Stiglitz: Obama’s Ersatz Capitalism

Joseph Stiglitz is not a fan of the Geithner bank bailout plan:

Obama’s Ersatz Capitalism, by Joseph E. Stiglitz, Commentary, NY Times: The Obama administration’s $500 billion or more proposal to deal with America’s ailing banks … is based on letting the market determine the prices of the banks’ “toxic assets”… The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.

The two have little to do with each other. The government plan in effect involves insuring almost all losses. … This is exactly the same as being given an option. …

Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership! …

But Americans are likely to lose even more … because of an effect called adverse selection. The banks get to choose the loans and securities that they want to sell. They will want to sell the worst assets, and especially the assets … the market … is willing to pay too much for…But the market is likely to recognize this, which will drive down the price… Only the government’s picking up enough of the losses overcomes this “adverse selection” effect. …

The main problem is not a lack of liquidity. … The real issue is that the banks made bad loans… They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.

Some Americans are afraid that the government might temporarily “nationalize” the banks… What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. …

So what is the appeal of a proposal like this? Perhaps it’s the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

But we are already suffering from a crisis of confidence. When the high costs of the administration’s plan become apparent, confidence will be eroded further. At that point the task of recreating a vibrant financial sector, and resuscitating the economy, will be even harder.


Originally published at the Economist’s View and reproduced here with the author’s permission.

4 Responses to "Stiglitz: Obama’s Ersatz Capitalism"

  1. rfreud   April 1, 2009 at 8:19 pm

    In his NY Times op-ed today, Joseph Stiglitz’ perspective on the Treasury’s Public-Private Investment Partnership progam was off the mark. Yes, it will be a terrible and unfair deal for taxpayers, as he describes it, but in fact the taxpayer is anyway already in line for huge losses on the disposition of the junkyard of assets that have already been acquired in the course of FDIC bank seizures since this crisis began. There will be more. The FDIC has already gone to Congress for an appropriation of hundreds of billions to fund its foreseeable needs. Banks holding bad assets already have a put to the taxpayer by virtue of FDIC deposit insurance if not the myriad of new initiatives promulgated by the Fed and Treasury to prevent systemic failure and unfreeze credit markets.As with bank-owned foreclosed properties, anyone buying the FDIC’s junk will expect below market pricing. People remember the hefty fortunes that were made picking over the garbage that accumulated at the Resolution Trust Corporation. Even before Geithner’s PPIP announcement last week, numerous private equity-backed vulture funds were forming up.I worked as a consultant to a failed S&L in Federal conservatorship in the days prior to the RTC. Almost daily we received proposals from professional asset managers asking to be paid to take troubled assets off our books. In one memorable instance, in lieu of a foreclosure, the regulatory authorities ultimately in charge mandated that a debtor be given a sweetheart loan modification arranged in Congress, which was happy to do anything that saved spending a few million dollars to cover the loss content.Dr. Steiglitz’ mathematical illustrations of the benefits accruing to buyers and sellers thanks to PPIP leverage overlook the difficulty of assessing probable recovery rates and timing, always a problem with adversely selected assets and especially so in a moment characterized by unprecedented worldwide uncertainty as to economic growth, unemployment, tangible asset values and the consequences of innovative fiscal and monetary policies. Buyers will be wary. Even with generous leverage and low prices, odds of winning have to be much better than a 50/50 toss of the coin.Banks, moreover, will be unwilling sellers except under duress or regulatory pressure. Otherwise, in the imaginary case of a financial institution with superabundant capital and staying power, there would be no reason for a bank levered 20 to 1 or more with FDIC insured deposits to transfer its recovery upsides on marked down assets to a PPIP entity levered, as under the Legacy Loan Program, with non-recourse government loans at just six to one.Mathematically, a bank that enjoys a 5% profit margin on lending with 20:1 leverage has to deploy twenty dollars in new loans in order to recover one dollar of capital lost on bad loans in one year. Opportunities for this kind of exuberant high margin loan growth are not on the horizon. PPIP cannot in itself restore the health of banks that have suffered significant capital impairments.Realistically, PPIP must be understood as an additional, pre-emptive mechanism for providing liquidity to banks. To the extent that it lubricates the secondary market for distressed bank loans, it will be most beneficial to financial institutions that can absorb a realized loss. To the FDIC, it may prove to be quite useful as a pre-surgical treatment in preparation for a seizure or nationalization because it will help the FDIC manage the timing of the takeover and reduce somewhat the size and scope of tasks to be managed in the instant of takeover.The FDIC’s nationalization of Continental Illinois bank, cited by Stiglitz, was, in 1984, the seventh largest bank in the country and first too-big-to-fail takeover. It took fully seven years to resolve. There is no conclusive evidence that the systemic damage caused by this approach to Conti’s failure was less than it would have been in a normal seizure and rapid liquidation.Conti was a peanut compared to the gorillas that have to be caged today.Wachovia, cited by Stiglitz as an example of the FDIC’s efficiency, was snatched from a government-assisted merger with Citigroup when Wells Fargo presented an overbid without cost to the taxpayer. It remains to be seen if Wells can successfully digest the bigger bank it bought without assistance.Bank of America, which absorbed Countrywide and Merrill, subsequently needed government help and, to judge by its stock price, looks nearly as shaky as Citigroup, which has already been partly nationalized.Citigroup, which has a small FDIC-insured deposit base and a huge international footprint, represents systemic risk in large print. In just about everywhere in the world, Citibank, along with a handful of other multi-national corporations, represents the face of the projection of American power. Nationalized or not, its problems defy an easy fix.Seen in this way, PPIP is a fairly modest initiative that might very well serve the interests of the taxpayer by helping to keep problem financial institutions on life support until we are better prepared to deal with the consequences of their resolution.

