NYT Editors: "Will the Geithner Plan Work?...We asked four economists"

[ProSense]

March 24, 2009, 10:33 am

Will the Geithner Plan Work?

By The Editors

By offering private investors huge amounts of cheap financing at little risk to buy bad mortgage-related securities, along with an expansion of an existing federal program, the public-private plan unveiled by Treasury Secretary Timothy Geithner could buy up to $2 trillion in toxic assets now weighing down the banks.

The market soared on high hopes that this will solve unfreeze credit and revive the crumbling economy. But is this plan sufficient to restore the banking system to health?

We asked four economists — Paul Krugman, Simon Johnson, Brad DeLong and Mark Thoma — to tackle this question.

Perception vs. Reality

Paul Krugman, a Times Op-Ed columnist, is a professor of economics at Princeton University and winner of the 2008 Nobel economics prize.

<...>

So can this work?

Since the beginning of the crisis, there have been two views of what’s going on.

View #1 is that we’re looking at an unnecessary panic. The housing bust, so the story goes, has spooked the public, and made people nervous about banks. In response, banks have pulled back, which has led to ridiculously low prices for assets, which makes banks look even weaker, forcing them to pull back even more. On this view what the market really needs is a slap in the face to calm it down. And if we can get the market in troubled assets going, people will see that things aren’t really that bad, and — as Larry Summers said on yesterday’s Newshour – the vicious circles will turn into virtuous circles.

View #2 is that the banks really, truly messed up: they bet heavily on unrealistic beliefs about housing and consumer debt, and lost those bets. Confidence is low because people have become realistic.

The Geithner plan can only work if view #1 is right. If view #2 is right – if the banks are really in deep trouble that goes beyond lack of confidence — subsidizing investor purchases of toxic assets, many of which aren’t even held by the most troubled banks, has no real chance of turning things around.

As you can guess, I believe in view #2. We had vast excesses during the bubble years, and I don’t think we can fix the damage with the power of positive thinking plus a bit of financial engineering.

But that’s where the issue lies.

A Partial Answer, Maybe

Simon Johnson is a professor at MIT Sloan School of Management, a senior fellow at the Peterson Institute for International Economics, and co-founder of the global crisis Web site BaselineScenario.

<...>

Think of it this way. If the government offered you the chance to participate in a big new lottery at a cost of $10, you might be tempted. But what if the government wanted you to pay $1,000 and to have the I.R.S. camp at your house for a month to make sure everything you did was legal?

The Geithner plan may prove to be part of the solution, but a relatively small part. If the economy continues to deteriorate, we urgently need a “resolution mechanism for large banks”; in plain English, the government will supervise their bankruptcy and had better figure out how to do this more effectively.

We must learn the painful lessons of A.I.G. and create laws, put in place procedures, and hire people who can clean up massive financial messes. The magic of the market will likely not get us out of this morass; we need a new Resolution Trust Corporation-type structure and we need it fast.

Better Than Nothing

Brad DeLong is a professor of economics at University of California, Berkeley and blogs at Grasping Reality with Both Hands.

<...>

My guess, however, is that we would need to take $4 trillion of risky assets out of the supply currently held by private financial intermediaries to move financial asset prices to where they need to be.

The Geithner plan offers only $500 billion. The Federal Reserve’s quantitative easing plan will add another $1 trillion. I should hasten to say that the administration thinks that information-sharing effects of the plan will do three times as much good in raising asset prices as the simple change in asset supply (I discount that entirely.) So from their perspective the glass is 3/4 full. I think that 3/8 full is better than having no glass at all.

Why isn’t the administration doing the entire job? My guess is that the Obama administration wants to avoid anything that requires legislative action. The legislative tacticians appear to think that after last week’s furor over the A.I.G. bonuses, doing more would require a congressional coalition that is not there yet. The Geithner plan is one the administration can do on authority it already has.

How to Tell It’s Working

Mark Thoma is an economics professor at the University of Oregon and blogs at Economist’s View.

<...>

How will policymakers be able to tell if the plan is working? The first thing to watch for is whether private money is moving off the sidelines and participating in the program to the degree necessary to solve the problem. If the free insurance against downside risk that comes with the non-recourse loans the government is offering doesn’t induce sufficient private sector participation, then it will be time to end the Geithner bank bailout. Even if increasing the insurance giveaway would help, legislative approval would be unlikely and the political fight that would ensue would hurt the chances for nationalization.

