There are lots of diaries flying around regarding Geithner's new plan this morning, and a lot of people seem to think that the problem is very simple to solve (just find a post with "Krugman" in it; I'm not going into it here). I fall into the camp of "I really don't know what I'm talking about, so I'm going to let the people I help elect do the job I elected them to do" - which is not a popular position around here. However, I'm a good liberal, trained to question authority, so I'm trying to give both sides equal weight.
My understanding of the current financial crisis makes me uncomfortable with the Krugman plan. So, I posted this diary to articulate my concerns, in the hopes that people that are smarter than I am can tell me why I am wrong. :)
Let's start with why we have a problem today: we think banks are insolvent. In normal banking operations, banks are allowed to lend more money than they have; I'm not sure of the ratio, and frankly it is irrelevant. If they remain under a particular debt threshold, they are considered solvent; i.e. able to meet their obligations. If not, they are insolvent. At this point, we suspect the banks are insolvent. We do not know for sure (we are pretty damn sure), because knowing for sure means knowing the values of the assets on the books, and we don't know what the value is on the books is for reasons we will get into in a minute.
Banks go insolvent all the time. It is standard operating procedure for the FDIC to take 1 or 2 a week into receivership; essentially bankruptcy for a bank. This is common thing, and a strong reason to back Krugman's approach.
The problem is in the assets on the bank's books, specifically two kinds: mortgage-backed securites and credit default swaps. Both are currently being counted as assets on the bank's books. However, under current accounting rules, they are being valuated at the price paid for them, not the price that they can be sold for today.
These assets have a troubled relationship. CDS's are essentially insurance policies that a bond (a mortgage backed security) will not default. Given a bond and a CDS issued on that bond, only one of them has actual value: either the bond will pay out, and the CDS will not be excercised, or the bond will not pay out, and the CDS is excercised.
These instruments should have a reciprocal relationship to one another. As the likelyhood of a bond default goes up, CDS price should go up, and the bond price should fall. However, because of the failure of the housing market, and the difficulty of trying to figure out how a particular mortgage security is tracked back to an individual bond, no one is willing to buy these mortgage securities. Therefore, it is really impossible to figure out how much either one is worth. This only becomes hugely important when one tries to sell - like you would in a bankruptcy.
And this is why I have a problem with the Krugman plan: if we are forced to valuate these securities against the market price today, as we would in a bankruptcy, then they will be hugely undervalued, only because no one is willing to buy them due to the underlying uncertainty. The Krugman plan's greatest advantage is that it establishes a definite floor for the crisis: once we do things his way, we will know that the worst is over. However, I contend that his bottom is a lot lower than it has to be. Moreover, and I think this is a big unknown for Krugman and the public, but not for Geithner - we do not know to whom these banks owe money. I strongly suspect that a lot of the money that these banks owe belongs to foreign investors, who we cannot afford to anger - mainly because these are the same entities that finance our debt. No one seems to be talking about who the losers would be if we "nationalize" the banks; I suspect the answer to this question would explain a lot of policy.
Geithner's plan seeks to create an artificial market for these securities by removing a lot of the risk for buying them. This will almost certainly net a higher asset valuation than taking the banks into receivership. The argument against it is that it still leaves toxic assets on the bank's books, potentially leaving a zombie bank lurching around the landscape.
Here is the hidden genius in Geithner's plan: after we go through this process, and a market is created for these securities, then you take the banks into receivership. There is now a market for these assets that you can valuate them against. The bottom in this scenario is a lot higher, so to speak, and the recovery would potentially be faster.
Anyway, this is how I see things at the moment. Any comments?