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Streetwise Professor

March 24, 2009

The Most Important Sentences in Tiny Tim’s Plan

Filed under: Economics,Politics — The Professor @ 4:53 pm

The most important sentences in the Geithner Toxic Asset plan are:

To start the process, banks will decide which assets – usually a pool of loans – they would like to sell.  

To start  the process, banks will identify to the FDIC the assets, typically a pool of loans, that they wish to  sell.

The bank would then decide whether to accept the offer price.

In other words, the Geithner plan gives valuable options to the banks holding toxic assets.  They have to the option to choose to participate.  They have the option to choose the assets to sell.  They have the option to accept, or not, what independent buyers bid for the asset.  

Banks, of course, will exercise these options to maximize the value to their shareholders and managers.  Period.  Let me repeat: banks  will exercise these options to maximize the value to their shareholders and managers.  

But it is well known that insolvent banks, or banks teetering on the brink of insolvency, face extremely perverse incentives.  Shareholder and manager maximization for such institutions is often at odds with efficiency, and wealth maximization.  This is true because managers and shareholders of troubled financial institutions have incentives to take unwarranted risks and invest in projects that dissipate wealth.  That is, zombie banks (or more accurately, their owners and managers) are living, breathing moral hazard problems.  Maximization for them means minimization for us.  

Options in the hands of people facing perverse incentives are usually very, very bad things.  Sort of like matches, gasoline, and tinder in the hands of pyromaniacs in a lumberyard.  

In the present instance, giving potentially insolvent or near insolvent banks options can be expected to exacerbate, rather than mitigate, the current financial crisis, and the ultimate cost to us as taxpayers and economic agents could be huge–and, in my view, is likely to be so.  

So why is Treasury going down this path?  Were the pyromaniacs very persuasive?  In the virtually vacant Treasury department is there nobody of sufficient stature, without deep and longstanding connections to troubled financial institutions, who is willing to challenge the advisability of giving fragile financial institutions options to engage in morally hazardous behavior?  Nobody willing to call Bulls*it on Citi, BofA, Goldman, etc.?  

Maybe this reflects a mindset at Treasury that this is a liquidity problem, not a solvency problem.  After all, Geithner has said the banks have enough capital.  (Really? Evidence, please?)  And options in the hands of solvent but illiquid banks are not as dangerous as in the hands of insolvent ones.  So, the decision to give banks the options is consistent with thinking that they are really solvent.

I would offer two points in rebuttal.

First, the liquidity story is less and less plausible in the aftermath of the Fed unleashing a tsunami of liquidity on the US financial system.  You’ve all seen the chart with the spike of reserves being held at banks.  And the Fed just announced that it was going to unleash a second tsunami in the coming weeks.  So, the Fed has addressed the liquidity issue, meaning that there’s no need for the new Treasury program.

Second, maybe I’m wrong that this is a solvency problem–but maybe the Treasury is wrong that it isn’t (and if that’s not their belief then the plan is particularly foolish as it ignores the incentive effects of that insolvency).  There is certainly a high likelihood that many banks are insolvent.  Myriad knowledgeable commentators believe they are (appeal to authority, I know. . . ).  I would certainly be very reluctant to declare definitively that there is not a large possibility that many major banks are insolvent.  I would be doubly, trebly, reluctant to base a policy involving potentially trillions of dollars on such a belief.  

Given that this may well be a solvency crisis, those three little sentences could lead to disaster, the S&L crisis on steroids, meth, and angel dust.  All at once.

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4 Comments »

  1. Obama and Geithner Knew and Bonuses Flew. There are many reasons we cannot trust Geithner. Chief among them are the grossly incompetent way the treasury has handled the AIG bonuses. Both Obama and Geithner knew of the bonues and then acted outraged when the public showed uproar. In addition, they still have not corrected mistakes like TARP. They
    should correct what mistakes were done in the past before they ask for more money. Otherwise we are burning money. Get the full details here:

    http://tinyurl.com/obamaknew

    Comment by Jed — March 24, 2009 @ 9:36 pm

  2. I am reading that one of the touchy issues facing banks while contemplating voluntary selling of troubled assets is that they would have to sell these at a discount. The accounting rules apparently allow the banks to state the value of the assets at the original amount agreed to, with a correction factor for the expected losses. However, since no one is good at estimating the loss factor, the banks can use whatever factor pleases them. However if they sell the assets at a discount, it would go down in the balance sheets as a loss. Hence there would be a natural reluctance on part of the banks to take a hit as this would adversely affect further capital raising. Which means the banks would try to repay the TARP loan asap and indulge in extravagant kamikaze risk taking. Scary.

    Comment by Surya — March 25, 2009 @ 12:41 am

  3. Surya–you hit the nail on the head. That is why the banks will not exercise their option to participate. They will reveal to the world that they are stark naked (i.e., insolvent) if they mark their books accurately, as selling assets will require them to do. That is why the worst banks are least likely to participate. And that is why this is an incredibly stupid way to fix bad banks.

    The ProfessorComment by The Professor — March 25, 2009 @ 7:12 am

  4. SWP, I commend this article to you. After I read it, I felt like the line in the old Pace Picante Sauce commercial “New York City!!! Get a rope!”

    It also includes a reference to what Bernanke was pushing on 60 minutes – “no, the money from the Fed is not taxpayer money.”

    All of this bailout stuff seems to me like the resurrection of the Soviet Union in the United States, complete with dachas in the Hamptons and elsewhere for the privileged few, including Congress, who “toil” for the benefit of the great unwashed.

    It is sickening and disgusting.

    I always thought that investors bore the risk of their investment – not taxpayers, and not the Fed.

    This whole bailout thing is really, really putrid, sick, horrid and disgusting. It is a power grab.

    And Obama, and Moveon.org, keep talking about “investing in health care” to “get the economy moving.” Huh?????????

    Obama does not deserve a honeymoon – he is a horrible disappointment. He can take his rhetorical skills back to Chicago, as far as I’m concerned.

    http://www.rollingstone.com/politics/story/26793903/the_big_takeover/print

    Comment by elmer — March 25, 2009 @ 1:35 pm

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