Geithner-Summers Plan : Jeffrey Sachs

The Geithner-Summers Plan Is Even Worse Than We Thought

by Jeffrey Sachs

Director of the Earth Institute, Economics Professor,
Columbia University



Two weeks ago, I posted an article showing how the
Geithner-Summers banking plan could potentially and
unnecessarily transfer hundreds of billions of dollars
of wealth from taxpayers to banks. The same basic
arithmetic was later described by Joseph Stiglitz in
the New York Times (April 1) and by Peyton Young in the
Financial Times (April 1). In fact, the situation is
even potentially more disastrous than we wrote.
Insiders can easily game the system created by Geithner
and Summers to cost up to a trillion dollars or more to
the taxpayers.

Here's how. Consider a toxic asset held by Citibank
with a face value of $1 million, but with zero
probability of any payout and therefore with a zero
market value. An outside bidder would not pay anything
for such an asset. All of the previous articles
consider the case of true outside bidders.

Read the entire piece at the Huffington Post.
Cynics believe that the Geithner-Summers Plan is
exactly what it seems: a naked grab of taxpayer money
for Wall Street interests. Geithner and Summers argue
that it's the least bad approach to a messy situation,
in which we need to restore banking functions but don't
have any perfect ways to do that. If they are serious
about their justification, let them come forward to
confront their critics and to explain to the American
people why the other proposals are not being pursued.

Let them explain the hidden and not-so-hidden risks to
the American taxpayer of the plan that they have put
forward. Let them explain why they are so intent on
saving the banks' bondholders, even the long-term
unsecured creditors who clearly knew they were taking
market risks in buying Citibank bonds. Let them work
with their critics to fashion a less risky and less
costly plan. So far Geithner and Summers tell us that
their plan is the only option, but without a word of
further explanation as to why.

The AIG Debacle

The AIG Saga: A Brief Primer
By Dean Baker

The awarding of $165 million in bonuses to AIG executives has dominated the news in the last week. There has been widespread outrage over the idea that taxpayers' dollars are being used to reward the people who effectively bankrupted AIG and cost the government more than $160 billion in bailout funds to meet the company's obligations. This primer addresses some of the issues raised by both the bonuses and the much larger sum going toward the AIG bailout.
The Bonuses: What Did They Know and When Did They Know It?
One of the silliest distractions in the AIG saga has been the various accounts of when AIG told Treasury Secretary Geithner of the bonuses and when Geithner passed the information along to President Obama. This discussion is silly because Geithner almost certainly knew of the bonuses ever since the initial takeover on September 15th. He just didn't think they were important.

Geithner was the chair of the New York Fed at the time of the original takeover. In that capacity, he was the person directly overseeing the takeover. As the chairman of the New York Fed, Mr. Geithner was undoubtedly familiar with the Wall Street culture and knew that financial firms paid out large bonuses each year to their most-valued employees. Since he did not issue any directives to AIG telling them not to pay bonuses, it was reasonable to expect that AIG would do so, just like it always did.

In other words, Geithner had every reason to believe that AIG would continue to pay out bonuses even after it was bailed out by the government, because he did not tell it stop paying bonuses. He may not have considered this issue important until the last week. And, he may not have known the exact size and the structure of the bonuses, but for all practical purposes he has known for six months that AIG would be issuing million dollar bonuses to certain employees, in spite of the fact that it was dependent on massive infusions of government money to stay alive.
Should the Government Have Gotten Something in Return for Giving Tens of Billions to the Banks?
When the government lent hundreds of billions of dollars to the banks through TARP, it got preferred shares of stock in return, in addition to placing conditions on the banks' conduct. By contrast, the government received absolutely nothing for the tens of billions of dollars that it passed on to the banks through AIG. It may have been desirable to ensure that AIG's defaults did not lead to the collapse of the major banks that were its counterparties, but this could have been accomplished by directly giving these banks capital through TARP or some equivalent mechanism. There is no obvious reason why it was necessary to give the money through AIG without getting anything in return.

It is worth noting that if the government had instead lent the AIG money to the banks through TARP, and under similar conditions, it would own an even larger share of these banks. Obviously the banks prefer that the money instead pass through AIG without conditions, but there is no reason that the taxpayers should prefer this route.

It is also worth noting that several of the recipients of AIG money were foreign banks. While the public has an interest in the stability of the world economy, which means preventing major foreign banks from going bankrupt, there is no obvious reason that American taxpayers should be forced to bail out foreign banks of wealthy countries. It is possible that there is some quid pro quo under which foreign governments are bailing out U.S. banks on losses suffered in their countries, but there has been no public acknowledgement of such an arrangement.

There is a possible alternative explanation. The government may have made these payments in order to preserve the international reputation of the U.S. financial industry. If that is the case, then this is a rather expensive subsidy to the financial industry. To date there has been no explanation as to the reason for making these payments.

What to do about the banks?

And this from the New York Times.
JANUARY 21, 2009, 4:00 PM
Should Obama Seize Citigroup?

By ERIC ETHERIDGE
This is probably not a news story that a new president wants to read on his first full day in office. Bloomberg.com reports:

U.S. financial losses from the credit crisis may reach $3.6 trillion, suggesting the banking system is “effectively insolvent,” said New York University Professor Nouriel Roubini, who predicted last year’s economic crisis.

“I’ve found that credit losses could peak at a level of $3.6 trillion for U.S. institutions, half of them by banks and broker dealers,” Roubini said at a conference in Dubai today. “If that’s true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis.”

