The Geithner Plan

Today, the details of Geithner's new plan to address the banks' toxic assets was released. He also penned an op-ed in the Wall Street Journal and appeared on CNBC (not sure of other media appearances). The U.S. Treasury website has also released a wide array of information regarding the plan - this is a good place to start if you want to read some of it.

Here are the basics. Private investors will compete in auctions to purchase the toxic - now called "legacy" - assets from financial institutions. The private investor will receive matching funds from the Treasury and a non-recourse loan from the FDIC as additional assistance. (The details are slightly different for "legacy loans" and "legacy securities" - my examples concentrate on the legacy loans. The legacy securities, which are the derivatives of the actual loans such as MBS, will receive loans from the Fed through the TALF program.) Recall that a non-recourse loan means that the borrower (the private investor) does not need to provide collateral. If the loan goes bad, the FDIC just loses the money.

So, let's take a look at a quick example of how this might play out. Let's say that Bank A is holding legacy loans of questionable value. For the sake of simplicity, let's normalize the original value of the loans to $1 - in other words, the net present value of the loans as they were written was $1. With the decline of the housing market, increasing foreclosures and mark-to-market accounting rules, Bank A has already written off 20 cents and hold the asset on its balance sheet at a value of 80 cents.

Bank A now contacts the FDIC who then organizes an auction. The FDIC will provide a loan at six times the amount of money coming in - and remember, the money coming in is a 50/50 split between the private investors and the Treasury (via TARP II). Here are some scenarios to consider as to what might happen:


Remember, Bank A had the loan on its books at 80 cents. There is little incentive for Bank A to accept a bid at any price which is too far below this price - if they do, then they immediately take that as a loss. If the loan sells for more than 80 cents, then Bank A immediately posts a profit. In both cases, Bank A gets a fresh cash infusion which could be used to make new loans (which is the hope of Geithner, Obama, et al). It will be interesting to see if banks are willing to sell at prices below their current marks. If so, we could see large short-term losses in the financial sector. If not, then either a) this plan won't work because the sales will not happen, or b) it implies that the sales are generally above current marks. Clearly the latter must be the hope of Geithner.

If we look at this option, then the only relevant scenario in the above chart is the first one where the investor puts up a whopping 6 cents which is matched with TARP funds and supplemented with a loan of 72 cents from the FDIC. At a purchase price of 84 cents, Bank A gets the cash and records a profit of 4 cents. Then, the investor crosses his fingers and watches the cash flow in. Clearly, the investor is hoping for a positive return which means that the true value (the amount cash ultimately collected against the loans discounted for time) would have to exceed 84 cents. If the investor loses, he only loses no more than his initial investment of 6 cents. The taxpayers could lose much more (28 cents under a scenario where the true value ends up at only 50 cents).

This program only works if the current value that the banks have marked these assets on the books is significantly below true value. Keep in mind that the true value will only be known once the loans have all been collected. This is the only scenario under which a) banks will sell, b) investors will jump in and buy the assets, and c) taxpayers remain whole.