4 Reasons Geithner's Plan Won't Work

The more I think about it, the more I realize Treasury Secretary Tim Geithner's plan to rid banks of toxic assets won't work. At first glance, I thought it had some attractive features -- and it does -- but I'm quickly realizing they're seriously overshadowed by its faults.

Here are four big holes the plan fails to address:                                                              

1. Liquidity isn't the problem
Since day one, a major flaw has been treating the financial crisis like a liquidity issue rather than a solvency issue. Liquidity’s all about how quickly money can be moved around, while solvency deals with companies’ ability to remain going concerns. There aren't armies of cash-strapped investors salivating over the prospect of toxic assets. There's plenty of cash out there. Its owners have just realized that bad assets are really, really bad. The idea that investors will suddenly grasp the hidden beauty of these assets if you give them cheap leverage isn't realistic.                                                            

Nor is it supported by the facts. Last August, Merrill Lynch (now part of Bank of America (NYSE: BAC  ) ) provided cheap, non-recourse funding for a collateralized debt obligation (CDO) sale to private equity firm Loan Star Funds. The terms were almost identical to what the Treasury is offering today -- 75% financing, no recourse. Even with all that extra juice, Merrill was only able to sell the assets for the grand sum of twenty-two pennies on the dollar. And that was last August, when things were still "good."

2. Price discovery might backfire
Speaking of prices, the current belief is that bad assets aren't being priced accurately because the market is busy wetting its pants in fear. Provide a little liquidity, the thought goes, and the true price will be "discovered." Once a real price is found, clouds will part, rainbows will form, and markets will regain confidence, wise men tell us.

While an awesome idea in theory, it's only beneficial if the discovered price is higher than what banks currently assume. What happens if a CDO sitting on Citigroup's (NYSE: C  ) or Morgan Stanley's (NYSE: MS  ) books is held at $0.80 on the dollar, but Goldman Sachs (NYSE: GS  ) sells a similar asset via the Geithner plan and "discovers" it's worth only $0.40 on the dollar? Banks that don't even want to sell assets could be forced to take writedowns to comply with mark-to-market accounting rules. While that certainly isn't a bad thing -- I'm all for accepting reality -- the price discovery process could blow open the doors and reveal a big, sad group of insolvent banks. Call that the mother of all unintended consequences. 

3. Will anyone show up?
And who are all these private investors we hear about? A few notable names have announced they'll participate, but a meaningful turnout seems questionable -- and not because Congress has proven to be the world's worst business partner after the AIG (NYSE: AIG  ) snafu.

With 6-to-1 leverage, these asset sales are designed so investors will either make a killing, or lose everything. As attractive as non-recourse funding is -- since it limits borrowers' risk -- there simply isn't an appetite for high-risk, high-reward investments these days. This is not the kind of environment where hedge funds are eager to dive into a deep, dark, unknown world of arcane investments.

This is a world where investors are happy to buy 30-year Treasuries at 3.6%, and the default risk of Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) is perceived to be higher than the Republic of Colombia. There's a tremendous premium on safety and almost no interest in anything with less than 100% certainty these days. That doesn't bode well for assets that need premium prices to clear.

4. Haven't we tried this before?
On the other hand, trying to find a true market price won't happen unless a true market exists. While cheap leverage might lure in enough capital to start clearing trades, it's not a true market -- it's a propped-up one. Just like housing supported by subprime leverage, "real" prices can become a cruel fantasy when unsustainable leverage is involved. 

Hence, as soon as the cheap funding stops, we're back to square one. No one knows when that will happen, but it will happen. It's also safe to assume the plan could be scrapped if it works so poorly that taxpayers are stuck with massive losses, or so well that hedge funds are vilified for making triple-digit returns off taxpayer money.

If Geithner's strategy doesn't work, what's plan B? Nationalization?

Where to now?
While the plan is a step in the right direction, I'm hesitant to think the Treasury can uncover gold where private capital sees dirt. Maybe I'm just discounting Geithner's alchemy skills. Then again, probably not.

