March 25, 2009 | WebMemo on Economy
Over a month after formally announcing the plan, Treasury Secretary Timothy Geithner yesterday released details on his proposal for removing toxic assets from the balance sheets of banks and other financial institutions.
The keystone of the program is the "Public-Private Investment Program" (PPIP), through which these so-called "toxic" or "legacy" assets would be taken off the books of financial institutions. In the wake of the announcement, the stock markets soared, grateful that the Administration was finally clearing up the uncertainty as to its intentions. Substantively, however, while the plan does have positive elements, it is significantly flawed. Just as important, Secretary Geithner has not demonstrated the need for such government intervention.
From TARP to PPIP
The proposal is but the latest in a series of initiatives dating back to last fall to address the problem of toxic assets, the securities and loans held by financial institutions whose value is uncertain in the wake of the financial crisis. Last fall, then-Treasury Secretary Hank Paulson proposed that the federal government purchase such assets directly. This plan was soon abandoned, however, due largely to the problem of determining how much the government should pay for those assets.
Earlier this year, the Obama Administration was reportedly considering a "bad bank" approach, under which toxic assets would be aggregated in a government-owned and -managed bank created for that purpose, thus isolating the assets until they could be sold and leaving banks with clean balance sheets. This plan, however, still offered no way of valuing assets.
The current approach was publicly announced by Secretary Geithner last month. Essentially, the idea is to use federal funds to facilitate the purchase of toxic (or what Treasury now calls "legacy") assets by public-private investment groups, which would bid against each other for the assets. Yesterday's announcement provided details for how this approach would work.
For "legacy" loans, private investors would provide 1/14 (about 7 percent) of the partnership's total assets, matched by another 1/14 provided by the Federal Deposit Insurance Corporation. The remaining amount (6/7 of the total, or about 85 percent) would be covered by guaranteed loans provided by FDIC. For "legacy "securities (as opposed to loans), up to five fund managers pre-qualified by the Treasury Department would raise private capital that would be matched dollar-for-dollar by the government. Treasury would also provide loans to enable the partnership to purchase even more assets.
In both cases, while the government would share profits equally with the private-sector partner, taxpayers bear most of the risk of losses. In other words, the private-sector partner cannot lose more than its investment. Any further losses after the private capital is gone would be covered by the taxpayers.
To its credit, this approach involves the private sector in making the investments necessary to address the toxic asset problem. And by allowing competitive bidding, some approximation of a market could be made.
That said, however, the plan still suffers from a number of flaws:
Is It Really Necessary?
The American public has justifiably grown skeptical of interventions that create more problems than they solve, entangling the federal government in the management of private-sector businesses. And they have good reason to be skeptical of this plan as well. Since this plan was originally announced, Secretary Geithner has argued that, despite its massive cost and certain flaws, the plan is necessary to avoid a complete collapse of the American financial system. Certainly the banking system is still quite fragile, and for this reason the Administration should be very alert to conditions and ready to respond as appropriate.
However, there is not an imminent threat of a collapse. On the whole, financial markets are impaired but functioning. Indeed, many of these "toxic" assets are still performing despite problems in housing and other markets. Given the dangers of market intervention of this kind-not only to taxpayers in the form of massive costs but potentially to the financial markets themselves-actions such as the PPIP program should be a last resort, engaged in only when absolutely necessary. That standard has not been met.
James L. Gattuso is Senior Research Fellow in Regulatory Policy and David C. John is Senior Research Fellow in Retirement Security and Financial Institutions in the Thomas A. Roe Institute for Economic Policy Studies at The Heritage Foundation.
See David C. John and James L. Gattuso, "Obama's Bank Bailout Plan: Not Ready for Prime Time," Heritage Foundation WebMemo No. 2291, February 12, 2009, at http://www.heritage.org/Research/Economy/wm2291.cfm.