The Treasury’s Financial Stability Plan

Here’s my two cents on the latest two trillion.

Treasury Secretary Timothy Geithner began his remarks to the Senate Banking Committee this morning as follows:

To get credit flowing again, to restore confidence in our markets, and restore the faith of the American people, we have proposed a fundamental reshaping of the government’s program to repair the financial system.

It all begins with transparency. We propose to establish a new framework of oversight and governance of all aspects of our Financial Stability Plan. The American people will be able to see where their tax dollars are going and the return on their government’s investment. They will be able to see whether the conditions placed on banks and institutions are being met and enforced. They will be able to see whether boards of directors are being responsible with taxpayer dollars and how they’re compensating their executives. And they will be able to see how these actions are impacting the overall flow of lending and the cost of borrowing.

To which I responded, Amen! And Amen! And I continued reading:

These new requirements, which will be available on a new website FinancialStability.gov, will give the American people the transparency they deserve.

So I surfed to that site, where I read:

This site is coming soon.

Hmmm. Going back to Geithner’s statement:

Second, we are going to bring together the government agencies with authority over our nation’s major banks and initiate a more consistent, realistic, and forward looking assessment about the risk on balance sheets. We’re calling it a financial “stress test.” We want banks’ balance sheets cleaner, and stronger. And we are going to help this process by providing a new program of capital support for those institutions that need it.

OK, so what do we do if we discover that an institution’s balance sheet is, like, stressed?

Institutions that need additional capital will be able to access a new funding mechanism that uses money from the Treasury as a bridge to private capital. The capital will come with conditions to help ensure that every dollar of assistance is used to generate a level of lending greater than what would have been possible in the absence of government support.

Oh, dear. We obviously don’t have clear details of the plan, only the concept, but it sounds to me like the wrong concept. As I’ve argued before, there basically are five parties who might be asked to absorb the losses on existing assets, namely, stockholders, creditors, managers, employees, and the taxpayers. My favored concept is, we use player 5 to get as much leverage as possible out of the first 4. It appears that the Treasury’s concept is instead a continuation of Plan A, namely, hope that if we hold on tight and keep the ship from sinking long enough, everything will turn out OK.

And maybe it will. But if I were in Geithner’s position, what I would be asking for immediately is legislative authority, where needed, to crack heads and make the tough decisions necessary to turn the financial system over to good banks rather than the walking dead.

But let’s hand the microphone back to the Treasury Secretary:

Third, together with the Fed, the FDIC, and the private sector, we propose the establishment of a Public-Private Investment Fund. This program will provide government capital and government financing to help leverage private capital and get private markets working again. This fund will be targeted to the legacy loans and assets that are now burdening many financial institutions.

I’m even less clear as to exactly how that’s going to work. Perhaps the statement released separately by the Federal Reserve fills in some details:

The Federal Reserve Board on Tuesday announced that it is prepared to undertake a substantial expansion of the Term Asset-Backed Securities Loan Facility (TALF). The expansion could increase the size of the TALF to as much as $1 trillion and could broaden the eligible collateral to encompass other types of newly issued AAA-rated asset-backed securities, such as commercial mortgage-backed securities, private-label residential mortgage-backed securities, and other asset-backed securities. An expansion of the TALF would be supported by the provision by the Treasury of additional funds from the Troubled Asset Relief Program.

Here’s what I don’t like about this. The Treasury is acting as though there’s a sixth party who can step into the funding gap here in the form of the Federal Reserve. Once again, that will be OK if Plan A works out, that is, if things go well enough that the Fed’s losses on any assets acquired and loans extended are limited to the TARP funds already authorized. But if not, we’re back to the same calculation– the Treasury must borrow (if foreigners remain willing) and taxpayers must ultimately pay the bill. Either that, or the Fed just covers the bill by printing money for the whole thing.

There’s a very real danger in going as far down the road of Fed-Treasury cooperation as we already have. The Administration starts to think of the Federal Reserve as another cookie jar it can draw on to cover all these pesky bills which, if Plan A fails, we’ll find are impossible to pay by any means other than monetization and a huge inflation.

And fear of that, if it catches fire, would be a far more destabilizing event than a controlled receivership for a few more big financial institutions.

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