Robert Kuttner
The indignation over AIG will serve a useful purpose if it focuses public attention on the much larger issue -- the failure of the entire approach that Treasury Secretary Tim Geithner and White House economic czar Larry Summers are using to rescue the banking system.
It would be hard to find two administrations more different than Bush and Obama. Yet, when it comes to bailing out financial firms, Geithner's approach is a seamless continuation of his predecessor, Hank Paulson's. It makes you wonder who is the permanent government. Perhaps Wall Street?
Even the players are the same Goldman-Citigroup crowd. The well named Neel Kashkari, the Citigroup executive brought in by Paulson to run the TARP program, is still in place. Geithner's top assistant, Mark Patterson, is from Goldman. And most of the concepts are coming from the same Wall Street crew.
So far, the policy has been an abject failure. The latest idea is to use some of the remaining Treasury funds from the TARP program approved by Congress last October to anchor several trillion more in loans and loan guarantees by the Federal Reserve and FDIC. For weeks, Geithner has announced only vague principles of his next move.
Over the weekend, some details were released, and a full blown unveiling is expected any day. But at this writing, despite leaks from the Treasury to friendly reporters, the several agencies who need to be party to the plan are still in disagreement. And the unveiling may well be delayed again. Judging by the versions of the plan leaked to the New York Times and the Wall Street Journal for Saturday, and the Washington Post for Sunday. The plan seems to be changing daily.
In the latest version, the Treasury will put up between $75 to $100 billion to leverage loans and loan guarantees from the Federal Reserve and the FDIC (down from earlier projections as high as $200 billion.) The money will be used to entice a new round of speculative bets by hedge funds and private equity companies.
The FDIC is the newly drafted participant in this scheme and its leaders are said to be less than thrilled with its designated role. Compared to the Treasury, the FDIC has been a model of competence and transparency. The FDIC is coming before Congress to seek replenishment of its somewhat depleted insurance funds, and now Treasury is coveting that money to underwrite much of Geithner's latest scheme. But you can only safely insure so many risks with the same capital (shades of AIG!)
The scheme is described as a public-private partnership, but most of the real money is slated to come from public agencies. So why go to all this trouble to enlist private money, which will put up little of the capital and bear little of the risk?
Under one part of the plan, the FDIC will put up most of the money to create a new public corporation which will capitalize private funds to buy up sketchy loans. In the second part, hedge fund and private equity speculators will purchase older toxic bonds clogging bank balance sheets, which Treasury now calls by the delightful name, "legacy" assets. (Sorry, a legacy is a gold watch from Grandpa. This legacy is junk.) Under yet another part of the plan, hedge funds and private equity companies are expected to buy newly issued bonds from banks, so that banks resume normal lending.
An alarming aspect of the plan is that private investment companies will manage the process on behalf of the government, despite the fact that government is providing most of the capital and insuring most of the risk. Basically, the Treasury is colluding with private speculators to create off-balance sheet entities, to offer new windfall profit opportunities and disguise the true degree of risk. If this all sounds vaguely familiar, Geithner's Treasury, with no sense of irony, is offering a reprise of the several abusive and opaque gimmicks that produced this crisis, a tour that winds back down Memory Lane, from AIG to Enron.
Like everything else about the Paulson-Geithner approach, this latest twist is totally clubby and non-transparent. There is no objective process, and no public criteria. Congress is being kept in the dark. The Congressional Oversight Panel is being denied the documents it needs. (If you want to delve deeper, the Panel's reports are must-reading.)
The Treasury does not have the staff resources to do the job properly, so it hires private investment bankers. This recalls the era when J.P. Morgan and his financier pals mounted a private rescue to halt the bank panic of 1907. But Morgan was a purely private banker, and he was using his own bank's money. It this case, the Treasury is supposedly a public institution using taxpayer funds, yet behaving with all the transparency of Morgan.
Further, the problem that stopped Hank Paulson dead in his tracks last fall, when he gave up on trying to have the government purchase toxic assets, continues to stymie Geithner: how to price the assets. If the price that the hedge funds and private equity companies pay is too low, they make a financial killing with government guarantees. If it is too high, government will subsidize the loss. The idea that private speculators will divine the right price because this is "the market" speaking is delusional -- look what these markets have delivered so far. Either way, far too much power is being given to the least regulated and least transparent players in the financial game, and too much is being left to the caprices of speculators. Indeed, these are many of the same firms that took the other side of bets with outfits like AIG, whose gambles crashed the system.
