Streetwise Professor

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.