The second factor to watch is the percentage of bad loans the government makes as part of the program. These non-recourse loans are the source of the free insurance against downside risk. Borrowers can walk away if there are large losses, and if the number of bad loans is unacceptably high (a potential political nightmare), then policymakers will need to act quickly and pull the plug on the program.

Unfortunately, however, the loan terms make it unlikely that we’ll have timely information on the percentage of bad loans. But there is something else we can watch to assess the health of the loans: the price of the toxic assets purchased with the loans. If the price of these assets is increasing sufficiently fast, then the loans will be safe. But if the prices do not respond to the program, then the loans will be in trouble.

In that case, we will need to end the program as quickly as possible and minimize losses. The next step will have to be bank nationalization, though the political climate will likely be difficult. Sticking with the plan until it completely crashes and burns on the hope that a little more time is all that is needed will make nationalization much more difficult.

[FrenchieCat]

1. In otherwords, no one knows, but its better than nothing,

and congress can't be looked upon to make things any easier.

That's about the size of it.

As far as getting rid of toxix assets,

The Geithner plan provides tax payers with 85% loss as opposed to 100%.

Any other plan provides taxpayers with a 100% loss.



I'll take ;the Geithner plan for the 15%.

[Hamlette]

2. You're right, Frenchie

at least I hope so.

Here's the big problem: there are enough regulations already to keep banks et al out of trouble they just have not been enforced. How do you do that? You have government employees at the FDIC standing up against rich powerful banks. If you have the wrong people in those positions, people who "go easy" with full bancking from the government in charge (GOP), you're screwed. I saw it happen with state insured thrifts years ago. I had a front row seat. If you've never seen a run on a bank, you don't understand how scary and disturbing it is.

[ProSense]

4. Some of those regulations were repealed and amended and

others contain loopholes that need to be closed. Regulation reform needs to address these and other issues.

FDIC Chair Sheila Bair (PDF)

In the case of a bank holding company, the FDIC has the authority to take control of only the failing banking subsidiary, protecting the insured depositors. However, many of the essential services in other portions of the holding company are left outside of the FDIC’s control, making it difficult to operate the bank and impossible to continue funding the organization’s activities that are outside the bank. In such a situation, where the holding company structure includes many bank and non-bank subsidiaries, taking control of just the bank is not a practical solution.

If a bank holding company or non-bank financial holding company is forced into or chooses to enter bankruptcy for any reason, the following is likely to occur. In a Chapter 11 bankruptcy, there is an automatic stay on most creditor claims, with the exception of specified financial contracts (futures and options contracts and certain types of derivatives) that are subject to termination and netting provisions, creating illiquidity for the affected creditors. The consequences of a large financial firm filing for bankruptcy protection are aptly demonstrated by the Lehman Brothers experience. As a result, neither taking control of the banking subsidiary or a bankruptcy filing of the parent organization is currently a viable means of resolving a large, systemically important financial institution, such as a bank holding company. This has forced the government to improvise actions to address individual situations, making it difficult to address systemic problems in a coordinated manner and raising serious issues of fairness.

<...>

The current financial crisis demonstrates the need for changes in the supervision and resolution of financial institutions, especially those that are systemically important to the financial system. The choices facing Congress in this task are complex, made more so by the fact that we are trying to address problems while the whirlwind of economic problems continues to engulf us. While the need for some reforms is obvious, such as a legal framework for resolving systemically important institutions, others are less clear and we would encourage a thoughtful, deliberative approach. The FDIC stands ready to work with Congress to ensure that the appropriate steps are taken to strengthen our supervision and regulation of all financial institutions -- especially those that pose a systemic risk to the financial system.

[FrenchieCat]

5. The problem are the hedge funds and companies like AIG......

which apparently lack regulatory oversight!

Hedge funds are exempt from regulation in the United States.

Several bills have been introduced in the 110th Congress (2007-08), however, relating to such funds. Among them are:

S. 681, a bill to restrict the use of offshore tax havens and abusive tax shelters to inappropriately avoid Federal taxation;
H.R. 3417, which would establish a Commission on the Tax Treatment of Hedge Funds and Private Equity to investigate imposing regulations;
S. 1402, a bill to amend the Investment Advisors Act of 1940, with respect to the exemption to registration requirements for hedge funds; and
S. 1624, a bill to amend the Internal Revenue Code of 1986 to provide that the exception from the treatment of publicly traded partnerships as corporations for partnerships with passive-type income shall not apply to partnerships directly or indirectly deriving income from providing investment adviser and related asset management services.
S. 3268, a bill to amend the Commodity Exchange Act to prevent excessive price speculation with respect to energy commodities. The bill would give the federal regulator of futures markets the resources to detect, prevent, and punish price manipulation and excessive speculation.
None of the bills has received serious consideration yet.
http://en.wikipedia.org/wiki/Hedge_fund

After Dodging Many Bullets, Hedge Funds Are Back in Regulators' Sights
Published: March 18, 2009 in Knowledge@Wharton

The hedge fund industry has a long history of avoiding tougher regulation. But as the Obama administration and Congress look for ways to avoid another financial meltdown, that history may soon come to an end.

