So Now We Know . . .

Counting down to the announcement of the Geithner plan, the New York Times has this account of how it came into being (and why it should be called the “Geithner plan,” although maybe Larry Summers is hiding behind him):

In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.

Mr. Geithner, who will announce the broad outlines of the plan on Tuesday morning, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.

I’m not a huge fan of executive compensation caps, as I think they are something of a sideshow. But I think the general approach of playing nice with banks and their shareholders is a mistake, because it leads to intransparent subsidies like the privately-financed bad bank is sure to be. (If the government is guaranteeing assets bought by private investors, as is widely rumored, it’s still a subsidy; it’s just not as obvious as writing a check.)

The most important thing in the bank rescue plan should be cleaning up their balance sheets to the point where even in a worst-case scenario we don’t need to worry about bank solvency (at least for those banks that are left standing by the rescue). If the government announced, “we will buy any assets you want to sell, at their current book values,” this would be a massive subsidy worth hundreds of billions of dollars (and requiring trillions of dollars in initial outlays), but it would at least restore confidence in the banks. If the government announced, “we are taking over Citigroup, Bank of America, and JPMorgan because they are insolvent, and we will write down their questionable assets to nothing, recapitalize them, and later reprivatize them,” this would also restore confidence, although it would unleash a flood of litigation and political attacks against the government for engaging in “socialism.” But if instead you try to split the difference, avoid too much government involvement, and pretend you are not subsidizing the banks, you end up coming up with these too-clever-by-half subsidies that you are trying to hide from Congress and the public, and no one can be confident that they will work.

It’s possible that the “uniform stress test” will be rigorous enough to weed out and either close or recapitalize all those banks that may become insolvent in a severe recession. And it’s possible that the government guarantees will be generous enough to bring in enough private capital to buy up enough toxic assets to make bank balance sheets trustworthy enough. So it will take a few months to learn if the plan will work.

9 responses to “So Now We Know . . .

  1. Can you think of any reasons why it might make sense for somebody in Geithner’s position do come up with something weaker than you’d like, at first glance? I’m not sure (which is why I’m asking you) but perhaps, for example, if he came down too heavily the private sector response would be unhelpful. I’m thinking of possibilities like groups of traders quitting and getting some private backing to start up new brokers, or M&A guys leaving to set up new M&A boutiques, and this taking business away from all these banks who now owe the taxpayer billions. I’m not sure if these possibilities I’ve dreamt up make any sense, but that’s not so important – what I’m getting at is that people in the industry may have been telling Geithner “if you screw us too hard, we’re going to do … [whatever]”. I guess what I mean is, that if we were thinking in principle agent terms, he has to have everybody’s incentive compatibility constraint in mind, and that might mean going easier on the banks than might otherwise seem desirable.

  2. > I’m not a huge fan of executive compensation caps, as I think they are something of a sideshow.

    The DRIVING FORCE of all this is somehow a sideshow?!?!?!?
    Incentives drive behavior. We have the mess we have because of the incentive system….if we treat it as a side show, we’ll be filling the hole while the executives continue digging
    themselves a gold mine.

  3. Charles R. Williams

    This is insane. Axelrod wants to put the bankers in stocks and throw rotten tomatoes at them and put a couple trillion in their back pockets to manage as they see fit. Geithner wants to be nice to them and put a couple trillion in their hands to manage as they see fit. This is nothing but the Bush-Paulson plan increased in size by an order of magnitude and covered over with a veneer of slick public relations and “transparency.” A catastrophe for the American taxpayer and, combined with a permanent expansion of government masked as economic stimulus, a prescription for a decade-long recession.

    How does this differ from what the Japanese did in the nineties? The Japanese economy could afford it but ours cannot.

    Let us hope the Congress balks and if these programs go forward let us hope that at least one political party unanimously rejects it.

  4. Why would one political party reject “the programs” if it’s essentially the same package from a republican administration forwarded by a democratic one?

    I think the reason why we have similar stimulus packages is because essentially mainstream/powerful economists are pushing for very laissez-faire, don’t manage the banks, policy prescription. It’s partly a reaction to political realities regarding the banking system, an irrational fear of “socialism” along with a prevailing economic paradigm also fearful/weary of government intervention.

  5. The market reaction says it all. The deeper you see the more you trust – so fudging reassures no one. Only specific action to address local issues can be credible.

  6. Here’s the problem: Nobody knows what anything is worth right now. Do you know what your house is worth? Probably not. How could you? Have you tried to sell it lately? Find any comers? It’s not worth half of what you paid, if you bought it in the last 5 years. Americans are going to have to get used to the fact that we are only half as wealthy as we thought we were a year ago. Our standard of living must decline precipitously, in equal measure.

    And so it is with the banks. Monetary value can only exist in a market where there is a buyer and a seller. Banks can just “hang out” and wait for the market to recover. But our economy cannot wait until then for our credit markets to re-open. The best thing that can happen now is rapid failure, where values promptly reach a bottom. Then we can all begin to rebuild together from there. Decisiveness requires political backbone.

  7. Compensation caps as implemented are so porous anyone can get around them. To be serious about a cap, you not only fix a number, but also the type of compensation allowed.

    For example: $1 million, salary compensation only, 30% of which is performance-based. No options, stock, benefits or gifts allowed. You want a chauffeur, a golf membership, a nice apartment? Pay for it out of your own salary. You want stock? Buy it yourself. To do any less would be like pinching one end of a balloon. And even with this, I’m not sure that people won’t eventually find a loophole.

    The rest of the plan is just too vague. If they haven’t worked out the details, they shouldn’t have bothered to announce it. It doesn’t just disappoint the market, it saps confidence in the government’s competence.

  8. I think we can all be kind of glib about our solutions because we don’t have to make the decisions and don’t have to live with the consequences. Letting two or three major international banks fail (Swedish banks had nowhere near the international exposure and Sweden is not America) could unleash market psychology consequences that are unknown and maybe more devastating than allowing the banks to continue in business and work through their problems, which are now also the consequence of a rapidly deteriorating economy that very few predicted.

    Frankly, except for a very few of us, every American contributed to the current situation by living for years well above their means. We are as much to blame for the current crisis — by over borrowing, by over leveraged investments, and by the poor lifestyle choices we have made — as the bankers, who essentially gave us what we wanted.

    Government also is to blame. Not only did it not properly regulate, it encouraged and even demanded lending to poor credits, which contributed to the mortgage problem, and it (at all levels of government) did not manage its own finances in a prudent and conservative way. Our representatives gave us what we wanted. Now we are gong to pay for it.

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