Mr. Geithner's Plan
JUST A MONTH or so ago, the stock market plunged because investors did not like Treasury Secretary Timothy F. Geithner's outline of a plan for removing toxic assets from bank balance sheets. Yesterday, Mr. Geithner announced the details and -- what do you know? -- the market shot up. Obviously, the market's mood swings are not the best indicator of Mr. Geithner's merits or of his plan's. But what's new as of yesterday is that we have a fuller basis for evaluating his program. And the best judgment is: It's worth a try, but hardly guaranteed to succeed.
Estimates vary, but there are probably between $1 trillion and $2 trillion worth of toxic assets on the balance sheets of America's financial institutions -- heavily concentrated in the largest banks. These are instruments (often backed by troubled real estate and often of mind-blowing complexity) for which the market has collapsed, because investors regard them as risky and incomprehensible. The resulting paper losses are eating away at the banks' capital, eroding their ability to lend. Until banks can unload toxic assets, they will find it hard to raise private capital -- and must devour more and more government capital.
Mr. Geithner explained yesterday that the Treasury's plan relies on $100 billion from the Troubled Assets Relief Program to leverage hundreds of billions of dollars in Federal Deposit Insurance Corp. loan guarantees and Federal Reserve financing. Private-sector hedge funds and the like will supply the remaining equity capital, for a potential asset-buying total of $1 trillion. The private partners will compete among themselves to buy assets, then manage them and profit in proportion to their investment. The government will see a proportional share of the upside -- but bear practically all of the losses. This is the sweetener that induces private firms to participate. If all goes according to plan, the market know-how of the private firms will lead to maximally efficient deployment of government resources, and taxpayer losses will be relatively modest. Indeed, Mr. Geithner expects the initial federally backed purchases to help establish market prices for previously illiquid assets, which will then bring in more and more private buyers with no need for federal support.
This cleverly avoids having to ask Congress for more Wall Street bailout money. One problem, though, is that the banks that now own the toxic assets think they're worth a lot more than would-be buyers do. It's unclear whether Mr. Geithner's incentives will bridge the gap. The trick is to make the government's private partners put up some of their own money so that they have an incentive not to overpay the banks -- while subsidizing them enough that they don't haggle endlessly and defeat the purpose of the program. We won't know whether Mr. Geithner has struck that balance until his private partners try their first purchases, probably a month or so from now.
Notably, there are no limits on the compensation that participating firms may pay their employees. This strikes us as appropriate, since the private partners are putting their own money at risk and, unlike AIG or the automakers, are not using government help to survive in the first place. Even the threat of inconsistent or vindictive changes to this policy could deter private participation in this important policy effort. We don't know whether Mr. Geithner's plan will work. But it won't have a chance unless everyone involved -- private investors, regulators, Congress and the Obama administration -- plays by a clear and consistent set of rules.