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.


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


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).



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.


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.


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

Allan Schmid

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.


"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.



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.


Who is it out there unknown behind the scenes behind the curtain against whom the almighty federal government will not act?

To nationalize/socialize the banks (say Swedenishly) would destroy shareholder equity and it seems it is this group which it is within the scope of risk (theirs, not ours) to liquidate in order to salvage the world financial system, but something somewhere, someone somehow stops us from this all-too logical step. It's going on six months now, and still the half-measure two-step remains our only considered dance.

I don't believe in the Bilderberger conspiracies, you know, the European power structures we've heard whispers of since high school thirty years ago, but our government's hesitation to act to reconcile fact with reality leaves me to wonder if the Rothschilds are still, in fact, behind the Earth-throne as they are purported to have been since Acquitane had a Pope.

What gives? Is the powerstructure we think to be in power but a visage of duty-bound clowns, while some sinister plot reigns supreme? Somebody ask somebody who knows and get back to us all. We're wondering out here in Citizenville what gives. And who's taking all our money; talk about a clenched fist.

Chris in Verona, wishing he weren't.



I don't think we should completely nationalize the banks, but we definitely should buy up the bad/faltering ones and run them for the benefit of the taxpayers and borrowers, earning a profit before then eventually selling them back to private industry when they're stable. Simply shoveling money into the black hole of the current industry with little or no assurances or transparency is the heighth of lunacy!

And while underwater mortgages are the "trigger" for this crisis, they are NOT the underlying cause. The true cause is the hemorhaging of good paying, dependable jobs, either offshore or by simple elimination, all done in the quest for short term profits and huge executive bonuses. Low interest rates and easy credit allowed this "cancer" to be masked, much like morphine to a cancer patient, but it eventually outgrew the panacea. Until we provide the majority of Americans -- those NOT in the upper 10% income bracket -- with steady, decent income streams and thus allow our economy to be fueled by a dependable consumer engine, we're simply shoveling sand against the tide.

But in the short term, before the millions of new jobs we need are created, we can begin to turn things around. However this effort should NOT be aimed at the greedy incompetents who are in charge now. We should be aiming the bulk of our relief at homeowners and borrowers who are in danger of foreclosure and/or bankruptcy, and we should be extending and expanding programs like unemployment benefits, and heath care to prevent even more people from falling into those categories. Doing that will restore the needed confidence to the banks and markets. Geithner's plan is bass-ackwards and based on the fully discredited idea of "trickle down economics". We need to restore the health of the bulk of America, not the wealthy few.

Dave Fichter



If the bailout money was used to pay down the mortgages of the American public whose homes have plummeted in value it would serve a dual purpose. The banks would not have to worry about writing off bad assets as the pay-off of the mortgage loans would eliminate the bad debt. The American public would have a lot more money each month to spend without their mortgage payments to worry about. The real property would be free and clear for homeowners to sell at the current market rate and the economic effect would be an immediate injection of cash into the economy. Simple debits and credits accounting and we all win!


A fairly thorough assessment. But two troubling statements jumped out:
First, the authors presume that requiring banks to lend money received from the public will INEVITABLY force banks into unwise lending decisions. Hogwash. Are bank executives instinctively, uncontrollably incompetent at what they do? If so, why give them any money at all? They deserve to be fired and their institutions deserve to fail. Let's save our money for people who can discern between a good loan and a bad one, please, and impose regulations and oversight for the rest.
Secondly, the conclusive paragraph of this article argues that POLITICAL skills are essential to delude the public into supporting the plan EVEN if, in it's details, the plan benefits existing investors at the expense of taxpayers.
What an incredibly corrupt suggestion.


Leslie (#11):

The only flaw in your reasoning is that it makes too much sense and is way too simple. Where is all the tangled verbiage to enable the wealthy and powerful to scurry through the loopholes like rats? But it's a great idea nonetheless!

James Cessna

Sweden's nationalization of banks (1992) worked fairly well for them and has been one of the ideas mentioned as a solution. However, nationalization has the stigmata of third world tactics associated with the term and the adverse polarization of the banking community and investors (bondholders and shareholders would be wiped out). But, we really do not have much choice when confronted with the massive expenditures, and taxpayer risk, required by other plans. We should nationalize our larger banks and the big regional banks that are insolvent, perhaps renaming the process, with some smoke and mirrors, to a more palatable term. This is a much better alternative than partial recapitalization with failure (recurrent recapitalization, etc). We have already fundamentally nationalized AIG, Freddie Mac, Fannie Mae, and to a significant extent, BAC and CitiBank. Nationalization with reorganization and recapitalization is looking more and more attractive, and the risk to taxpayers under this scenario is less than other alternatives.



Why do taxpayers have to buy out the old banks. Why not start new government banks with the bailout money, regulate them properly, then when the economy recovers, let them go private. The bailout money will be the new capital made available to new investment.


The problem would be solved if people could get back to work. Make JOBS, because jobs generate paychecks which pay mortgages, pay credit card debt, buy groceries, generate tax revenue, etc. The creation of one good-paying job can lead to 4 more if the money flows within the economy.

People without jobs cannot take on more credit.


problem: banks paid $100 for $1 asset.

give them $99.
don't have that kinda money?
well, increase inflation. soon $1 will look like $100.

problem solved.


"did you see what happened to sweden's currency post nationalization? pull up a chart pal." - mises

This is a good point. George Soros attacked the Swedish kronor (and the British pound) in late 1992 and caused the kronor to crash (and the banks to fail). The result was the nationalization of the banks by the government, which resulted in a steady strengthening of the kronor in the subsequent years.

The US probably doesn't want the dollar to become too strong since it's partially trying to export it's way out of this recession.


How about a score card on the 4 Cs professors? Grade the plan now and as it evolves. Feel free to give Fs.

All that fat cats are going to learn from the bank bailout plan is "keep taking ridiculous risks, keep screwing up, keep raking up the bonuses based on phony numbers and relax, the US government will never let you perish." It's like raising teens -- sometimes you have to let them bear the consequences -- really bad consequences -- even it also really bad for the family -- in order to change behavior. And anyway, the 'really bad' thing has already happened to our economy -- so why not let the banks sink?


one thing that bothers me is all this effort to get banks 'lending again'.

Isn't this exactly what caused all the problems. They found a way to lend like crazy and off load the risk to unsuspecting investors. 'Most of that lending should not have been going on to begin with.

With all this talk about banks not lending, we haven't heard anything about companies going under because they couldn't borrow money. That has been the mantra for the last 4 months but it doesn't seem to be happening.

We still haven't heard that the credit-default-swaps have been banned or the rating agencies regulated. Hopefully that is to come but you can get the feeling that the status quo is being propped up somehow.