Friday, April 10, 2009

Is The Geithner Plan necessary? Rationale of the Public Private Investment Program

There have been many articles out that criticized the Geithner Plan, mainly because it it’s a mechanism that further privatizes the gains and socializes the loss from the toxic assets held by US banks. With a mechanism where the government leverages the private sector bidder for the assets 7 times, and has a proportional share of the loss but a 50% sharing in the gains, this is indeed a private sector subsidy of a massive scale.

But we have to ask ourselves the question – why did the government decide to make this kind of lopsided proposal? To get the toxic assets out of the bank’s books. Keeping the toxic assets, which have continually slid in value as more home defaults arise, has continually eaten away at the banks’ equity capital. If more defaults are to happen, more writedowns will have to occur, and more banks will end up insolvent.

The Geithner Plan provides a nice way to entice private sector investors - the hedge funds and investment banks – to buy the assets and take them out of the commercial banks’ books. Because the leverage provided by government increases their potential returns on the investment, it incentivises them to bid higher for the assets, thereby restoring capital to the commercial banks.

But we have to ask ourselves a question again – Does anyone really believe that these toxic assets may be worth more than how much they are currently valued? Because if current market value is correct, any rational investor shouldn’t bid more than that, and perhaps should bid less to account for further possible writedowns. The only way anybody can earn a positive return is if these toxic assets end up more valuable than they are currently worth. And many investors seems to think that way, given the various ways they are now trying to game the public private investment program, the “Geithner Plan”. Even the commercial banks, the entities supposed to be helped by the plan by being rid of the assets, seem to be coming up with ways to still end up with the assets.

So what gives? Perhaps insiders know these assets are worth more than the market is currently pricing them. After all, if the banks have thought all along that the toxic assets were to end up continually writing down their equity capital, they would have rid of them a long time ago. Yet they continue holding on to them. Perhaps some people really believe that home defaults will end up a small minority in the toxic asset pool, and more borrowers will end up paying out to maturity.

If that’s the case, the Geithner Plan is a mechanism that will transfer wealth not just from the taxpayer to the hedge funds, but from the commercial banks to the hedge funds. If you were a commercial bank, you’d find ways to end up with the assets back in your hands. Otherwise, hedge funds will end up with the largest gains, at taxpayer’s cost, while taking the gains away from commercial banks.

So is the Geithner Plan the best way to help the banks? If everybody – the government, the commercial banks, the hedge fund investors – believe that toxic assets will end up worth more than they currently do, then maybe we should just suspend marking-to-market for toxic assets, until we do see if they're right. They may end up right, and the taxpayer and the commercial banks need not lose out on anything. I don’t need to repeat what my stand is on mark-to-market acounting (See previous posts here, here, and here). That, or just nationalize the banks where government will buy the assets, so taxpayers get both possible gains and losses.

1 comment:

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