The Plan

It seems we now have the details of the administration’s plan to clean up the banking system. Convention seems to dictate that we refer to this as “Geithner’s plan” though with something of this level of importance, it’s not like Barack Obama and the White House staff were somehow kept out of the loop.

I would say that what we’re seeing here is a strong view on the part of the administration that it is dramatically more desirable for major financial institutions to continue to be managed by their current managers rather than subject to government authority. If you just keep that in mind—they think it’s extremely important that Vikram Pandit and the rest continue running their firms without interference from congress or the executive branch—then the plan all “makes sense” whether or not you agree with it.

The crux of the matter is that “toxic assets” will be put for sale at auction, in which the bidding will be done by private parties but whoever buys the asset will have their downside risk mitigated by the fact that the government is actually putting up the bulk of the money as a silent partner in the venture. The odds are strong that this will lead to banks being able to sell their assets for more than they’re really worth. This is the basic dynamic of an auction. Ten people guess what something’s worth, and whoever’s guess is highest “wins” the auction. As per the winner’s curse, this usually means that the “winner” of the auction is someone who’s guessed too high. The fact that the government, rather than the bidders, will be bearing most of the risk further encourages the bidders to guess too high. Consequently, the winner of the auction will stand a small chance of making a bunch of money and a large chance of losing a small amount of money. The government will stand a small chance of making a bunch of money and a large chance of losing a bunch of money. And the banks selling the assets will stand a large chance of making a bunch of money.

The basic dynamic here is that the banks will get a bunch of money and be able to go about their business, and the taxpayer will almost certainly be out a bunch of money. That sucks. But it must be understood that in the case of a nationalization plan the taxpayer would be out a bunch of money anyway. The heavy taxpayer losses aren’t really the difference. The difference is that under the administration’s plan the existing banks under existing management will go back into “normal” business, rather than being broken up and sold to new managers. To my way of thinking, this is a big problem—it’s an unjust reward to current managers, it’s an unfair penalty to the managers of better-managed but smaller institutions, it’s likely to keep the banks being well-managed, and it seems to still leave us with the existence of an undesirably large number of “too big to fail” financial institutions. To the administration’s way of thinking, however, this is superior to a situation in which the government would have too much control over the banks.

Think of it this way. There are too lessons you could have learned from AIG. One is that the public has had it up to hear with giveaways to financiers. The other is that congress is prone to overreacting to momentary spasms of outrage fanned by cable news. The administration seems to have decided that the second lesson is more important.

See also: Calculated Risk, Yves Smith, and Paul KrugmanPat Garofalo.