1. First the hedge fund buys an asset with a face value of $100 for $80. The hedge fund puts up $2.40, while the Fed contributes the rest, $77.60. Huge leverage.An even more devastating assessment appears in an interview with noted economist James Galbraith, who finds the plan "extremely dangerous":
2. The next day, the hedge fund re-runs the model and realizes that they overpaid the bank. Turns out, it was only worth $20 -- which was where the market had been, sans-government leverage.
3. The hedge fund loses it entire $2.40, and the taxpayer loses its entire $77.60.
4. BUT! The bank buys the asset back from the hedge fund at $20, while paying it a $5 million fee for its trouble.
5. The upshot: The banks sells high, buys low. The hedge fund collects a fee for holding the asset. And the taxpayer is screwed.
Why? In short, because the plan is yet another massive, ineffective gift to banks and Wall Street. Taxpayers, of course, will take the hit Why does Tim Geithner keep repackaging the same trash-asset-removal plan that he has been trying to get approved since last fall?
In our opinion, because Tim Geithner formed his view of this crisis last fall, while sitting across the table from his constituents at the New York Fed: The CEOs of the big Wall Street firms. He views the crisis the same way Wall Street does--as a temporary liquidity problem--and his plans to fix it are designed with the best interests of Wall Street in mind.
If Geithner's plan to fix the banks would also fix the economy, this would be tolerable. But no smart economist we know of thinks that it will.
We think Geithner is suffering from five fundamental misconceptions about what is wrong with the economy. Here they are:
The trouble with the economy is that the banks aren't lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it. As consumers retrench, companies that sell to them are retrenching, thus exacerbating the problem. The banks, meanwhile, are lending. They just aren't lending as much as they used to. Also the shadow banking system (securitization markets), which actually provided more funding to the economy than the banks, has collapsed.
The banks aren't lending because their balance sheets are loaded with "bad assets" that the market has temporarily mispriced. The reality: The banks aren't lending (much) because they have decided to stop making loans to people and companies who can't pay them back. And because the banks are scared that future writedowns on their old loans will lead to future losses that will wipe out their equity.
Bad assets are "bad" because the market doesn't understand how much they are really worth. The reality: The bad assets are bad because they are worth less than the banks say they are. House prices have dropped by nearly 30% nationwide. That has created something in the neighborhood of $5+ trillion of losses in residential real estate alone (off a peak market value of housing about $20+ trillion). The banks don't want to take their share of those losses because doing so will wipe them out. So they, and Geithner, are doing everything they can to pawn the losses off on the taxpayer.
Once we get the "bad assets" off bank balance sheets, the banks will start lending again. The reality: The banks will remain cautious about lending, because the housing market and economy are still deteriorating. So they'll sit there and say they are lending while waiting for the economy to bottom.
Once the banks start lending, the economy will recover. The reality: American consumers still have debt coming out of their ears, and they'll be working it off for years. House prices are still falling. Retirement savings have been crushed. Americans need to increase their savings rate from today's 5% (a vast improvement from the 0% rate of two years ago) to the 10% long-term average. Consumers don't have room to take on more debt, even if the banks are willing to give it to them.
What no one seems ready to discuss at this point is where they think all this poorly conceived planning will wind up. I hear talk about prolonged recession, but what does that really mean? With millions of Americans losing their homes and jobs, out on the street, begging for food, how long a "recession" can be tolerated?
Especially disturbing is that all our high hopes for the newly minted Obama administration seem about to be dashed. His plan is almost sure to fail and the Republicans will certainly be there, ready to pounce when that happens. What we need at this point is exactly what we do not have: a viable party of the left, socialist, liberal, whatever, with no ties to big money and a credible leadership. If some sort of meaningful political alternative doesn't emerge soon, we may all be screwed, and for a long time to come.