Although it is not clear that hedge funds actually played much of a role in the current crisis, the industry's sagging performance, combined with investors' and regulators' heightened demand for transparency, will likely cause big changes in the way these secretive investment pools operate, suggest several Wharton faculty members.

Worries about hedge funds are likely to escalate after The Wall Street Journal reported on March 18 that the now-notorious insurance giant AIG might use taxpayers' money to make good on hedge funds' bets that the housing market would fall. At the same time that the government is struggling to revive housing, it could spend billions rewarding hedge funds that profit from the housing decline, the paper said.

Critics have long wanted a regulatory crack-down on hedge funds, arguing that regulators, investors and the public at large know too little about how this industry influences the financial markets. But the industry has staved off regulatory pushes, the most serious of which was a 2005 Securities and Exchange Commission proposal to require the funds to register with the agency and submit to some scrutiny. The industry challenged the move, and in 2006 a federal court ruled that the SEC did not have that authority.

Now the push for regulation is gathering momentum. A bill introduced on January 29 by Senators Carl Levin, a Michigan Democrat, and Charles E. Grassley, a Republican from Iowa, would give the SEC authority to regulate hedge funds. Grassley argues that the political mood has changed since two years earlier, when he had introduced a similar bill that went nowhere.

Obama Administration officials also are pushing for tougher regulation, though how tough is still to be determined. According to news reports earlier this week, the administration's broader plan for tighter regulation of the finance industry would include assigning greater oversight of hedge funds to the Federal Reserve. Stricter rules might require the funds to make public disclosures. Conceivably, tough rules could even limit hedge funds' ability to borrow money to supercharge bets, or even curb some high-risk investments. The guiding principal will likely be to assure that a fund's activities can hurt only its investors, not innocent bystanders. And it seems apparent that any regulation will come in stages, with the initial disclosure requirements leading to new rules as hazards are detected.

The 10,000 funds control about $1.5 trillion in assets, according to industry estimates. Hedge funds grew dramatically over the past two decades as investors sought market-beating returns, but now hundreds of money-losing funds have shut down and investors are clamoring to get their money back from many others. "The hedge fund industry is really swooning at this point," says Thomas Donaldson, professor of legal studies and business ethics at Wharton. "We're watching an industry whose bubble has popped."

"We will see a major shift in regulation in the next year or so," adds Wharton finance professor Richard Marston, referring to oversight of the entire financial industry, including hedge funds. "I don't really care if the rich in Palm Beach are fleeced.... I care whether businesses in Philadelphia suffer because hedge funds have set off a panic in financial markets. Hedge funds didn't this time. The banks did it. But next time, it may be the hedge funds."

more... http://knowledge.wharton.upenn.edu/article.cfm?articleid=2185

[KittyWampus]

7. your spin is wrong again. There are alternatives and your constant attempt to pretend otherwise

if ridiculous.

And we DO KNOW what worked in the past.

No matter how many times you try to make "size" mean something, it doesn't change reality.

[FrenchieCat]

10. Please, lets have your spin.

what is it?

Thanks.

[Beetwasher]

3. Why Is Everyone Glossing Over The Oversight In The Geithner Plan????

FDIC is running the show AND APPROVING THE ASSETS TO BE SOLD AND ANALYZING AND EVALUATING THE ASSETS and then running the auction. The FDIC determined values and a debt-equity ratio are going to determine the size of the loans and essentially limit the price paid for the assets. With competent oversight there should be NO HYPER-INFLATED prices paid for the assets.

And who here thinks for a second that FDIC will be able to get away w/ lax oversight? Will Krugman allow them? Will the media allow them? Will the Repubs allow them? Is Obama so stupid that he would allow lax oversight of the process after everything that's happened?????

Think about it. All eyes are going to picking over every single penny with a focus that's probably never been applied before at any time in history.

[FrenchieCat]

6. Because they decided against the Geithner plan before it even came out!

Remember that Krugman's column was written and published a day before Geithner actually announced the plan. :eyes:

[depakid]

8. who here thinks for a second that FDIC will be able to get away w/ lax oversight?

