Diamond, Kashyap, and Rajan on the Geithner Plan

University of Chicago Professors Douglas Diamond and Anil Kashyap, whose description of the causes of the financial crisis is the most widely circulated post ever to appear on this blog, are back to explain the Geithner Plan in simple-to-understand terms, along with what they do and don’t like about it.

For this post, they’ve also drafted highly respected Chicago economist Raghuram Rajan, former chief economist at the International Monetary Fund.

Decoding the Geithner Plan
By Douglas Diamond, Anil Kashyap, and Raghuram Rajan
A Guest Post

Timothy Geithner has announced his intention of making a full-scale attack on the nation’s banking problems.

Clearly, the objective of making banks willing to lend again — with them paying due, but not excessive, attention to risks — is the right one. To achieve this, not only do banks have to be confident about their own financial health, they have to feel that there are no more pennies waiting to drop and that the system is stable enough that asset prices will not fall significantly, so that they can start locking their money up in term loans.

“The plan should be evaluated not just on what it proposes, but on what it does not touch.”

The Geithner Plan to stabilize the system should be judged according to whether it meets the test of the four C’s: being comprehensive, clear, cost-effective, and credible.

Geithner’s plan has four elements. First, it seeks to audit banks and measure how much capital they will need, with an offer to invest government money in the preferred stock of banks that cannot raise private capital.

Presumably, the government will close down unviable banks, but we do not know how tough regulators will be. Moreover, the government seems to want to avoid roiling existing shareholders and bond-holders by talking about closure or announcing its intentions about sharing losses, but this creates substantial uncertainty in the market. It is important that this phase of the plan be effected quickly, with some burden-sharing with existing investors where necessary, to restore clarity and reduce costs to the taxpayer.

Second, the plan seeks to buy toxic assets from banks through a public-private partnership, thus freeing banks to raise new capital without new investors being worried about getting saddled with further losses. This is the murkiest part of the plan; there is little trade in these “legacy” assets partly because private investors are unsure about the size of potential losses they will have to bear if they buy these assets, while banks are unwilling to sell at the prices on offer. Investors will want to know what share of the losses the government will bear before they participate. And the government will have to determine what fraction of the upside it will need so that the deal is fair. Too little upside and the taxpayer will end up subsidizing private investors, too much and the government will elicit little private participation.

The public-private partnership does not absolve the government of assessing, pricing, and sharing the risk in these assets, and there is far too little clarity on how this will be done. A comprehensive plan must tackle these issues and show that there are sufficient resources available to resolve the uncertainty. A good first step would be to share reasoning used to determine the size of this program so as to build confidence that the plan can succeed.

Third, Federal Reserve programs to purchase securities issued against packages of loans (such as student loans, auto loans, and commercial real estate) will be expanded from $200 billion to $1 trillion. This will clearly encourage banks to make such loans, because they know they can securitize them; and it can help boost lending, provided there are enough credit-worthy borrowers.

Finally, the plan praises efforts to help home owners; yet there is little in the initial proposal that suggests any dramatic new initiatives. Perhaps this is appropriate, for other than facilitating the restructuring of mortgages when both borrower and lender are willing, many of the extant proposals seem to attempt to postpone the inevitable adjustment of house prices.

The plan should be evaluated not just on what it proposes, but on what it does not touch. For instance, while there have been many calls to impose lending requirements on banks that take public money, such requirements would be crude, and they may create more risk for taxpayers as banks are forced into unwise decisions. The plan takes an intermediate (and appropriately balanced) approach by requiring more transparency about bank actions while not mandating lending. It also takes long-overdue actions — like banning banks that take public money from paying dividends.

As a whole then, the plan takes important steps in the right direction, but it is unclear in critical aspects. We do not know whether this is because the Treasury cannot afford to be too clear, or whether it is because the Treasury still has little idea about what to do. The coming days will tell.

Finally, the plan will need public and political support to be credible. This means that bankers and existing investors should not be seen as benefiting at the expense of the taxpayer, and that all the government investment should start paying off in the not-too-distant future. While the Treasury has resisted the urge to ceremonially sacrifice the bankers, this makes it even more imperative that President Obama‘s political skills be used to sell the plan.

