THE GEITHNER-SUMMERS PLAN IS WORSE THAN YOU THINK
April 7, 2009
The Geithner-And-Summers Plan (GASP) to buy toxic assets from the banks is rightly scorned as an unnecessary give-away by virtually every independent economist who has looked at it. Its only friends are the Wall Street firms it is designed to bail out, say Laurence J. Kotlikoff, a professor of economics at Boston University, and Jeffrey Sachs, a professor of economics at Columbia University and director of the Earth Institute.
One defect is the systematic overbidding entailed by the proposal. Others have since made similar calculations, including Joseph Stiglitz and Peyton Young. The situation is even worse that it looks, however, since the GASP can be gamed by the banks that own the toxic assets to boost the purchase prices for their bad assets even higher than has been suggested to date, say Kotlikoff and Sachs.
Suppose that Citibank holds $1billion face value of toxic assets that will pay $1billion with 20 percent probability and $200 million with 80 percent; the market value is $360 million:
- The GASP calls on investors to establish a Public-Private Investment Fund (PPIF) to bid for the toxic assets.
- For each $1 that a private investor brings in equity to the PPIF, the Treasury will put in another $1, and then the FDIC will leverage the $2 in equity with $12 of non-recourse loans (6-to-1 leverage).
It's easy to show that a risk-neutral and arms-length PPIF will bid $636 million, financed with an Federal Deposit Insurance Corporation loan of $545 million, Treasury equity of $45 million and private equity of $45 million, explain Kotlikoff and Sachs:
- The expected profit to the private investor is one-half of 20 percent of $1 billion minus $545 million, or $45 million.
- The private investor therefore has a net expected profit of zero.
- The PPIF overpays by $276 million, which equals the expected loss to the Treasury.
- The ultimate beneficiaries are Citibank's shareholders and bondholders, whose net worth rises by $276 million at the taxpayers' expense.
The Geithner-and-Summers Plan should be scrapped. President Obama should ask his advisors to canvas the economics and legal community to hear the much better ideas that are in wide circulation, say Kotlikoff and Sachs.
Source: Laurence J. Kotlikoff and Jeffrey Sachs, "The Geithner-Summers plan is worse than you think," Financial Times/Economists Forum, April 6, 2009.
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