Methinks that the FDIC neither has the resources nor the personnel to oversee and administer a freewheeling program of this breadth and scope effectively enough to prevent collusion and self-dealing.

Joining me in this assessment are many other more eminent and seasoned experts and observers.

[Beetwasher]

9. So Then, What's A Workable Solution???? If They Can't Handle THIS How Could The Gov't Handle

Any alternative? What makes you think the gov't would be able to manage/oversee nationalization competently then? What OTHER alternative is there that they WOULD be able to oversee competently? :shrug:

[FrenchieCat]

11. And yet, Nationalization is supposed to be the answer.

I talk about the issue of personnel as one of the many problems facing this solution here: http://www.democraticunderground.com/discuss/duboard.php?az=view_all&address=132x8282342

[Beetwasher]

12. The Cognitive Dissonance Is Staggering

"They can't possibly handle this smaller role competently! So let's nationalize and give the gov't an ENORMOUS role!"

Incredible.

[depakid]

14. There's a BIG difference between handling matters internally and having to oversee

a massive program with intertwining entities all playing some sort of angle.

Exponentially more complicated- and prone to abuse.

[Beetwasher]

17. Really? How So?

You mean like nationalization wouldn't be exponentially more complicated and prone to abuse??? Really? But the gov't will be running things, and accorrding to you they're not capable.

And there's no political considerations, operational considerations either? Why, congress would just approve it!

All of a sudden everything will just be magically nationalized in a matter of days and we'll all be just swell because the nationalization fairies will take care of everything!

[depakid]

23. Collusion and self-dealing in the bidding for starters

among banks, hedge funds and private equity funds (the latter of the two being largely unregulated). If the government owns the assets, rather than attempting to subsidize private party to party sales, we both have more control over the timing and the terms, and it's far easier to detect efforts to game the system.

[Beetwasher]

26. Not W/ Competent Oversight

FDIC is approving ALL sales FIRST. If they can't handle this smaller role competently (according to you) how can they handle the larger, messier process of nationalization?

"If the government owns the assets, rather than attempting to subsidize private party to party sales, we both have more control over the timing and the terms, and it's far easier to detect efforts to game the system."

That's not true. The FDIC oversight in Geithner's plan gives the Gov't practically identical control over price and sale through the approval of the assets to be auctioned, the evaluations and limitations on the loan amounts.

In addition it REQUIRES evaluation which is a NECESSARY precursor to nationalization, which IS STILL ON THE TABLE.

[FrenchieCat]

18. There is so much that could go wrong, with the media microscope looking for something.....

it's almost like dealing with dynamite.

Why wish that on anyone?
Why set yourself up to fail?

[depakid]

13. The various temporary nationalization (or partial) plans laid out by Stiglitz and others

will require something akin to the resolution trust corporation (which was effective) - and while it will take experienced administrative staff, it is much less ripe for the sort of repeated abuses and lack of transparency that we've seen with TARP.

That would seem to be the consensus developing among many of the more objective economists outside of the Rubin/Summers/Paulson/Gaithner circle.

[Beetwasher]

15. And That Would Take How Long To Implement?

Any idea? I don't think you do.

"it is much less ripe for the sort of repeated abuses and lack of transparency that we've seen with TARP."

Really? Why would that be??? It would be ripe for exactly the same abuses. Who do you think would staff it? Who would approve of the staffing? Who would do the vetting? How would the budget for it get through Congress in a reasonable time-frame? How would it be regulated?

[depakid]

20. You can probably get something of gauge on that from looking at the S&L experience

Obviously, this is much more complicated- but the processes are similar enough.

[Beetwasher]

21. "Obviously, this is much more complicated"

Quite the understatement. We don't have the time for that model. I guess you could argue that we do have the time, and it wouldn't take that long to set up, but I would argue that's not true and even according to the people who are FOR nationalization (like Krugman) time is of the essence and they don't explain how to accomplish such a feat in a short amount of time.

[ProSense]

16. What?

Where are these plan, including the details of this authority?

People have been screaming nationalization for weeks as if nothing else need be done but walk in and seize the companies.

Last week Obama mentioned such an authority and no one seemed interested in that because it interrupted the calls to "just nationalize them."

[Beetwasher]

19. The Nationalization Fairy Takes Care Of It!

He's the tooth fairy's brother. He waves his magic wand and everything is nationalized w/out a hitch and we're all just groovy!

[depakid]

22. Why be insulting?

Not generally your style.

To put it pointedly- if people don't think that contingency plans have been drawn up for what happens in the event that the Summers, Gaither et al. critics are right- then we don't have a very competent administration.