In addition, this desperation use of private equity companies and hedge funds is compromising government's ability to regulate these shadowy players. As recently as late last week, Geithner was sweetening the terms of his deal, because not enough players were coming to the table. At the G-20 economic summit next week in London, the Obama administration and the Europeans are likely to be at loggerheads over whether to toughen regulation of hedge funds and private equity. But it's awfully hard to be a tough regulator when you are begging them to participate in your program.
It all adds up to the most expensive and risky way of trying to recapitalize banks, and the least likely to succeed. Instead of simplifying, it is adding complexity and leverage. In effect, Geithner is doubling down on the same kinds of speculations that crashed the system. This time, however, the government guarantees are explicitly negotiated in advance, rather than being cobbled together after the crash.
Since the administration knows that Congress is unlikely to appropriate another nickel for bank bailouts in the current climate, the Treasury is relying on the Federal Reserve as a largely unsupervised piggy bank, and drafting a reluctant FDIC as well. The Fed's operations are beyond the direct scrutiny of Congress. The problem is that even the Fed can go broke, or it must resort to creating money to avoid that fate. The Fed's own balance sheet has roughly doubled since last September to about $2 trillion. With the latest Geithner scheme, it will roughly double again. The Fed is known as a very conservative institution. But increasingly, it is holding the bag for the system's most dubious assets.
On Thursday of last week, the Fed surprised everyone by announcing a plan to purchase $300 billion of Treasury bonds, to keep down the government's borrowing costs. We have not seen this sort of intervention since World War II. The Fed has begun monetizing the public debt, a process that works for now, but one that could end in a far more severe form of the "stag-flation" that wracked the economy in the 1970s.
The main purpose of this entire strategy is to disguise the true depth of the hole in bank balance sheets and to prop up insolvent banks, not to repair the larger system. It has been largely designed by and for the same Wall Street players that created the crisis.
In the aftermath of the AIG debacle, the silver lining in this sorry mess is that the Geithner approach could well fall of its own weight. Not only are many inside the government skeptical. Financial markets are unlikely to be impressed. The press commentary is likely to be withering. And Congressional Democrats did not spare Geithner in their assault on the AIG bonuses, and are unlikely to be gentle in their appraisal of the plan when all the gory derails are finally released.
Which brings up the question: where in this affair is the president who hired Secretary Geithner and at whose pleasure the embattled treasury secretary serves? For the moment, President Obama is standing by his man, something he has to do until the moment that Obama decides to ease out Geithner, work around him, or fire him.
The problem, of course, is larger than Geithner. The entire Obama economic team is far too close to Wall Street and far too much a continuation of the Paulson approach. And though Geithner is primed to take the fall, the plan is the work of senior economic strategist Larry Summers as much as it is Geithner's.
The grave political and economic risk is that Obama continues to let Summers and Geithner lead him down the garden path; the industry-oriented mortgage rescue saves too few homeowners; housing remains in the doldrums and mortgage securities with it; the hedge funds and private equity companies make some money with government guarantees, but the banking system remains comatose; and Republicans increasingly become the instruments of public anger.
For the moment, the president is a prisoner of this thinking and these appointees. If this were merely The West Wing, it would be the stuff of terrific drama. But alas, it's reality; and we all will live with the consequences.
In a different possible scenario, however, Obama lets the financial and political marketplace test the Geithner plan for another week or two. Then, when its failure is palpable, Obama announces a dramatically different approach, either with or without a different treasury secretary.
If this movie were Bull Durham, the most plausible veteran that Obama could bring in to play Crash Davis to Geithner's Ebby Calvin LaLoosh would be Paul Volcker. The former Fed chairman is no fan of the Paulson-Geithner approach.
If Obama handed Volcker the ball, as some kind of senior counsel, they could drastically change the game plan without even having to fire Geithner. This would be the smoothest and least awkward way of changing course. Obama could simply say that we tried variants on the Paulson formula and it didn't work. Now it's time to try something else.
The alternative course, which is winning converts across the political spectrum, is a variant on the Reconstruction Finance Corporation of the Roosevelt era. With an R.F.C. temporarily taking over the insolvent banks, you wouldn't have to bribe hedge funds and private equity companies to speculate on toxic securities. Government would take over zombie banks and use government auditors to determine just how much new money was required to bring a vastly simplified financial system back to life. Shadow banks, loan securitization, and convoluted high-risk schemes would loom smaller, not larger. The process would have far greater simplicity and transparency. And it would be far more likely to get the banking system working again, more quickly and at less public expense.
Barack Obama is a president of great promise, reassurance, and political skill. In the next few weeks, we will learn how he performs in a crisis that is being worsened by his own appointees.
Robert Kuttner is co-editor of The American Prospect and a senior fellow at Demos. His latest book is Obama's Challenge: America's Economic Crisis and the Power of a Transformative Presidency."
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