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Toxic Asset Plan: Heads I Win, Tails You Lose

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Wednesday, 25 Mar 2009 02:09 PM Current | Bio | Archive

Treasury Secretary Tim Geithner's plan for the banks' toxic assets is, in retrospect, probably the single biggest policy error committed in this crisis because it deliberately fails to address the problem of an undercapitalized banking sector.

That doesn't mean the program couldn't succeed, but it will do it on its own limited terms whereby it will create an "artificial" liquid market for bad assets. Unfortunately, this will turn out to be another expensive scheme at the American taxpayer's expense that won't do the job. Geithner's public-private scheme to buy toxic assets at inflated prices is "in expected value terms" a hidden subsidy to bank shareholders paid for by U.S. taxpayers.

Let me explain. If the toxic assets turn out to be good investments, there is no transfer of wealth. But if they turn out to be bad loans for the FDIC, the taxpayer will be on the hook for several hundreds of billions while the private investors walk away.

Here's the balance sheet of the private guys that will buy the toxic assets: For every $100 of toxic assets that the private investors buy from the banks, the FDIC will provide non-recourse loans at low interest rates up to $85.70 (of the $100) and the Treasury and private investors will each put in just $7.14 in equity to cover the balance.

In understandable English, this means that if the purchased toxic assets fall in value below the amount of the FDIC non-recourse loans, the private investors will default on the loans, and the FDIC will end up holding the toxic assets. Now, there is serious risk because of the massive implicit subsidy that is provided in the FDIC non-recourse loans. Private investors will carry extremely low proportional risk and could easily bid up substantially above the actual market value of these toxic assets.

You don't have to be a rocket scientist to see that the FDIC, and through it the American taxpayer, takes on serious risk of massive default on its loans to these private investors. Honestly, I don't think most American taxpayers know the FDIC is giving a "heads you win, tails I lose" offer to these private investors.

Also interesting: Yesterday, during an audience discussion at The Wall Street Journal's Future of Finance Initiative, President Barack Obama's chief outside adviser Paul Volcker made two remarks that shouldn't be overlooked by the investor.

First, on the current state of the U.S. economy he said: "We're in a government-dependent financial system; I never thought I would live to see the day. … We've got to fight to get away from that."

Second, Volcker showed his real concern is a reemergence of inflation and said it makes him a "little nervous" when the Fed talks about an inflation rate that is conducive to recovery: "I don't know what 'the amount of inflation that's conducive to recovery' would be appropriate. I'd much rather they say that they want to maintain stability in the currency, which is conducive to confidence and recovery."

Additional currency and trade notes:

United States: President Barack Obama said: "I don't believe that there's a need for a global currency." Meanwhile, Treasury Secretary Timothy Geithner was asked: "Would you categorically renounce the United States moving away from the dollar and going to a global currency as suggested this morning by China and also by Russia, Mr. Secretary?" to which he replied: "I would, yes."

Japan: Exports fell a record 49.4 percent year-on-year in February, the largest drop since 1957, while imports slid 43.0 percent. This saw the trade balance swing into positive territory for the first time in five months. Shipments to the United States and Europe also fell at record rates, down 58 percent and 55 percent respectively, although the pace of decline in exports to China narrowed for the first time in seven months, falling 39.7 percent compared with down 45.2 percent in January.

Bank of Japan Deputy Governor Hirohide Yamaguchi said: "Japan, unlike the U.S. and Europe, isn't facing the real threat of bank failures or bank rescues through public fund injections. … But with the economy expected to continue worsening in the near term, Japanese banks' business and their ability to take risks could gradually weaken, making them less able to lend. We need to be mindful of such a possibility."

China: People's Bank of China advisory committee member Fan Gang said: "Before the economy bottoms out, it has to bottom. I believe it has bottomed, with the stimulus package and signs of recovery in some industries." Asked about further rate cuts, he said: "I don't think anybody would rule it out. But it depends on China's liquidity, how China's recovery takes place, and how the stimulus package works out."

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HansParisis
Treasury Secretary Tim Geithner's plan for the banks' toxic assets is, in retrospect, probably the single biggest policy error committed in this crisis because it deliberately fails to address the problem of an undercapitalized banking sector. That doesn't mean the program...
toxic,asset,plan
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2009-09-25
Wednesday, 25 Mar 2009 02:09 PM
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