New toxic asset plan flawed: Kohler

In the next few days, US Treasury Secretary Timothy Geithner will announce the Obama Administration’s plan for dealing with the banks’ “toxic assets”. It will be the most important moment of this crisis so far, but the plan looks flawed and the process has become messy and unpredictable.

The slowly developing plan has now been completely swamped by outrage over the AIG bonuses, to the point where “curbing Wall Street excesses” has become the dominant political force in the US – not filling the holes in the banks’ balance sheets.

Members of Congress have been vying with each other to display the most extreme outrage, and from a distance it looks like the whole country is now the United States of Indignation.

Not that dudgeon isn’t justified; virtually all of the bailout money to AIG went on bonuses to derivatives traders and paying off investment bank counterparties to credit default swaps – banks that had themselves been bailed out. One letter to the New York Times described AIG as Obama’s “Katrina moment”, and others have taken up that theme.

Now anything that looks like doing any favours to the Wall Street fat cats is more toxic than the assets the banks hold.

This is especially problematic, since the Obama plan for dealing with those toxic assets relies not just on using public funds to bailout the banks, but also on private investment and management by hedge funds. They are all now terrified of the immense political forces that have been unleashed by AIG.

Even without that scandal to complicate matters, Barack Obama and Tim Geithner are like Bruce Willis and Ben Affleck in the disaster movie Armageddon, where to save the world the heroes have to fly up and land on the meteor rushing toward earth, drill a precise hole in it, drop a nuclear bomb down the hole and then run away before it blows up. It turns out they can’t detonate it remotely so Bruce Willis (Geithner) says goodbye to his daughter (telling her to marry Ben Affleck) and goes down the hole with the bomb.

President Obama gave an interview over the weekend in which he said he would refuse to accept Geithner’s resignation, but things don’t look good for the Treasury Secretary. If the markets give the thumbs down to his toxic asset plan, he should start saying his goodbyes.

With the AIG scandal, it looks more like The Core, in which to save the world Hilary Swank and Aaron Eckhardt have to go down to the extremely hot centre of the earth and precisely plant a whole series of nuclear bombs on the earth’s core to make it start spinning again.

Essentially the US Government wants to create a series of leveraged hedge funds to buy the banks’ bad loans and mortgage securities at “market prices” and have the assets privately managed.

There will be three parts to the program; a set of public/private investment funds to buy mortgage securities, funded on a dollar-for-dollar basis by the Government, and run by private fund managers; another set of partnerships funded by non-recourse loans from the Federal Deposit Insurance Corporation up to 85% of value, to buy loans from the banks; and thirdly an expansion of TALF (term asset-backed secure lending facility) to include older securities instead of just new ones.

According to the weekend reports, the Government will be funding about 95% of the plan and private investors 5%, for which they will get a much larger proportion of the equity.

The problem with all previous plans was that if the Government paid too little for the assets, it would not help the capital position of the banks; if it paid too much, taxpayers would be in the hole.

It seems the Geithner plan hopes to avoid this by setting up an auction in which market prices are paid by privately-managed organisations funded largely by non-recourse government loans.

It seems to me that unless there is something we still don’t know, the plan is fundamentally flawed.

It appears to be based on the proposition, mistakenly held by many politicians and commentators around the world in my view, that the crisis is one of sentiment and confidence – that if we don’t panic, and stay calm, the economy will simply recover.

But actually this financial crisis is very soundly based: US and European banks did make bad loans and buy over-priced securities and derivatives.

As a result, they have actually lost money. This is not a situation where a panic attack is leading to a bank run, where depositors’ fears can be soothed and the run brought to an end by reassurance. The banks are genuinely insolvent and the world’s credit system is genuinely dysfunctional.

The bank capital must either be replaced or written off, so that the owners of the capital – shareholders and bond holders – have their losses crystallised. Either that, or someone must buy the assets for trillions of dollars more than they are worth.

Some are suggesting that the Geithner plan is just a way to disguise the fact the Government is overpaying for the assets. If that’s true, and they overpay by enough, it might work.

In which case the banks’ follies will have been socialised and the US taxpayers will lose a fortune, perhaps more even than the US can afford to lose – while paying hedge funds another fortune in fees and bonuses along the way.

After the AIG bonus scandal, that is hard to imagine.

This appeared originally on Business Spectator