What do you think of it all? Feel free to share your thoughts in the comment section below.

Related Foolishness:

Fool contributor Morgan Housel owns shares of Berkshire Hathaway, which is Motley Fool Inside Value and Motley Fool Stock Advisor selection. The Fool owns shares of Berkshire Hathaway and has a disclosure policy.


Read/Post Comments (7) | Recommend This Article (24)

Comments from our Foolish Readers

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  • Report this Comment On March 25, 2009, at 1:51 PM, chicagomarvin wrote:

    I lose track of what kind of bad assets are intended to be part of the program. Are we talking about sub-prime mortgages? If so, as long as the mortgaged properties keep sinking in value the bad assets will have hardly any value. Home must be occupied by people paying a reasonable amount of principal and interest or rent. If the house is vacant, it must be safely secured and sold as soon as possible.

    The bad assets under the Treasury plan have little value as long as the underlying collateral keeps dropping in value.

    If bad assets are car loans, school loans, commercial property that becomes another matter. However, it is still necessary to work out the debtor payment plans for each underlying obligation. X % of the debtors will pay something.

    Someone must manage the underlying collateral with an eye to collecting the most possible. The rest is lost, but what is collectedis likely to be much more than zero.

  • Report this Comment On March 25, 2009, at 4:00 PM, FundInsider wrote:

    I have worked in ABS markets and at multiple large institutional investors. The good news is, asset managers are willing to look over the ABS, whether credit cards or mortgage backed and try to determine which are likely to have value (and if market price is over/undervalued). I doubt that the majority of securities will be discovered to be overvalued still. The market over-corrected out of fear.

    The bad news is that the gov does flip flop and any deal to get investors to buy must be an ironclad contract that future politicians can not modify. It's very expensive, hard work to sift through and wisely select ABS securities, and our clients need to know they stand to benefit and not be treated as AIG execs (who did deserve the bad press the get now - totally different story).

    As far as artificially pumping up a market, many many social and economic institutions are founded on government support, and after they justify themselves the private sector can and will take over. This article implies that there is nothing the gov can do, short of permanent socialism.

  • Report this Comment On March 25, 2009, at 4:45 PM, TMFDiogenes wrote:

    Nice article, Morgan, and great comment, FundInsider.

  • Report this Comment On March 25, 2009, at 4:48 PM, golfer121501 wrote:

    Fundinsider:

    Your quote of "This article implies that there is nothing the gov can do, short of permanent socialism." is missing the point.

    Whether the article implies it or not, this is REALITY. Those in charge of the government WANT permanent socialism. This allows them to have the most power and that is all that they care about. If they cared about fixing the problem, they would have kept their greedy hands out and let the private industry sort it out on its own.

  • Report this Comment On March 25, 2009, at 5:45 PM, mjonesy1985 wrote:

    It is going to work and you are going to look so stupid when it does. If you are so smart then why were you not employed by Obama? So tired of these writers thinking they know better than the ACTUAL professionals.

  • Report this Comment On March 25, 2009, at 6:14 PM, LeoGetz wrote:

    Well, let's hope the plan works for everyone's sake, but I think that Morgan and FundInsider are more realistic. By-the way, I don't think that being smart is a prerequisite to be hired by Obama. (Or any government job for that matter.)

  • Report this Comment On April 01, 2009, at 9:37 PM, martins222 wrote:

    The concerns about price discovery being too low, etc are very silly. The whole point of the plan is to have the assets sold at prices way, Way, WAY above what they are really worth, to have the loan money for the purchase handed to the banks and have the taxpayer holding an empty, non recourse loan defaulted on bag.

    The only attractive features are for the banks and the bank stockholders who let the bank executives do stupid things. If you ever thought this was attractive, then it means you have no scruples about ripping off American citizens who had nothing to do with the gambling the banks engaged in and lost at.

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