Commentary Type

Economics of the Geithner Plan


The Private-Public Investment Program (PPIP), or “Geithner Plan,” would ironically use financial leverage to help resolve a financial crisis caused in considerable part by excessive leverage. As Robert Samuelson, citing Yale economist John Geanakoplos, has pointed out, a rationale for this paradox is that the process of deleveraging has gone too far in the opposite direction as loanable funds for leveraged investment have dried up. The premise of the plan is that troubled assets on the books of the banks cannot be sold except at prices far below their long-term cash-flow value because of lack of liquidity in this distressed market. The PPIP seeks to jumpstart a return to liquidity for this asset market, thereby setting the stage for a normalization of the banking sector and financial conditions more generally. A key motive of this arrangement is to use private investors, rather than bureaucrats, for “price discovery,” addressing a central problem that derailed the original Troubled Asset Relief Program (TARP) plan of Geithner’s predecessor, Henry Paulson: the difficulty in determining a price that will be fair to both the taxpayer and the bank. For this purpose, the government would in effect provide lending to enable the leverage needed to attract private-sector investors.

Problems with the Critiques of PPIP

Some prominent economists have decried the plan as a giveaway of public funds to the banks and private investors such as hedge funds, private equity firms, pension and endowment funds, and others. Jeffrey Sachs has attacked it as a “massive transfer of wealth.” Joseph Stiglitz has called it “robbery of the American people.” They as well as Paul Krugman have provided numerical examples of large overpayment by private investors at the public’s expense.

A fundamental problem with these attacks is that they omit on the benefit side of a costbenefit analysis the potential gains to the public from an improvement in the economy that could flow from a normalization of the financial system. Even on the narrower analytics ignoring such social externalities, however, the analyses tend to make crucial assumptions that seriously bias them toward the conclusion that investors will pay far too much for the troubled assets, and thus that the public will experience serious losses as a result while the banks and private investors enjoy any gains. This paper will illustrate this bias using the Sachs results.

The essence of the critiques is that government loans for leveraged private investors on a nonrecourse basis create a “heads I win, tails you lose” situation for the investors. Nonrecourse borrowing means that if the assets purchased go sour, the investing firm walks away from both the assets and the loans it borrowed from the government using the assets as collateral. The defaulted assets become the property of the government, which seeks to recover what it can but is unlikely to recover much, and the government has no recourse to recover from the private investing firm itself.

However, a key feature of the PPIP will limit this asymmetric risk. The amount the government will lend will apply a variable “haircut” against the face value of the loans in arriving at what will be acceptable as collateral value. For the Legacy Loan program, the FDIC will exercise oversight; for the Legacy Securities program, the Federal Reserve will do so. Both are almost certain to require larger haircut discounts in determining the collateral value for more risky loans or securities. With lower permissible collateral, the investor would not be able to make as large an offer. The critiques of Sachs, Krugman, and Stiglitz do not take this into account.

In the case of the Sachs analysis, as set forth below, the conclusion of overpayment is exaggerated for four reasons. First, he assumes an unrealistically high probability of default. Second, he assumes an unrealistically low rate of recovery given default. Third, he applies a leverage ratio higher than that available in the PPIP. Fourth, he assumes perfect competition and therefore zero profits for the investing firm, instead of a more realistic target profit rate.

Moreover, two further considerations suggest that there is considerable reason to fear that the private-public initiatives will underpay rather than overpay for the troubled assets. The economist who has been credited in part for the conceptual framework of the PPIP, Lucian Bebchuk of Harvard University, has emphasized that insufficient competition among prospective private-sector participants could cause the prices offered to be too low, because of what is technically “oligopsony power” used to extract a “rent” from the potential sellers.7 For this reason he has emphasized the need for many participants to compete against each other. The Legacy Loan half of the PPIP is structured with many investors in mind, but the Legacy Securities half only calls for five initial hedge funds, a number that may or may not be sufficient to overcome the oligopsony problem.

The other reason for concern about underpayment is the recent political climate, in which private-sector bonuses and profits at firms in some way involved in the credit crisis and, especially, the public-sector intervention to address it have become the target of retroactive taxation. The shaky rule of law substantially increases the risk to privatesector partners in the PPIP.

Overall, these considerations suggest that the outcry of some economists against the PPIP as a giveaway to banks and private investors is at best useful as an alert to the need for close monitoring of the mechanism (especially in FDIC and Federal Reserve determination of the collateral haircut) but at worst constitutes an unhelpful undermining of public confidence in an approach that could play an important role in stabilizing the financial crisis.

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