Through the Looking Glass

Couple reactions to the Geithner Plan:

• There are two major schools of thought on this crisis. One-the government has to do something to ease the asset deflation occurring around the world. The second says, let the banks fail so that prices "over correct" and asset prices will eventually rebound once speculators step in. Historically, that is how all crises end with speculators stepping in once prices over correct a bridge too far. If you are in favor of the second method aka "government intervention" on asset prices this is probably the best you are going to see from an analytical perspective. In short "It's the sort of thing you'll like, if you like that sort of thing"
• The government's approach since Paulson began intervention and now continued with Geithner represents the largest and perhaps one of the most inequitable wealth transfers in history. The approach has been to preserve existing debt stakeholders and support it with unlimited lines of credit, balance sheet guarantees and equity infusions. These bank creditors (lenders to the banks), lent money to support the mortgage bubble of the last decade with reckless and greedy abandon-- they knew what they were getting into and have no right to expect special protection from the government. The right approach would be for the government to take over bad banks some Friday night (all of them in one quick act of regulatory courage) and convert the debt into equity. Instead of the government putting in new money or issuing blanket balance sheet supports, these debt conversions would act just like new equity in the bank balance sheets. The government appears reluctant to do this post Lehman given the violent reaction in the money markets because of this failure. However, the damage is already been so why not act? The alternative is to convert all this private debt into public debt or keep the banks in "walking dead" states until this debt can be paid off. It also potentially saddles the nation with historically unprecedented debt burdens that jeopardize our ability to have a modern energy infrastructure and national healthcare.
• This plan is a lot like pretty much everything we have seen in the last two years something doesn't make sense about getting out of a crisis caused by excessive debt by borrowing a ton more. Geithner is essentially using leverage to try and juice up these asset prices. In a world where we have gone from 40:1 leverage down to a fraction of that--he is trying to find a temporary middle ground to ease the mass deflation is asset prices. When we started this crisis we were at about 325% to GDP. Two years later we are probably at 350-365. In the Great Depression, three years out debt to GDP had actually fallen by quite a bit.
• Geithners's plan attempts to address one of the major issues behind the Paulson plan by using private money to try and increase the capital raised as well as perform "price discovery" to make sure the government does not over pay by too much. It is really a derivative plan however. Nothing too earth shattering here.
  
• If in some cases the government does over pay --it can always fall back on the case that private money went right along with it at the same price (although the government is obviously a lot more leveraged here). Basically, "yeah we were stupid but so were a bunch of other people with us".
  
• Could we not have modified mark to market for distressed assets BEFORE introducing this plan? It doesn't cost a thing and makes a huge difference for some securities. We'll get this change soon, but it's a shame we couldn't get that adjustment first.
• One of the reasons the RTC plan worked was because there was no issue with what the government paid for the assets. The assets were essentially seized and the government owned the assets as part of taking control of a bank. You never had to worry if the government made some sort of judgement error which it is universally apt to do.
  
• Geithner is essentially using principles of using private money for price discovery (since we don't have the luxury of an RTC) and using government leverage to encourage risk taking. Frankly, those are the two most powerful tools he can use, and I'm not sure what else can be done unless you want to allow banks and the entities holding these assets to fail.
• The biggest downside to this plan is that while it is designed to move prices up and increase risk taking, real estate prices are still very much over shot from the bubble years. Government intervention is keeping a lot of sellers holding on. We are not going to return to 40:1 leverage any time soon and the free money that drove prices higher in many markets across the world won't return. Many sellers are holding on in the hope that the government will give them some sort of "graceful exit". By intervening and threatening even more intervention down the line, markets and prices don't clear and the crisis is effectively prolonged. Historical relationships between income and asset prices have to return to historical levels and this plan, in some cases, may push equilibrium pricing off.
  
• In a lot of cases, this deal is an exceedingly good one for investors. Guys like Bill Gross have got to be escatic. No doubt there will be funds created to try and take advantage of this. Huge leverage with with heads you win, tails the government loses. If they can expand it large enough it will have an impact.
  
• Folks like Krugman who think this plan is a bad idea need to come out with what is a better solution if they want intervention at all. It seems to me that to engage private capital to enter the market again you have two options. 1) Allow prices to drop so low and over correct is steps in (that is the government do nothing plan that allows failures in AIG, Citi etc), or 2) Do a plan that eliminates your downside and gives you leveraged upside to juice your returns and engage "greed". If Krugman and others are going to complain this is a horrible mistake, are they aware of some other method to engage private capital? These seem like two boundary conditions and the Treasury Secretary has picked one.
  
• One last thing. This exercise of using private money and leveraging it up to goose up price discovery and force a rebound in asset prices combined with Quantitative Easing from the Fed (never been done) are extreme examples of applied economic theory to fix the mother of all asset bubbles. Much like the last two years have been, it all feels like one big giant trip through the looking glass.