The Geithner-Summers Plan Is Worse Than You Think

The Geithner-And-Summers Plan (GASP) to buy toxic assets from the banks is rightly scorned as an unnecessary give-away by virtually every independent economist who has looked at it.  Its only friends are the Wall Street firms it is designed to bail out. In an earlier article, one of us (Sachs, FT, March 23) described the systematic overbidding entailed by the proposal.  Others have since made similar calculations, including Joseph Stiglitz (NYT, April 1) and Peyton Young (FT, April 1).  The situation is even worse that it looks, however, since the GASP can be gamed by the banks that own the toxic assets to boost the purchase prices for their bad assets even higher than has been suggested to date.

Suppose that Citibank holds $1 billion face value of toxic assets that will pay $1 billion with 20 percent probability and $200 million with 80 percent.  The market value is $360 million.  The GASP calls on investors to establish a Public-Private Investment Fund (PPIF) to bid for the toxic assets.  For each $1 that a private investor brings in equity to the PPIF, the Treasury will put in another $1, and then the FDIC will leverage the $2 in equity with $12 of non-recourse loans (6-to-1 leverage).

It’s easy to show that a risk-neutral and arms-length PPIF will bid $636 million, financed with an FDIC loan of $545 million, Treasury equity of $45 million, and private equity of $45 million.  (The expected profit to the private investor is one-half of 20 percent of $1 billion minus $636 million, or $45 million.  The private investor therefore has a net expected profit of zero.)  The PPIF overpays by $276 million, which equals the expected loss to the Treasury.  The ultimate beneficiaries are Citibank’s shareholders and bondholders, whose net worth rises by $276 million at the taxpayers’ expense.

But the outcome could be even more outrageous than this.  Citibank can arrange to receive even more than $636 million for its assets by setting up its own Citibank PPIF (CPPIF) to bid for its bad assets.  The CPPIF will bid the full $1 billion in face value for its own toxic assets!

Too see this, note that on a bid of $1 billion by the CPPIF, Citibank would finance $71 million in equity of the CPPIF, the Treasury would add another $71 million in equity, and the FDIC would add $857 million in loans to the CPPIF.  The CPPIF will either break even (20 percent of the time), or go bankrupt (80 percent of the time).  The CPPIF is therefore a washout – with no chance of profits, yet also zero liability.

On the other hand, Citibank gets a sure boost of $1 billion minus $360 million, or $640 million in net worth, for which it pays $71 million.  Citibank’s gain from the CPPIF’s overbidding is $569 million, which exactly equals the taxpayer’s expected loss that is incurred by the FDIC loan and Treasury equity.  The real icing on the cake is that Citibank still ends up owning the toxic assets even after the assets are “auctioned,” but this time in an off-balance-sheet structured investment vehicle called the CPPIF.  The toxic assets revert to the FDIC when the CPPIF goes bankrupt.

It’s possible that some fine print of the GASP would try to preclude explicit hyper-self-dealing of the type just described.  But when there is free money on the ground, Wall Street will figure out ways to pick it up.   For example, Citibank could arrange to overpay Bank of America for some unrelated securities in exchange for having Bank of America do its bidding at the auction. Indeed, Citibank, Bank of America, and other toxic asset owners might join together in a consortium to finance an “arms-length” PPIF on favorable terms with the proviso that the PPIF bid for the toxic assets of the consortium. BusinessWeek has reported that “Administration officials confirm Treasury may allow such seller financing ( http://www.businessweek.com/magazine/content/09_15/b4126020226641_page_2.htm <http://www.businessweek.com/magazine/content/09_15/b4126020226641_page_2.htm> ).”

The sad part of all of this is that there are excellent alternatives to the GASP that are vastly more transparent and cheaper for the taxpayers.  The best of these involves separating a weak bank like Citibank into a  “Good Citibank” that holds Citibank’s good assets and its deposits, and a “Bad Citibank” that holds the toxic assets, the bondholder debt, and the shares of the Good Citibank.  The Good Citibank returns quickly to normal business, while the Bad Citibank is eventually liquidated under bankruptcy, with the bondholders and other uninsured claimants getting partial repayments depending on their priority under bankruptcy.  The best description of this approach is by Jeremy Bulow and Paul Klemperer (http://voxeu.org/index.php?q=node/3320).

Over time, we should consider more fundamental reforms, including the idea of establishing Limited Purpose Banking (http://people.bu.edu/kotlikof/newweb/The%20Financial%20Fix%20April%202009.pdf), in which the liquidity services provided by banks are undertaken by institutions with 100-percent reserve requirements, and which, therefore, are immune from runs, panics, and reckless gambles.  It would be absurd and self-defeating to bear the enormous social costs of the current financial crisis only to return to the same kind of flawed banking institutions that got us into this mess.

The Geithner-and-Summers Plan should be scrapped.  President Obama should ask his advisors to canvas the economics and legal community to hear the much better ideas that are in wide circulation.

Laurence J. Kotlikoff is professor of economics at Boston University.  Jeffrey Sachs is professor of economics at Columbia University and Director of the Earth Institute.