If that's shown to be the case- then people will be rallying to those solutions just as vigorously as if they'd been behind them all along.

Only the taxpayers will be out a ton more money- and arguably the administration will have lost more credibility and political capital.

[Beetwasher]

24. Just Goofing Around

Actually if you think that's not my style, you don't know me very well! I am an asshole after all!

Seriously though, I don't mean to insult you, we're having a nice discussion and I appreciate it.

I posted this in another thread but I think it fits in nicely here as a response to your latest comment:

As part of Geithner's plan, we will FINALLY have dependable valuations of these assets. That in and of itself is NO SMALL THING.

We can get a REAL handle on the scale and scope of the problem.

I cannot stress how important this is.

What people are not realizing is that NATIONALIZATION IS STILL ON THE TABLE. These valuations may in fact be a step in that direction while the auction will hopefully alleviate much of the problems and make it unnecessary (we will see), it at least will buy us some time and stabilization to possibly prepare for nationalization if it comes to that.

Nationalization is a complex, messy process that requires MASSIVE amounts of preparation on the scale that so many here are proposing. Not the least of which is proper evaluations.

Nationalization will be an easier pill to swallow if we go through these (possibly) intermediate steps first. If we evaluate these assets and find them to be so thoroughly fucked that FDIC determines they are complete garbage, I expect we'll see a much more serious consideration of nationalization.

BTW, this is happening w/ TARP funds which have ALREADY been approved and appropriated, so it's not like this is NEW or additional funding being "wasted".

[depakid]

27. One of the overriding criticisms however is that via the massive subsidation,

we won't have dependable valuations- but rather distorted ones that affect the value of other performing assets held by healthy banks and institutions.

Under the circumstances, which would you purchase, questionable assets where you had a backstop of non-recourse loans- or better performing and "less" risky ones, without the backstop?

btw: I too am appalled by the lack of beets in the Whitehouse garden. If the President doesn't like the common red variety- he should try the golden ones. My SO for example, doesn't care for the red ones (and down under they put "beetroot" on burgers and sandiwches and salads as a matter of course- so I get then shovelled onto my plate- which is fine by me. When in the states, I fixed her some golden ones- those she liked just fine. Can't find 'em in the stores down there, but I've ssen the seeds in the garden shop.</threadjack>

[Beetwasher]

29. But That's An Issue Regardless

Whose valuations should we depend on then? I'll take an FDIC evaluation over the bank that's holding the asset any day.

And that's sort of the point:

"Under the circumstances, which would you purchase, questionable assets where you had a backstop of non-recourse loans- or better performing and "less" risky ones, without the backstop?"

The point is to get confidence back in the system and stabilize the assets. That won't happen if the gov't just gobbles them up. How will credit start flowing if that happens? It will only happen if the market sees private investors willing to invest (even if it's w/ little risk on their part, it's still risk) and then subsequent stabilization (hopefully). Is there risk? Of course, but it's less risk than the gov't taking ALL the risk while injecting NO CONFIDENCE back into the system and NO INCENTIVE for OTHER investors to buy assets (w/out gov't loans) and get credit flowing again.

Thanks for the support on the beets issue! ;)

[ProSense]

25. Why would they think that?

Let's see, two things happened over the past 48 hrs.: Geithner introduced a plan, and then went to Congress to seek authority to take over firms.

[depakid]

28. Many seem wedded to the current plan- and bag on what may well be inevitable

perhaps it's a reflection of factionalism.

[ProSense]

30. That doesn't address the question. n/t

[Political Heretic]

31. Why are people so upset if they agree with Kr ugman?

Look, his take makes the most sense to me. If we don't have a core crisis with the actual structure of banks, then this is going to work. And we might not, so it could work and oh god I hope it does.

This is where Frenchie's post "no one knows but its better than nothing" is right.

But I'm a worry wart. I fear our problems in the financial sector are bigger and most systemic in nature. If that's the case, then this is going to fix things, which means we'll be back at the drawing board again - that worries me just because of the cost to main street in the meantime.

The request of the administration for seizure power appears to be an attempt to minimize the risk if they are wrong in their bank plan, which is a great thing if they can actually get that power. It would allow them to make rapid adjustments if it turned out the banking system had deeper more systemic problems that couldn't be fixed by just subsidizing crappy assets.

So cheers to the administration for attempting to be forward thinking like that. This would be an example of where I'm cheering the administration for a good move and also at the same time agreeing with Krugman's basic assessment of whether or not the banking plan will work... doesn't have to be either/or