Monday's proposal by Treasury Secretary Timothy F. Geithner is the government's latest shot -- and perhaps its last clean shot -- at extricating up to a trillion dollars' worth of toxic assets from the financial system and making an economic recovery possible.
But will it work?
We believe the best mechanism for solving the banking-sector crisis is government-supervised bankruptcy, also known as receivership. However, the Obama administration has made it abundantly clear that it will not consider this option, except perhaps as a last resort.
Without receivership, financial institutions can't be forced to sell toxic assets unless they choose to, nor can they be forced to lower prices that are unreasonably high. The problem in the market today is that the prices demanded by the banks are much higher than the prices that private buyers (hedge funds, private equity firms, sovereign wealth funds) are willing to pay.
The government has no way to bring down the banks' minimum sale prices, especially without the threat of receivership. So the only option is to induce buyers to pay more than they think the assets are worth in today's generally risky climate, and the only way to do this is through subsidies.
The Geithner plan offers private investors incentives to participate. Those who put up funds will be eligible for government-guaranteed loans to purchase larger shares of the toxic assets. Because these loans do not have to be paid back, investors cannot lose more than the money they invested, even if the value of the assets plummets. At the same time, there is no limit on the amount they can make if things turn out well.
There are three reasons for concern.
First, the subsidy may not be sweet enough to close the deal. According to one analysis, a specific mortgage-backed security was held on a bank's books at 97 cents, while its market price was about 38 cents. Even if you limit the buyer's potential loss to the capital he put in, it's unlikely he will raise his bid from 38 cents to anything near 97 cents.
Second, there is a "lemons" problem, also known as adverse selection. Even with a reasonable degree of disclosure, the selling banks will still know more about their assets than the buyers. The banks will be trying to dump their most toxic assets (their lemons); the buyers, fearing exactly this behavior, will reduce all their bids accordingly. This will make it harder for buyers and sellers to meet.
