The New Treasury Program: Sound Economics, Resting on Some Wishful Thinking

The Administration’s new program to wring the toxic assets out of the banking system is a huge bet which, like most of the previous reforms for the current crisis, is based equally on sound economics and a good dose of wishful thinking. The truth is, it couldn’t be otherwise: We’ve never experienced this kind of crisis before, so we cannot know which reforms will actually work.

The essence of the new Treasury program are the creation of new, public-private partnerships to purchase the bad assets held by Citigroup, AIG and others. The government and private funds or other entities would each put up one-twelfth of the money to buy tranches of toxic paper, and the other five-sixths would be borrowed by the private parties with federal guarantees for their lenders. One aspect of the plan that requires a good dose of faith is that reasonable prices can be set for these assets by using auctions. This aspect assumes that a number of private parties will bid on each tranche of assets and so set a reasonable price. The hope here is that the federal guarantees for the loans to buy these assets will unlock hundreds of billions of dollars in new financing, and that could well be the case. Score one for the Treasury: They’ve found a way to create a market for these assets, something which eluded the Paulson Treasury when they proposed auctioning off assets of unknown and dubious value.

Here’s the catch: The banks now holding these assets -- Citi, AIG, and so on -- have already written down their value on their books. And it’s impossible to say whether these write-downs -- "marking to market" in a market that hasn’t been operating -- are in the neighborhood of the prices which the Treasury auctions will produce. Selling them will increase "liquidity" in the banking system, which means there will be buyers for what’s being sold. But liquidity isn’t the main problem here. The core of the financial system crisis is that many of the largest institutions look like they’re insolvent or nearly so, and so unable to use the asset side of their books to provide new flows of credit for the economy.

Here’s where the pricing of the bad assets becomes important for the rest of us. If these institutions receive roughly the same price from the auctions as they’ve already assumed in their write-downs, they’ll be as insolvent as they were before the new program. One hope underlying the program is that the assets will auction for much more than their current owners believe they’re worth, bolstering their capital. Or, alternatively, there may also be the hope that all of the financial activity involved in selling off these toxic, "legacy" assets will bolster general confidence, so that businesses will be more willing to borrow and other institutions will be more willing to lend to them. In that case, the renewed economic activity could improve conditions for the sick institutions, slowly bringing them back from the edge of bankruptcy.

Much like the Treasury’s approach to stemming foreclosures in its new housing program, this approach addresses directly the secondary problem of liquidity, in the hope that doing so will affect the essential problem, which is that these institutions are bankrupt or nearly so. The alternative which the administration so far rejects is to address the core problem directly, with transitional or brief "nationalization" -- take over the sick institutions, pull out the bad assets (without having to value them), and then sell off the rest to another bank or group of investors, who would reopen it as a healthy bank that could resume lending. There are serious risks in that approach as well, both economic and political. The Republicans would surely go on a predictable tear denouncing it. More important, the market might believe that it was only the beginning of government takeovers, and pull back on a range of financial activities so far less affected by the systemic crisis. But if the current strategy doesn’t work, the only other option apart from transitional nationalization will be to ask the country to put up with an indefinite period of recession and stagnation, until the system slowly rights itself. Eighty years after the last systemic financial crisis, the option of "sit tight and wait for the markets to correct themselves" -- Hooverism in a pure form -- should be wholly unacceptable, both economically and politically.

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