Obama’s bank plan could rob the taxpayer

The Geithner-Summers plan, officially called the public/private investment programme, is a thinly veiled attempt to transfer up to hundreds of billions of dollars of US taxpayer funds to the commercial banks, by buying toxic assets from the banks at far above their market value. It is dressed up as a market transaction but that is a fig-leaf, since the government will put in 90 per cent or more of the funds and the “price discovery” process is not genuine. It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries.

The plan’s essence is to use government off-budget money to overpay for banks’ toxic assets, perhaps by a factor of two or more. This is done by creating a one-way bet for private-sector bidders for the toxic assets, then cynically calling it “private sector price discovery”. Consider a simple example: a toxic asset with face value of $1m pays off fully with probability of 20 per cent and pays off $200,000 with probability of 80 per cent. A risk-neutral investor would pay $360,000 for this asset.

Along comes the government and says it will finance 90 per cent of the investor’s purchase and, moreover, do so as a non-recourse loan. Non-recourse means the government’s loan is backed only by the collateral value of the toxic asset itself. If the pay-out is low, the loan is defaulted and the government ends up with the low pay-out rather than full repayment of the loan.

Now the investor is prepared to bid $714,000 (with rounding) for the same asset. The investor uses $71,000 of his/her own money and $643,000 of the government loan. If the asset pays off in full, the investor repays the loan, with a profit of $357,000. This happens 20 per cent of the time, so brings an expected profit of $71,000. The other 80 per cent of the time the investor defaults on the loan, and the government ends up with $200,000. The investor just breaks even by bidding $714,000, as we would expect in a competitive auction.

Of course, the investor has systematically overpaid by $354,000 (the bid price of $714,000 minus the market value of $360,000), reflecting the investor’s right to default on the loan in the event of a poor pay-out of the toxic asset. The overpayment equals the expected loss of the government loan. After all, 80 per cent of the time (in this example) the government loses $443,000 (the $643,000 loan minus the $200,000 repayment). The expected loss is 80 per cent of $443,000, equal to $354,000.

The idea of “private sector price discovery” is therefore flim-flam. There would be price discovery if the government’s loan had to be repaid whether or not the asset paid off in full. In that case, the investor would bid $360,000. But under the Geithner-Summers plan the loan is precisely designed to be a one-way bet, for the purpose of overpricing the toxic asset in order to bail out the bank’s shareholders at hidden cost to the taxpayers.

The banks could be saved without saving their shareholders – a better deal for taxpayers and without the moral hazard of rescuing shareholders from the banks’ bad bets. Most simply, the government could provide loans to buy the toxic assets on a recourse basis, therefore without the hidden subsidy. Alternatively, the plan could give the taxpayers an equity stake in the banks in return for cleaning their balance sheets. In cases of insolvency, the government could take over the bank, the much dreaded nationalisation, albeit temporary. At the end of the Bush administration, Congress voted for the $700bn (€517bn, £479bn) troubled asset relief programme (Tarp) on the assurance the taxpayer would get fair value for money (for example, by taking equity stakes in the rescued banks). The new plan does not offer that.

Tim Geithner, Treasury secretary, and Lawrence Summers, director of the White House national economic council, suspect that they cannot go back to Congress to fund their plan and so are raiding the Federal Reserve, the Federal Deposit Insurance Corporation and the remaining Tarp funds, hoping that there will be little public understanding and little or no congressional scrutiny. This is an inappropriate institutional use of the Fed, the FDIC and the Tarp. Mr Geithner and Mr Summers should at the very least explain the true risks of large losses by the government under their plan. Then, a properly informed Congress and public could decide whether to adopt this plan or some better alternative.


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

7 Responses to "Obama’s bank plan could rob the taxpayer"

  1. richardberlin   March 26, 2009 at 11:42 am

    On target. Prof. Sachs, what you describe is what ought be throughout the financial webworld. The transfer of capital has occurred. The rest is the covering of tracks with time for second helpings if permitted.RichardBerlin

  2. Dan Link   March 26, 2009 at 1:22 pm

    I agree. The math is slightly wrong, the investor is willing to bid 666,666 for the asset under the assumptions listed, using 66,666 of his own money. That way, the profit if the asset goes to $1 million is 20% x (1 million – 666,666) = 66,666. If the asset goes to zero, he loses all of his own money.The error is with Dr. Sachs not subtracting the investor’s original investment from the profit if the asset goes to $1 million.

    • Sam Simpson   March 27, 2009 at 3:59 pm

      Dr. Sachs math is based on the assumption that the investor bids a price that would break even given the 20% prob of a 1,000,000 return and a 80% prob of a 200,000 return. Under the 80% scenario the investor loses the investment of 71,000 x 80% = 56,800. Under the 20% scenario the invest gains (1,000,000-643,000(loan amt)-71,000(return of equity)= 286,000 x 20% or $57,200. the difference b/t 56,800 & 57,200 can be attributed to rounding.

  3. Mark   March 26, 2009 at 2:42 pm

    Exceptionally well stated! The complexity of the plan is a camouflage that allows Geithner and Summers to make an end run around Congress, take taxpayer’s money, and pay “hold to maturity” prices for worthless bonds, all to the benefit of investors, shareholders, and creditors. Geithner and Summers are counting on Americans to be too stupid to get it and so far they’re way out in front.

  4. Howard   March 26, 2009 at 8:16 pm

    I think one thing keeping the Obama administration from nationalizing the banks, is that they don’t want to be in the position where they will have to foreclose on many 1000’s of homeowners. These people are having difficulty paying their loans, because they have fallen on hard times during a period when 4 million net jobs have been lost. With the PPIP the government could have their investor partners do the dirty work. In any case I think the government could soften the blow if they offer the borrower the right to payoff the loan at a premium to what the PPIP pays. For example, if the government pays 30 cents on the dollar, they should allow the borrower (or his designee, i.e. friend or relative) to payoff the loan at 50 cents. And the government should offer financing assuming the borrower or designee is creditworthy. This will allow these borrowers to get on with their lives and avoid financial devestation. I also think FICO rules should be changed so that all negative info is erased after one year (instead of the current 7 years). This will also enable individuals to get their financial lives back in order.

  5. Young Economist   March 26, 2009 at 10:31 pm

    Governments do not overpay if the government control1. The sellers cannot join bidding to protect the price manipulation.2. All return on investment must pay back to FDIC first and the interest rate of FDIC charge to investment fund at risk-adjusted rate of private investors like the Hedge fund or unknown investors get the higher interest charge than others.

  6. Guest   March 28, 2009 at 3:46 pm

    Dear Jeffrey,The real problem is the FED is owned by Individuals and Institutions outside the US Government with its jurisdiction in The City of London.Its mandate should had been terminated in 1933 or 76 years ago.The FED does what it pleases without any consultation because the US Government allows it.It is time to recognize this absurd fact.Regards