Last week’s bad news from Citigroup and Bank of America had already prompted a round-robin discussion in the blogosphere on the wisdom of nationalization. With tongue somewhat in cheek, John Quiggin blogged at Crooked Timber on Monday:
All reasonable commentators now agree that nationalisation of big banks like Citigroup, Bank of America and Royal Bank of Scotland must take place soon, explicitly or otherwise. As I said at just before the second (failed) Citigroup bailout, banks like Citi are not only too big to fail, they’re too big to rescue with any of the half-measures that have been tried so far.

Others were wary of this solution: At his New Yorker blog, The Balance Sheet, James Surowiecki wrote the same day, “I think that as the ‘nationalize now’ meme has taken hold in the blogosphere, people are talking about nationalization ‘awfully casually.’ . . . [T]he idea that most of Barack Obama’s Presidency will be spent presiding over a government-run banking system is a daunting thought.”

And at Marginal Revolution, Tyler Cowen listed his concerns about how a nationalization strategy would play out:

How many years of profits are needed to create the cushion of capital which is required for re-privatization? And how many years of government ownership will be needed to generate that many years of profits? Will banks owned by the government be allowed to pursue profits, rather than lending to troubled industries in the districts of influential Congressmen? Or will government just stick money in the bank and hope they have thereby created a sound enterprise?

Quiggin’s argument is that current rescue efforts — especially including leaving current bank managers in place — simply won’t work. Blogging today in response to Surowiecki and others, Quiggin writes:

Financial restructuring is going to be a huge challenge, involving both a radical redesign of national regulations and the construction of an almost completely new global financial architecture. To attempt this task while leaving the banks under the control of discredited managers nominally responsible to shareholders whose equity has, in the absence of massive transfers from taxpayers, been wiped out by bad debts, seems like doing live electrical work while wearing a blindfold and standing in a pool of water.

In Britain, where the banks and the pound are collapsing, and the government announced its new, just-short-of-nationalization rescue plan on Monday, Financial Times blogger Willem Buiter is leading the charge for going all the way.

Yesterday he laid out his thinking in a long post, which began with a comparison of the recent banking excesses in Iceland and the U.K.:

Both countries allowed the unbridled growth of banks that became too large to fail. In the case of Iceland, the banks also became too large to rescue. In the UK, the jury is still out on the ‘too large to rescue’ issue, but I have serious and growing concerns. Incrementally, the British authorities have guaranteed or insured ever-growing shares of the balance sheets of the UK banks. And these balance sheets are massive. RBS, at the end of June 2008 had a balance sheet of just under two trillion pounds. The pro forma figure ws £1,730 bn, the statutory figure £1,948 (don’t ask). For reference, UK GDP is around £1,500 bn. Equity was £67 bn pro forma and £ 104bn statutory, respectively, giving leverage ratios of 25.8 (pro forma) and 18.7 (statutory), respectively.

With a 25 percent leverage ratio, a four percent decline in the value of your assets wipes out your equity. What were they thinking? The fact that Deutsche Bank used to have a leverage ratio of 40 and is now proud to have brought it down to just below 34 is really not a good excuse.

Buiter goes on to argue that the near-nationalization rescue plans will only make things worse:

In the name of preventing a collapse of the UK banking system, we are witnessing the socialisation — at first gradual, but now quite rapid — of all balance sheet risk of the UK banks by the UK government. This is risky and, in my view, unwise. The manner in which it is done also seems designed to maximise moral hazard. The good news is that it is unnecessary for restoring and maintaining the flow of new credit in the the British economy. . .

My belief that the UK government should take over all UK high street banks (on a temporary basis) is based on the simplification this would provide as regards the governance of these institutions under extreme circumstances, when private ownership and governance have clearly failed, and on its positive effect on incentives for future bank behaviour (’moral hazard). When the public interest and the interests of the existing private shareholders and the incumbent managers and boards of directors diverge as manifestly as they do in this crisis, the sensible thing to do is to buy out the existing shareholders (as cheaply as possible). That way the failed and failing management and boards can be restructured (fired without golden parachutes) and the new owner can insist on and enforce an open, verifiable valuation of toxic and dodgy assets, on and off the balance sheet of the bank.

He then lays out his four-point plan:

(1) Take into complete state ownership all UK high street banks. This has to be mandatory, even for the banks that still like to think of themselves as solvent.

(2) Fire the existing top management and boards, without golden or even leaden parachutes, except those hired/appointed since September 2007.

(3) Don’t issue any more guarantees on or insurance for existing assets - regardless of whether they are toxic, dodgy or merely doubtful. Issue guarantees/insurance only on new lending, new securities issues etc. A simple rule: guarantee the new flows, not the old stocks. This will reduce the exposure of the government to credit risk without affecting the incentives for new lending.

(4) Transfer all toxic assets and dodgy assets from the balance sheets of the now state-owned banks (or from wherever they may have been parked by these banks) to a new ‘bad bank’. If possible, pay nothing for these toxic and dodgy assets. Since the state owns both the high-street banks (I won’t call them ‘good’ banks) and the bad bank, the valuation does not matter.

Back in the States, watching Tim Geithner’s confirmation hearing today, Kevin Drum seizes on this remark by the soon-to-be Treasury Secretary:

The tragic history of financial crises is a history of failures by governments to act with the speed and force commensurate with the severity of the crisis. If our policy response is tentative and incrementalist … then we risk greater damage to living standards, to the economy’s productive potential, and to the fabric of our financial system … In a crisis of this magnitude, the most prudent course is the most forceful course.

Drum’s conclusion?

Nationalization fans should rejoice at hearing this. More and more, that includes me, by the way. The news out of Britain is beyond grim right now, and [throughout] this financial crisis the U.S. has never been more than a couple of months behind the UK. If that stays the case, nationalization of at least a couple of big banks will hardly even be a debatable option a few weeks from now.