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Rating Geithner's Pitch

A couple thoughts:*

First, as a political speech, which this partly was, I think it was strong. Geithner's challenge was to restore the credibility the Bush administration pissed away with its overly credulous, seat-of-the-pants approach to the banks last fall. Geithner, by conceding the recent failures, by clearly laying out the point of all this (to get credit flowing again to businesses and consumers), by stressing that the far greater risk lies "in gradualism than in aggressive action," and by acknowledging that progress will be "uneven or interrupted," bought himself and the administration some breathing room. 

Second, Geithner's balance sheet stress test idea is critical. One reason private investors are so reluctant to invest in banks, and that most banks are so reluctant to loan money to one another, is the opacity in the system. It's not that everyone's insolvent. It's that we don't know who is and who isn't. And so it's safer to assume everyone's insolvent and not give anyone anything. Shining a light on balance sheets will be painful for those banks that really are insolvent. But it will help us quantify the size of the hole. And it will be hugely helpful to the banks that turn out to be sound. (Right now, they're being unfairly tarred with the assumption that everyone's belly up...)

Third, the upshot of this process will be more capital for banks that turn out to need it, Geithner said. Again, this is absolutely essential. My concern is how far we're willing to go with this. That is, an honest accounting could reveal the need to be well over a trillion dollars (maybe more than two). Are we ready to spend that much? And, if we did, wouldn't it give government effective ownership of a lot of banks, something Treasury wants to avoid?

Fourth, the idea of expanding the Fed's purchase of loans to consumers, students, and small businesses is very sound. When you get a loan to buy, say, a car, the financing company often turns around and sells the loan to another institution, which bundles lots of loans together and ships them to Wall Street, where they get sliced up and sold off as securities. It's this secondary market that makes it possible for a lot of people to get credit, but which has frozen up lately. (Something similar happens with student loans and small business loans.) Geithner is vowing to spend up to $1 trillion in collaboration with the Fed to get it flowing again. (Basically the Fed would be the financial institution that buys up the loans from the financing companies.) That's a very good thing.   

The place I stumble is where most people have stumbled, which is Geithner's proposal to "start a market for the real estate related assets that are at the center of this crisis" through a government-private sector collaboration. The dilemma facing most banks with these assets is that, while they continue to value them on their balance sheets at 80 or 90 cents on the dollar, they're only really worth 30 or 40 cents. Summed up over billions worth of assets, that's a pretty huge deficit.

Suppose a bank bought $100 billion worth of mortgage-backed securities, which it now says are worth $90 billion, but which are really only worth $40 billion. Suppose also that a $50 billion write-down would leave the bank insolvent. In that case, the bank's problem isn't that it can't sell the assets; it's that it can't sell them for nearly enough to avoid insolvency.

While I don't know the details of Geithner's plan, I don't see how you design a proposal that avoids that basic problem. If the public-private entity Geithner is proposing pays the fair value of 40 cents on the dollar, that will leave many banks insolvent. And if it overpays, it could keep them solvent. But then the government will have to kick in a substantial amount of money to support the overpayment. (Certainly no private investor is going to overpay.)

Now, maybe the point of the asset purchases isn't to make the banks solvent, but simply to take the assets off their books--the theory being that merely owning the assets has spooked investors, who would otherwise supply the banks with capital. But I'm skeptical. I don't think the assets per se are spooking investors so much as the banks' tendency to ludicrously overvalue them (which all but guarantees future losses). 

It's entirely possible that I'm missing something, and I'm certainly open to hearing how I might be wrong. But when I think about this in the most fundamental terms, I only see two ways to deal with banks made insolvent by bad assets: 1.) Shut them down. 2.) Give them enough money to make them solvent. We're obviously not going to do the former on a large scale. But I'm pretty hazy on where the money will come from if we go the second route.

*Note: Treasury held a background briefing for reporters after Geithner's speech, which may have clarified some of these questions. I stupidly forgot to sign up for the briefing in advance, though, so I wasn't able to attend it. I promise I won't drop the ball on something like that in the future.

--Noam Scheiber