A spoon-full of toxin

When 'Uncle Joe' Stiglitz criticizes a program for 'socializing losses', there must be something seriously wrong.

The Geitner Plan for the U.S. banking system appears on the surface to be a way to create and isloate bad banks. These new institutions will be built by a partnership of government and private investors who will buy-up and hold the 'toxic' assets pending the market placing a firm and less panicky valuation on them.

Once removed from the mainstream—so the theory goes—the toxic assets will have a less poisonous effect on the financial system. Meanwhile, time will drain the toxin from the assets of the bad banks. If the government's private partners in the deal price the toxic-asset-purchases cannily,they will make a profit from their eventual re-sale and the government could even make a profit on it's credit-subsidies. A 'win-win'.

But that's a myth as Stiglitz points out in the New York Times.

The private partners are not pricing the toxic assets at all, but an option on the toxic assets that has been created by the government offer to bear most of the losses. The government is putting up 92% of the purchase price in the form of equity and debt, but receives only 50% of any gains (see this Financial Times interactive graphic explanation). When the private partners bid, they're bidding on their expectation of gains from the deal, not expressing their view about the long-run price of the underlying assets.

Given that the taxpayer will absorb almost almost all of the risk, the private partners will likely pay too much for the assets. That's good for the banks who now own the assets but only because they're moving their riskiest debts to the taxpayer. Obviously it's also good for the 'private partners'. As Stiglitz says:

"What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses."

But, isn't it inevitable that the taxpayer will fund the recapitalization of the banks? Probably. But the taxpayer is also enriching the 'private partners'. Now, guess who they are likely to be? The banks themselves.

Warren Meyer has a nice, step-by-step explanation of the key Stiglitz points. JS makes some additional observations about 'adverse selection' incentives, however, that wonks will like.

Tags for this entry: policy people macroeconomics finance banks geitner stiglitz