The Financial Instability Plan

As a House-Senate conference wrangles over how many hundreds of billions to spend on an economic stimulus package, Treasury Secretary Tim Geithner has unveiled his Financial Stability Plan costing over $2 trillion, some from taxpayers, some from the private sector, and some from the Federal Reserve.

The Dow Jones Industrial average fell almost 400 points Tuesday on the news, and the Asian equity markets followed. That’s financial stability? The steep decline is symptomatic of the unease that permeates financial markets.

With good reason. It’s not just that the amount of money is troubling. The markets were also distressed by lack of detail, especially on how to take so-called toxic assets—loans with diminished and uncertain value—off banks’ books. Last fall the difficulties of pricing toxic assets caused the Bush administration to switch to infusions of fresh capital by purchasing banks’ preferred stock.

Charles Calomiris, business professor at Columbia University, told me that “the new Treasury approach is designed to take little risk, economically or politically, but to pretend that it is doing something. The market saw right through it.” Last month Calomiris laid out sound principles for a financial stability package, including the following:

Not all banks are the same, and not all should be saved. If a bank is in severe financial difficulty, the government shouldn’t try to prop it up with additional capital or enhanced asset insurance. Better-performing banks should be rewarded.

The government helps those who help themselves. A bank should only be permitted to participate in the bailout program if it can raise some capital on its own.

No dividend payouts. Banks receiving government help should not be allowed to pay dividends, because they deplete capital and prevent recapitalization.

So far Geithner and the administration do not appear to have consulted Professor Calomiris, much less Congress. Geithner and an assortment of government agencies instead have embarked on a journey to save the American economy all by themselves with no principles, no standards, and no details.

Last October, after much debate, Congress allocated $700 billion to the Troubled Asset Relief Program, after then-Treasury Secretary Paulson said, “The financial security of all Americans — their retirement savings, their home values, their ability to borrow for college, and the opportunities for more and higher-paying jobs — depends on our ability to restore our financial institutions to a sound footing.” But TARP, with roughly half the $700 billion disbursed, has not yet delivered on its promises.

Then, on February 10, it was déjà vu all over again, except to the tune of $2 trillion, as Geithner declared, “Our plan will help restart the flow of credit, clean up and strengthen our banks, and provide critical aid for homeowners and for small businesses.” He didn’t say how long it would take—because no one knows.

The Geithner plan is another version of TARP, but with more bells and whistles. Banks would undergo a “stress test,” an intensive audit, to measure their capabilities. A Public-Private Investment Fund would purchase troubled assets and provide additional funding to reach the $1 trillion level, although how private investment is to be mobilized was unclear. In addition, Treasury will use $100 billion to leverage up to $1 trillion in lending from the Federal Reserve.

The idea behind TARP was not new. Similar programs had successfully been put in place in the Asian banking crisis of the late 1990s. A government agency, a so-called “bad bank,” would buy the toxic assets, paying for them with fresh capital so that the banks could continue to function.

By definition, if the government is purchasing distressed assets it is paying more than the "market price," more than a private buyer would pay.

Geithner might be better off just admitting that these assets will have to be purchased by the Treasury at prices higher than market, and going before Congress and the American people to make his case. He could say up front that this will be expensive, but that this course of action will allow banks to clear underperforming assets off their balance sheet, thereby enabling banks to start lending again. In turn, with revived credit markets, the economy can grow.

Why, with the economy contracting and losing over half a million jobs a month, is the administration taking special pains over banks? This question is said to rankle Main Street.

The answer is that banks are essential to commerce. Businesses run in part on revolving credit—to carry inventories, to smooth out seasonal dips in revenue, to pay for construction, to finance consumer credit cards.

The implicit reason message from Geithner is: “Trust us, we know what we are doing.” Yet he repeatedly undermined that message by stating that all of this is uncharted territory and that mistakes would certainly be made. Neither the message nor the messenger reassures financial markets. Quite the opposite.