8 Responses to "The Geithner-Summers Plan Is Worse Than You Think"

  1. Guest   April 6, 2009 at 12:36 pm

    “The sad part of all of this is that there are excellent alternatives to the GASP that are vastly more transparent and cheaper for the taxpayers.” There in lies the problem for the policy makers…They are beholden to Wall Street. To fleece the taxpayers, they need to cloak their policy actions. Thank you for shining daylight onto GASP and Obama’s Plan.

  2. Guest   April 6, 2009 at 3:08 pm

    All this is meaningless flailing. No one CARES how much is stolen as long as SUBURBIA IS EMPLOYED. This is the constant failure of commentators outside the political system: they ignore politics.If suburbia thinks it’s working, it’s policy. America is suburbia and ONLY suburbia. Why is there a “drug war?” Because suburbia thinks it works. Think I’m oversimplifying? Look at who pollsters poll. Look at who the PARTIES poll. Suburbia votes–the other slobs don’t. Is there any popular support for your approach? Show me some, show me the polls.You’re quite content stroking your own egos–actually, it doesn’t matter a bit to you whether your plan is adopted or not. It’s just vanity on your part. Pathetic.What will change the equation? Suburbia losing its jobs. NOTHING else. So before you waste more effort doing these politically naive calculations, wait until the jobless rate for those with a Bachelor’s degree or higher, goes to 40%. Until that happens, NOTHING will change.Cheers,John Ryskamp

  3. NFrazier   April 6, 2009 at 3:47 pm

    Thank goodness for freedom of speech and for people who use their intelligence in a noble manner. Let us hope that congress and the Obama administration follow their example.

  4. NFrazier   April 6, 2009 at 4:56 pm

    Here may be the political-economic context of the GASP:Deflation – Qualitative easing – Propping up excess supply – Collection of debt* associated with that excess supply – Deflation…This process can go on forever if inflation and the yield curve drop to 0%, since government debt doesn’t need to be serviced under such circumstances. In fact, the more aggressive the stimulus, the more the above process breaks the policy tools.The Fed is mandated to continue this process. The Treasury* doesn’t seem to have a problem with it. Either the democrats in congress don’t understand that one doesn’t extinguish a fire with gasoline or they like the idea of being able to spend forever.Notice the best way to make money under such circumstances might be to open a retail bank* and collect a portfolio of fixed interest rate loans. Assuming the stagnation in the US leads to political and economic problems abroad, money may continue to flow into the US to prop up its protected excess supply as well.

  5. devils advocate   April 6, 2009 at 7:26 pm

    after reading your post, underneath the text, I sense not so much outrage as the sub-conscious fear lurking in our heart of hearts:what will we do if the GASP Plan does not “work”?

    • devils advocate   April 6, 2009 at 7:30 pm

      p.s. to Lawrence:I keep re-reading your bookand wondering how will “we the people”be able to take care of the baby boomers going to go on Medicare startingin just two years?this one program is enough to break the piggy bank

  6. Anonymous   April 6, 2009 at 11:38 pm

    Quite a few prominent economists have now made the point that the PPIP represents a fat kiss for the banks, a steal for the investors and a very bad deal for taxpayers. The mathematical analysis provided to illustrate the case does not make sense to me. Here’s my hypothetical. Perhaps someone can help.Suppose that the FDIC as seller sets a minimum bid at $646 million for a portfolio with a face amount of $1 billion. The seller will retain a payment preference of $545 million at some interest rate and share any remaining recovery with the purchaser 50/50. You can deduce from the minimum bid and the terms of the sale that the seller believes that the probability of collecting $91 million is 100% and that an investor would should be willing to pay $45.5 million for the right to half that amount.As the investment manager, you would be trying to figure out how much you would have to collect over some period of time to cover your costs of collection and make an internal rate of return of say 20% on your cash outlays.One thing for sure is that you are going to have to collect substantially more than 65.6% of the $1 billion face amount implied by the $646 million minimum bid to break even.So far as you can see, based on examination of the loan files and looking into your crystal ball, there is a 20% probability that $1 billion can be collected ($200 million–but when?) and an 80% probability that at least $200 million will be collected ($160 million–but, again, when?). Mathematically, without the leverage provided by the seller, these probabilities imply that the portfolio has a value of $360 million.If the government wants to induce me into buying this, I might have a bit over $25 million to invest for a 50% profit share of anything I can collect over $309 million, if it is really easy to work and I can get my money back in a year.

  7. Anonymous   April 7, 2009 at 1:31 am

    We keep the situation as it is now. The banks keep on having losses until their capital is wiped out. The FDIC puts them in receivership. All that this means is that it can keep them running without capital. If the FDIC thinks that this is a bigger bite that they can chew, it can keep the entire staff or replace some. If recurring losses mean that they have to reduce lending the Fed. can lend the banks money to keep their lending at desired levels.The toxic assets don’t need to be bought now. Better to hold them until the economy recuperates. It took about four years for the RTC to process the bad assets from the Savings and Loans.If we want to “save the banks because the provide the oil that makes the economy run” then we