithner plan has all the moving parts of a Hail Mary play, a little clarity is called for. Forget the left tackle swapping places with the right tackle and the multiple laterals; here’s the key take-home point: the U.S. government may pay as much as 97 percent of the purchase price, while our co-investors (hedge funds, private equity firms) chip in as little as 3 percent.

That feature of the plan has been attacked on the grounds of “that's not fair, our partners won't have enough skin in the game.” That's misleading. That shouldn't be perceived as a dealbreaker. Think of it this way: If you had a smart friend with no money, and you had money but not much smarts, you could still work nicely together as a team. He finds a great investment opportunity, you supply the cash, and you both pocket a nifty profit.

The problem enters when you think about what situation this scenario really applies to. It's roughly the following one: There's a great investment opportunity, and let's say it’s pretty widely known, but no one steps forward. Why? Well, they can't scrape together the money. Credit is tight. Interest rates are too high.

In other words, this smart guy-deep pockets team makes perfect sense when the problem is liquidity. The partners can make out like bandits because a lack of cash has sidelined their rivals. But what if liquidity isn't the issue? What if the investment opportunity really isn't that good? What if all those assets (turning to our current crisis) that American banks are so anxious to unload can’t be sold because they want an unreasonable price for them, not because of a credit shortage?

Then the Geithner plan looks completely wrongheaded. His public-private partnership would work great in a liquidity crisis, as private investors introduce price discovery while leveraging their small stakes. The same concept isn't suitable for a solvency crisis, where the main problem is that the banks can't accept a “true value” for their assets, as they’d be forced to declare themselves insolvent.

However the really interesting part of the plan lies in:

The one big question:

How are profits to be shared between the partners on the way up and losses to be shared on the way down? This is a HUGE point that I haven't read anything about yet (to be fair, the plan hasn't officially been unveiled), but it's absolutely critical to understand. One thing you can be sure of: our smart private investor partners will be all over this angle, looking for clever ways to profit.

The fairest way to divvy risk, of course, would be proportional in both directions. If Joe's Hedge Fund throws in 5 percent of the purchase price, it gets one-twentieth of the profits and also absorbs one-twentieth of the losses. That's not likely to happen. Joe’s Hedge Fund likely will want a sweeter deal.

Another scenario: since apparently up to 85 percent of the price will be covered by FDIC non-recourse loans, you could treat that as "free” money and focus on the remaining 15 percent. If 10 percent of the overall comes from the government, and the other 5 percent from Joe’s Hedge Fund, then the U.S. could take two-thirds of the profit, and the hedge fund the rest.

Ah, but what happens when money is lost? Fair treatment would dictate the same split on the way down. But I would watch very carefully to see if down matches up (whatever the agreement). I doubt that it will. I bet that somehow the private partner will be protected against losses.

Why? Because otherwise the private partner won't have an incentive to bid higher than the current market price for these distressed assets. The banks won't accept that “fire sale” price, knowing it would push them into insolvency. The plan will be a complete bust, in the sense that nothing will happen. The banks will keep all the crappy assets. We'll be right back at square one.

Obama’s economic team is making the same bad kinds of decisions that the Bush crowd did. Let's hope that they discover this is a solvency, not liquidity, crisis before they've squandered all their political capital and we’re in a terrible mess.