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  1. frankenduf says:

    quit stalling and socialize the banks- it’s the only ethical use of taxpayer money, and it would provide a quicker recovery so that the banks can be bought off again by private investors- Sweden nationalized and their banks recovered- Japan stalled ala the Obama administration and had an economic black hole for a decade

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  2. mfw13 says:

    What I don’t understand is why the government is not trying to attack the fundamental problem, i.e. underwater mortgages.

    Let’s remember that all of these so-called toxic assets that are the root of the banking crisis are not inherently toxic. They are only toxic because the housing market is in a slump and foreclosures are way up. But in a normal housing market, these assets are sound.

    So to me, the government main focus should be on shoring up the housing market. The easiest way to do this would probably be to have the government buy underwater mortgages at full price instead of letting houses go into foreclosure. This would get these “bad loans” off the books of the banks while allowing people to stay in their homes (the government would rent the homes back to their occupants). The government would become a landlord (enter HUD) and eventually would re-sell the houses once the housing market recovers.

    Additionally, the government could try to shore up housing prices by increasing immigration (i.e. increasing demand) and putting a moratorium on new residential housing permits (i.e. restricting supply).

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  3. Shirley says:

    I agree with the first post. Nationalize the banks, let the the greedmeisters who got us into this mess look for a job along with the rest of us.

    When the banks are making money, keep them for as long as needed to repay the taxpayer, and, only AFTER we have been repaid (with interest, mind you) then we sell them back to the private sector, complete with a host of regulations that will make sure the bankers’ interests are aligned with ours.

    Oh, and we as tazpayers make a tidy profit on the new, cleaned-up bank.

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  4. RandFan says:

    I have yet to hear a coherent, effective explanation of why “the banking industry” needs to be “saved.” Banks deal in a commodity: money. They don’t even manufacture it or dig it out of the gound; they just trade in it. If the fast-food industry for some reason or another faced calamity and bankruptcy, would the federal government be as eager to bail those companies out to “promote the general welfare?” Wouldn’t cattle, potatoes, and farmers still exist? Yes, these commodity markets would be disrupted temporarily, but would eventually right themselves. It is increasingly clear that the actions of the Fed, Treasury, and Congress are designed to first help their respective political interests, with whatever is left to “trickle down” to the average person; an amount that will pale in comparison to the eventual price to be paid.

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  5. mises says:

    did you see what happened to sweden’s currency post nationalization? pull up a chart pal.

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  6. Allan Schmid says:

    With respect to toxic or leagacy assets, some portion of these representing the decline in housing prices should be taken off the books of the banks. When a bank lends money it creates new money. The loss is a charge against the bank’s capital by rule of the Federa; Reserve. This rule can be changed in this emergency so that some portion of the unperforming loan can be removed from the books. This does not require any public money to buy these assets at their old, inflated values.
    We should not be bound by rules of the past.

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  7. jfx says:

    “Let’s remember that all of these so-called toxic assets that are the root of the banking crisis are not inherently toxic. They are only toxic because the housing market is in a slump and foreclosures are way up. But in a normal housing market, these assets are sound.” – mfw13

    Sounds like a NYT editorial – lets just reset prices to “high” and then everything should be OK. Except that it isn’t anymore likely than someone today would pay $140 or even $100 for a barrel of oil, a “normal” price not long ago. Causes of the unsustainable housing prices included too much credit (90% to 100% loans), too low interest rates (partly pushed by government monetary policy), and tax policies (mortgage interest deductible from income).

    While we’re at it, I have some shares that I’d love to sell the government at those old “normal” prices too. The bubble burst because the price levels and 10% to 20% annual increases were not sustainable.

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  8. teej says:

    mfw13 – in what way was the bubble of the last 8 years, when these securities were created, a “normal housing market”? As I understand it, these tranched securities were a terrible idea even then, because they were based on people who couldn’t afford to honor their debts. No housing market can correct for that.

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