Why Geithner’s toxic debt plan can work: Kohler

The Geithner plan is not too bad at all. A lot of the commentary this morning is very negative, but to paraphrase Winston Churchill, it looks like the worst possible plan, except for all the others.

The market clearly likes it, and as I write this morning it’s rallying hard in the belief that the plan will help put in place a late 2009/early-2010 recovery in the US, which is the US Congressional Budget Office’s baseline forecast (4.1% growth in both 2010 and 2011).

Does the Geithner plan mean the market has now seen its lows? Unlikely – the global downturn in trade and activity is still broadening and deepening, and deleveraging of the financial system still has a long way to run.

But in its relatively narrow but crucial intention of preventing further bank collapses in the United States, the plan might just work, with bank shareholders and taxpayers sharing the pain of the banks’ mistakes.

It is actually quite clever in the balance between getting banks off the hook and providing investors a reason to bid for their assets. The key is that the impact of the US Government’s money is maximised, and private investors stand to make a fortune when the economy recovers.

There are two separate schemes – one for loans and another for mortgage securities.

Under the legacy loans program, according to the examples given by Treasury, the Federal Deposit Insurance Corporation will guarantee debt financing to a gearing of 6-to-1, which means 14.3% will have to come from equity. Treasury will provide half the equity and private investors the other half.

So the Government is effectively financing 93% of the purchase price, with private investors in the driver’s seat, but putting up just 7%. Fund managers like Pimco and Morgan Stanley are already lining up to participate in the program, but obviously it remains to be seen whether they will offer prices high enough to get the “toxic loans” off the banks’ balance sheets.

Under the legacy securities program, the leverage being provided by the Government is much lower – only up to one-to-one, and usually less.

For every $100 a private investment fund can raise in equity capital, the Government will match it dollar for dollar. The Treasury will then lend $100 to this public-private investment fund, and will “consider requests” for up to another $100 in debt.

The share prices of both banks and fund managers have been going up strongly this morning, resulting in 5%-plus rise in the S&P500, which suggests that the market thinks the Government has got the balance about right.

The complaints are either that the Government is subsidising too much or not enough (that the prices paid won’t get the banks to sell, and therefore won’t achieve the result). Paul Krugman in the New York Times says it’s just a rehashed version of the old TARP plan announced by former treasury secretary Henry Paulson in September, which didn’t work then.

Some say the banks need to recognise their losses and just write their assets off. If that means stock and bondholders lose everything and the banks go bust, so be it.

Others say the Government should nationalise the banking system as Sweden did in the early 1990s, and set up a massive “bad bank” workout.

But while that might sound fine in theory, neither of those options is feasible in practice – the first would result in a much deeper recession and a collapse in employment, and the second would result in such colossal Government debt that hyper-inflation would be inevitable.

Timothy Geithner’s plan ingeniously combines government money and private market knowledge in an effort to find the middle course between the two.

At this stage the recession in the US is 15 months old. GDP has contracted by 3% and unemployment has gone up by 4 percentage points.

This makes it almost identical (so far) to the entirety of the recessions in 1982, 1975, 1958, 1954, 1949 and 1924, according to work by the analysts at Citigroup, using data from the National Bureau of Economic Research. In those other recessions, GDP contracted by an average of 3% over 13 months.

The reason the head of the IMF, Dominique Strauss-Kahn, called this one the “great recession” is that every economy in the world, except at this stage China and India, is contracting at once, which makes it quite different to those other five.

But the United States remains the key to ending it and preventing it becoming another Great Depression. And the key to that is stabilising the US financial system. Fiscal stimulus and money printing won’t cut it.

This article first appeared on Business Spectator