  2. Guest   April 2, 2009 at 9:38 am

    Stiglitz is right. Banks made bad loans – loans to companies and individuals who now cannot repay them. But the banks were not the only ones to do so. Pension and retirement funds, city and state governments, workers and widows all did the same thing. And for the same reasons – they were greedy and stupid and didn’t, or couldn’t, do due diligence.How is nationalization a cure for these errors? All it will do is replace one set of fools and crooks with another with even bigger faults and less experience. The lost money will still be gone, new money will still have to come from the taxpayers, the rich will still be smarter and stronger than the poor.

  3. Lincoln Stoller   April 3, 2009 at 11:33 am

    Stiglitz and above commentators ignore the possibility of the banks, through opaque intermediaries, acting both as the seller and buyer, using Federal money as the “private” contribution and bidding up the price of the “toxic” assets through false auctions. In this case there is no upper price limit, the public bears ALL the cost, ALL the risk, for 7.5% of the profit. See a simple “chalk board” explanation at http://www.youtube.com/watch?v=n-arbfLTCtI

  4. ReformerRay   April 3, 2009 at 1:30 pm

    A lot of smart people have discussed the issue of what to do about the credit default swaps that guarnatee payment if a loan defaults. No one has come up with a way to eliminate these contracts without paying near face value for them. Why is that? Why can’t the Federal govrnment just refuse to allow its money to be used to pay off these contraacts? The Federal government did not “take on” the responsibility for paying t hese contracts wh en they provided money to keep banks and AIG alive.The argument that the collapse of AIG and Citi group will bring down other financial institutions has no resonance to me. WE WANT THE MEGA BANKS TO BE OUT OF BUSINESS!!! Smaller banks without the toxic assets should be the aim of the Federal government.David Brooks says banks are getting larger rathr than smaller. That is because all the assets and liabilities of the failed bank are transferred to the new bank. The proper response to a bank or insurance firm failure in this environment is to split the assets and liabilities among several firms AND REFUSE TO ALLOT CREDIT DEFAULT SWAPS AND OTHER CONTRACTS MADE IN THE SHADOW BANKING SYSTEM TO ANY EXISTING BANK. These contracts must be settled with the assets that exist in the failed banks.