Defending the indefensible

I don’t think the latest Geithner plan to create a private/public partnership to buy up to 1 trillion of toxic assets from the Banks represents the zombie solution as described by many leading economists.

I think whether or not you nationalize some Banks makes less difference than is contended, since in my opinion it all boils down to how they are regulated and managed- albeit very poorly in the past. The latest Geithner plan proposes an auction purchase system of the the toxic assets held by banks by investors with up to 97% in non recourse funding whose risk and funding can be as low as 3%. In other words a Hedge Fund bidding 70 cents in the dollar for $100 million of debt securities held by Citicorp would purchase the $70 million dollars of securities but only be on risk for $ 2.1million or 3% of the $70 million dollar security parcel purchased.

These established Funds would be available to investors and 401K superfunds and so on.

The arrangement as I understand can be described as follows:

1. The FDIC (Federal Deposit Insurance Corporation) guarantees 85% of the value of the loans without recourse.
2. The Treasury provides further capital for 80% of the balance(balance is 15% after 85% guarantee by the FDIC )to cover 12% from TARP Funds leaving a balance of only 3%.
3. The balance of 3% represents the capital used from Private Investors (Hedge Funds) who risk losing all their capital (assuming they are unable to hedge their investments by buying credit default swaps) and who bid at auction for parcels of the securities to establish a market.
4. Banks holding the Toxic Assets will sell them to the highest investor Bidders (Hedge Funds)which will then enable eventually a resumption of normal lending.
5. The taxpayer effectively takes on 97% of the risk by virtue of the non recourse loans.

The concerns over taxpayers costs hinges on the economic outlook over the next 3- 4 years and the extent or otherwise of recovery in house prices and the general economy. In the event of a recovery, losses may be minimal, if any, with possible gains but should the reverse occur the consequences will be disastrous to the extent the whole economy collapses. The banking system may be equally badly off with no less in future challenges, but that would also signal even more deep seated economic woes at that time.

However a more pertinent argument is about whether or not you allow the banks to fail or as the case may be to recover of their own volition. Due to the very low funds cost now available (with Fed easing) margins have improved considerably, hence, putting aside additional write downs from prior toxic assets sales and bad debts and assuming economic recovery I would estimate all the write offs could be absorbed within a four year time span. But in the meantime the credit squeeze and all of its misery would continue with the risk of further contraction which clearly politically has become an untenable option.

Hence, if you are in favour politically of a bailout, you cannot avoid risk by nationalization as it involves simply transferring risk from the private sector under government regulation to the government under government regulation.If you are not in favour of bailouts you would argue it is better to do nothing and not risk further taxpayer money, but you cannot have it both ways and assume government nationalization would somehow provide an immediate superior solution.

Furthermore Bank nationalization is both complex and costly and for it to work would entail the need for a broad guarantee of the entire USA banking system obligations which would make people even more unhappy.

I don’t particularly like Geithner's plan but its worth trying. In the meantime it is sensible to enact new legislation to allow a single government regulatory agency( like the FDIC ) to vest with sufficient power, when necessary, to safely dismantle all big financial institutions so as to minimize damage to the financial system and overall economy.