Having received information tonight in the form of NY Times and a Wall Street Journal articles (actually, here, the Journal article is MUCH better), I am finally beginning to get a sense of what the administration is trying to do in terms of its financial plan. And it is actually not as bad as I feared and has a chance of being fairly successful. However, I don't think it is certain to work by any means and quite bad outcomes are still possible.
First, the fundamental problem right now is that major banks like Citi and B of A are essentially insolvent because their balance sheets are stuffed with so-called "toxic assets," in many cases mortgage backed securities (MBSs), structured investment vehicles (SIVs) backed by dodgy, worthless mortgages. However, it is important to also understand that these structured investment vehicles, many of which are mortgage backed, are not entirely backed by worthless assets. The problem is is that they have been put together in such a complicated manner that one doesn't know how to disentangle them and properly determine their worth.
What is certain is that they worth less than what the banks say they are worth (or at the very least, what they were originally worth). This is the crux of the problem. How, then, can the true worth of these SIVs be determined? How can the crap be unwound from the good? The troubled banks (Citi, Bank of America) don't want to sell them because buyers are only willing to pay prices for them that would essentially bankrupt the troubled institutions if they were to pay the current going rate. Actually, the government's supposition (and probably many others) is that they are worth more than the current market price. They certainly aren't worth what the banks originally paid for them, but they still contain underlying value. Again, this is what Geithner, Summers, and others think. This could be wrong. But it is a supposition that likely contains some truth.
Geithner, Summers, et al. also believe that many potential buyers would actually buy these assets off the banks at an OK price, but there is currently a level of risk baked into the market that means they are only willing to underpay for the SIVs. Thus, what the plan is intended to do is basically as follows:
To create a price at which buyers would be willing to buy the assets off the banks, government run auctions with a indetermine number of buyers will take place. At the end of the auction, a market price will be determined. The "winner" will then buy the toxic SIV(s) off the troubled bank. Now likely, this will still force the banks to take massive write downs from the SIV's original value.
This is where the so-called "stress tests" come in. The "stress tests" that are, as I understand it, currently ongoing, are to determine how great a write down the troubled institutions will be able to withstand. Now, hopefully, if the institutions can't take the "stress" the government will pursue other options - i.e. take the bank into receivership. However, the fear is this isn't going to happen and that the tests will be too lax.
But why would the buyers agree to come to the auction in the first place, you ask, if they aren't willing to independently buy the troubled assets right now? Well, the government will provide large loans to those willing to participate in the auctions as buyers so that the downside for the buyers is "minimized." Really, what this means is that if the assets - even purchased at written down values - nevertheless continue to lose further value after the sale, the government (i.e. the taxpayer) will eat the loss.
So this sounds terrible. Well, its not ideal. However, there are a few mitigating points to be made. First, all the money to be used as subsidies has already been appropriated as a part of TARP 1. Secondly, the government believes that the auction itself will allow "price discovery" to take place. As I noted above, the troubled assets DO have some underlying value, most likely. Thus, once a "market price" is created through the auction, the assets will become "normal" again in the eyes of buyers and thus they likely won't lose much value and might even gain value (which the taxpayer will pocket, in part).
Why do I think this plan is potentially workable, then? Well, the auction and the stress tests are key. The result of the auction will likely still force the big, failed banks to take significant write downs. Theoretically, they will have to pay close to the full price for the collapse of the asset's underlying value once the auction enables a price to be "discovered" that will subsequently be accepted by market participants.
The stress tests are also key here too. Theoretically, if performed honestly, the stress tests will determine to what degree troubled banks like Citi and Bank of America will be able to take big write downs.
However, if they can't, then we return to the zombie bank vs. nationalization debate. But at least this option remains open at this point.
Will this work as planned? I hope so, because it is actually fairly clever as it avoids basically taxpayer welfare to a large extent for the troubled banks. The tax payer is still on the hook somewhat, but the big troubled banks are still going to have to pay the biggest brunt IF this process is conducted transparently and honestly. Of course, this is the big IF.
But the key is is that at this point, I think a satisfactory conclusion to this crisis is possible. By no means guaranteed, but the problems can be solved in such a way that minimizes tax payer risk and forces the big banks to pay for the mistakes they made, while at the same time maximizing confidence of investors in the functioning of the system. The key - and this is THE key - is just how transparently and honestly the process will be. This is going to be where the plan and, dare I say the administration itself, lives or dies. The stakes are very, very high. Forget about nonsense sideshows like the AIG bonuses.