The Treasury plan for dealing with banks’ toxic assets has come under attack from Paul Krugman on the grounds that it won’t work, it wastes valuable time and it undermines President Obama’s credibility. He prefers the Swedish model, which is essentially to nationalize the troubled banks, and regards the Treasury plan as an extension of the Bush administration’s "cash for trash" policy, which, he says, basically offers private-sector investors a one-way bet whereby they take all the upside but can just walk away from the downside. He’s wrong. This plan makes sense.
The essence of the plan is this: if you (the private investor) want to buy one of these toxic assets from a bank, the FDIC will help you do it. Let’s say you want to pay $100 for the asset. You have to come up with $7.50 in equity. The Treasury will match you, putting up $7.50. The FDIC will lend you the remaining $85, at an interest rate which has yet to be determined.
Let’s say that in two years this asset has either (a) appreciated by 10% or (b) depreciated by 25%, and that the FDIC money costs you 10% per year. Here’s the outcomes:
(a) You sell the asset for $110. You pay off $85 in FDIC debt. You’ve paid $17 in interest (two years of payments at 10% on $85). That leaves a total profit of $8. You get $4, the Treasury (taxpayer) gets $4. So, for an investment of $7.50, you end up after two years with $11.50, a return of 53%, or 24% a year compounded. The Treasury has made the same return on its equity, and the FDIC has made 10% a year in interest. Everybody, presumably, is reasonably happy with this outcome.
(b) You sell the asset for $75. You lose all your equity. The taxpayer loses $0.50 (the $7.50 of equity put up by the Treasury, a $10 loss on the debt put up by the FDIC offset by $17 in interest on the debt).
What Krugman is saying is: you, the investor, will overpay for the asset and won’t mind losing all your equity. He contends that the plan is just an attempt to artificially prop up the prices of these toxic assets. He prefers letting the government take over troubled banks and liquidating the assets themselves.
What the Administration is saying is that you, the investor, will carefully evaluate the asset to ensure that you make a decent return on your money; and that losing your entire investment is a strong disincentive to overpay.
Personally, I’d go with the Administration on this one: as an investor, I’d be very careful not to over-pay for the asset, because I don’t want to lose all my money. In other words, Krugman’s contention that the private sector will overpay for these assets seems quite wrong to me. I’m not saying his plan is bad. I just think the Geithner plan will probably work better.
My only caveat would be to watch carefully to see that the private-sector participants aren’t paid any "consulting fees" or other compensation which protects them against overpaying for the asset. With this proviso, it’s a solid plan for using private-sector greed (for want of a better word) to get assets off the books of the moribund banks at a fair price.