It seems clear to me that the goal of the evolving financial rescue plan is to increase lending in order to facilitate economic recovery. From the details of the plan that Secretary Geithner unveiled last week it is also clear that he believes the way to do this is by getting those toxic (now legacy) assets off of the balance sheets of financial institutions.
The obvious question then, is will this work. It depends. The answer though, doesn't depend on whether or not Geithner has proposed the correct solution, but whether or not he has correctly diagnosed the problem.
Implicit in Geithner's plan (and explicit in the document describing the plan) is the fact that he believes what we face is a liquidity problem. This means that the assets that are being held by financial institutions are actually worth more than people are currently willing to pay for them. So the asset they are holding has value, but it is frozen, stuck in its current form. Being unable to turn these assets into cash cripples lending.
There could be a lot of reasons for this. Investors that would normally be willing to buy these assets may be reluctant to buy fearing more bad economic news. They may be reluctant to buy due to the complexity of these assets and the difficulty in accurately valuing them. Or they may be able to value them and are willing to buy, but they are unable to get financing to actually make the purchase.
The public/private partnerships in the Geithner plan are set up explicitly to address these problems. With the partnerships, assets get purchased, balance sheets improve, and institutions are willing and able to increase their lending.
There is another possibility, however. It is possible that the price people are currently willing to pay for these assets really is what they are worth. If this is the case, we have a problem of capitalization, not liquidity.
If banks and other institutions made loans and bought securities that are now worth a lot less than they paid for them, then they have lost money. If the losses are big enough, these institutions could be bankrupt.
The Geithner plan does not address this possibility. The question of whether or not banks had adequate capital was supposed to be answered by the 'stress tests' - remember those? No one hears to much about them now, certainly not in the context of the asset purchase programs.
Not only does the Geithner plan not address the capitalization question, but if the problem is in fact one of capital and not liquidity, the Geithner plan would be among the worst possible solutions from the taxpayer's perspective.
Treasury will use taxpayer money from the TARP and taxpayer guaranteed loans to entice private buyers to bid up the purchase price for these assets. If these assets really do turn out to be worthless, or close to worthless, taxpayers will be left holding the bag. A very big empty bag which we will have to fill with money.
It is true that in these cases the private entities will lose all of their money, but this represents a very small percentage of the purchase price. The vast majority of the funding is a government guaranteed loan that we will have to pay.
Given these two scenarios, I hope you can see just how important it is that our government has correctly identified the problem with the banks. If they have, then the Geithner plan may well work. If they have not, things are going to get much worse before they get any better.
Click here for the RWC Blog primer on the public private partnerships in the Geithner plan.