Geithner’s Toxic Asset Purchase Plan is a Scam

This week the Treasury announced its latest plan to defuse the Affordable Mortgage Depression. The new scheme would allow institutional investors the opportunity to buy Toxic Assets from hobbled banks under absurdly favorable terms offered by the U.S. Government. The generosity of the purchase financing conditions would make a subprime mortgage broker blush. Institutional investors will be required to put up 7% of the capital used to buy bad assets. The remainder of the financing will be provided by the Government which will contribute 7% of the purchase price in equity and 86% in the form of a low interest rate federal loan. The plan is another misguided attempt by the Government to prop up the collapsing economy at extraordinary taxpayer expense.

Why didn't the Treasury use the original $700 billion of TARP money, which was intended to purchase Toxic Assets, for this very purpose six months ago? Given that the Government is now willing to finance 93% of the purchase price of Toxic Assets, why doesn’t the Treasury just buy the distressed securities outright? Why have they proposed the notion of partnering with private institutional investors but only require that these “partners” put up 7% of the capital?

The problem with the TARP plan was the question of how much the Government should pay for the distressed assets? A rational solution would have been restoring liquidity to the system by paying the current market value for the securities. The problem is that banks don’t want to sell their bad loans at 30 cents on the dollar. They are still pretending that the Toxic Assets are worth 60 cents on the dollar. In fact, if these loans were sold to the Government or anyone else at market prices many more banks would fail. The distressed sellers would be recognizing huge and previously unrecorded losses. Such transactions would also establish irrefutable market prices for the entire pool of Toxic Assets. Banks with no intention of selling their distressed holdings would be required to revalue them. In doing so, many banks currently pretending to be healthy would be forced to recognize that they are insolvent. The Government couldn’t buy the Toxic Assets at their market value with TARP money without destroying this illusion.

The Government needed a solution that would allow the bad banks to sell and/or value their Toxic Assets at a substantial premium to the current market value. As such, the Treasury overtly considered buying the loans at prices well above the illiquid market values. This option was deemed politically unfeasible as it amounted to rewarding irresponsible banks for their failures and consciously overpaying for bad assets with taxpayer money. Such action wouldn’t have flown well politically six months ago. Now that politicians have whipped the public into a populist furor over the Government’s mismanagement of AIG, it is unlikely that policy makers have the backbone to attempt such direct and costly corporate welfare.

Treasury Secretary Geithner was entrusted with the responsibility of generating a scheme to bail-out the bad banks with taxpayer money while adequately obscuring the real intent, effect and financial cost of this sleight of hand.

The subsidized Toxic Asset Purchase Plan creates the impression of free markets, private transactions and a mechanism to capture fair market prices in a competitive process. In reality it is welfare for bad banks and a sweetheart deal for institutional investors which distorts the value of the problemed securities through subsidized purchases at considerable taxpayer expense.

The original rationale against valuing Toxic Assets at current market prices was that the market itself wasn’t functioning. The idea was advanced that a lack of market liquidity meant that current prices were not reflective of actual value. Banks argued that the value of these assets would rise when liquidity returned. Of course this theory was advanced 18 months ago when the credit disruption originally emerged in August of 2007. In fact, the value of Toxic Assets has continued to fall as the economy deteriorated, housing prices collapsed and the financial crises went global. At some point these perpetually optimistic fantasists need to recognize that current markets are the reality and things in fact can get worse.

This brings us to the Treasury Secretary’s proposed scam. The government is consciously structuring a rigged transaction process with the intent to create a Toxic Asset bubble by providing investors with favorable access to credit, subsidizing the rate of interest on the debt and allowing investors to lever their capital dramatically to magnify investment returns. This is virtually the exact scenario that created and perpetuated the Housing Bubble. Once again the Government has decided to solve the economy’s problems caused by excessive debt and overvalued assets with easy credit, cheap money and extreme leverage.

The scam continues as so-called “buyers” will receive the upside of any asset price gains, but the tax-payers will be on the hook for virtually all losses should the economy continue to deteriorate and the value of troubled loans fall.

By extending extraordinary leverage to investors and guaranteeing them protection against material losses, Geithner has dramatically increased the amount of money institutions will be willing to pay for these Toxic Assets. Amazingly the Government thinks that getting investors to overpay for distressed securities at taxpayer expense is a good idea. Taxpayers are directly liable for losses associated with bad asset purchases. The higher the valuations paid in the subsidized transactions, the greater the likelihood and size of Government financed losses.

The Government doesn’t appear concerned about its liability in the scheme. That is not the intent of the design. What the scam does is solve the Treasury’s political problem. The Government can’t overpay for Toxic Assets directly because they would be responsible for the valuations paid. Knowingly overpaying for distressed securities would insight public outrage. By introducing the gimmick of private investors, the Government generates political cover for itself by creating the impression of a market transaction while still subsidizing the incompetent banks.

There is no possibility that the prices paid for distressed assets will be reflective of actual value. The Government has rigged the process, manipulated the risks and rewards, and materially distorted the values at which the securities will be purchased. This is a direct transfer of wealth from taxpayers to the incompetent banks selling Toxic Assets and to institutional investors who are only willing to buy the securities because they are being directly compensated to do so