The Geithner-Summers Plan Is Even Worse Than We Thought

The Geithner-Summers Plan Is Even Worse Than We Thought

 

by Jeffrey Sachs

 

Director of the Earth Institute, Economics Professor, Columbia University

 

Posted April 6, 2009 | 12:38 PM (EST)

 

http://www.huffingtonpost.com/jeffrey-sachs/the-geithner-summers-plan_b_183499.html

 

Two weeks ago, I posted an article showing how the

Geithner-Summers banking plan could potentially and

unnecessarily transfer hundreds of billions of dollars

of wealth from taxpayers to banks. The same basic

arithmetic was later described by Joseph Stiglitz in

the New York Times (April 1) and by Peyton Young in the

Financial Times (April 1). In fact, the situation is

even potentially more disastrous than we wrote.

Insiders can easily game the system created by Geithner

and Summers to cost up to a trillion dollars or more to the taxpayers.

 

Here's how. Consider a toxic asset held by Citibank

with a face value of $1 million, but with zero

probability of any payout and therefore with a zero

market value. An outside bidder would not pay anything

for such an asset. All of the previous articles

consider the case of true outside bidders.

 

Suppose, however, that Citibank itself sets up a

Citibank Public-Private Investment Fund (CPPIF) under

the Geithner-Summers plan. The CPPIF will bid the full

face value of $1 million for the worthless asset,

because it can borrow $850K from the FDIC, and get $75K

from the Treasury, to make the purchase! Citibank will

only have to put in $75K of the total.

 

Citibank thereby receives $1 million for the worthless

asset, while the CPPIF ends up with an utterly

worthless asset against $850K in debt to the FDIC. The

CPPIF therefore quietly declares bankruptcy, while

Citibank walks away with a cool $1 million. Citibank's

net profit on the transaction is $925K (remember that

the bank invested $75K in the CPPIF) and the taxpayers

lose $925K. Since the total of toxic assets in the

banking system exceeds $1 trillion, and perhaps reaches

$2-3 trillion, the amount of potential rip-off in the

Geithner-Summers plan is unconscionably large.

 

The earlier criticisms of the Geithner-Summers plan

showed that even outside bidders generally have the

incentive to bid far too much for the toxic assets,

since they too get a free ride from the government

loans. But once we acknowledge the insider-bidding

route, the potential to game the plan at the cost of

the taxpayers becomes extraordinary. And the gaming of

the system doesn't have to be as crude as Citibank

setting up its own CPPIF. There are lots of ways that

it can do this indirectly, for example, buying assets

of other banks which in turn buy Citi's assets. Or

other stakeholders in Citi, such as groups of

bondholders and shareholders, could do the same.

 

Several news stories suggest some grounding for these

fears. Both Business Week and the Financial Times

report that the banks themselves might be invited to

bid for the toxic assets, which would seem to set up

just the scam outline above. What is incredible is that

lack of the most minimal transparency so far about the

rules, risks, and procedures of this trillion-dollar

plan. Also incredible is the apparent lack of any

oversight by Congress, reinforcing the sense that the

fix is in or that at best we are all sitting ducks.

 

The sad part of all this is that there are now several

much better ideas circulating among experts, but none

of these seems to get the time of day from the

Treasury. The best ideas are forms of corporate

reorganization, in which a bank weighed down with toxic

assets is divided into two banks -- a "good bank" and a

"bad bank" -- with the bad bank left holding the toxic

assets and the long-term debts, while owning the equity

of the good bank. If the bad assets pay off better than

is now feared, the bondholders get repaid and the

current bank shares keep their value. If the bad assets

in fact default heavily as is now expected, the

bondholders and shareholders lose their investments.

The key point of the good bank -- bad bank plans is an

orderly process to restore healthy banking functions

(in the good bank) while divvying up the losses in a

fair way among the banks' existing claimants. The

taxpayer is not needed for that, except to cover the

insured part of the banks' existing liabilities,

specifically the banks' deposits and perhaps other

short-term liabilities that are key to financial market liquidity.

 

Cynics believe that the Geithner-Summers Plan is

exactly what it seems: a naked grab of taxpayer money

for Wall Street interests. Geithner and Summers argue

that it's the least bad approach to a messy situation,

in which we need to restore banking functions but don't

have any perfect ways to do that. If they are serious

about their justification, let them come forward to

confront their critics and to explain to the American

people why the other proposals are not being pursued.

 

Let them explain the hidden and not-so-hidden risks to

the American taxpayer of the plan that they have put

forward. Let them explain why they are so intent on

saving the banks' bondholders, even the long-term

unsecured creditors who clearly knew they were taking

market risks in buying Citibank bonds. Let them work

with their critics to fashion a less risky and less

costly plan. So far Geithner and Summers tell us that

their plan is the only option, but without a word of

further explanation as to why.

 

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