Hey, It's Only a Trillion (or More)

By Phil KerpenDirector of Policy, Americans for Prosperity

The new Obama-Geithner plan to buy up bad bank assets is an improvement over the original Paulson-Bush plan for the government to simply buy up toxic assets directly. That plan was abandoned shortly after the Trouble Asset Relief Fund (TARP) bill was passed because it would have been too expensive and because there was no agreement over how to price the assets--set the price too low and banks would be hurt instead of helped by the deal, set the price too high and taxpayers get ripped off. The private part of the Obama-Geithner plan solves that problem, but the public half--the reliance on substantial taxpayer funding--is another misstep, and could ultimately cost trillions of dollars.

The major flaw in the new plan is that almost all of the downside risk is still borne by the taxpayer, not by private investors, creating a structure in which profits are privatized but risk remains largely socialized, setting up the potential for a huge taxpayer bill in the future if another shoe drops in the financial crisis.

The asset purchases would take place at auction, and that's good news, because it should solve the pricing problem that plagued the original TARP plan. It means that a functioning market would exist to finally get meaningful pricing information on assets that have been frozen on bank balance sheets.

The "Legacy Loans" program is designed to buy bad loans from banks and get them off their balance sheet. Funds would be created to participate in the program that would raise half their equity from private sources and half from Treasury, through the TARP. The funds would private managed by their private sector investors and would compete with each other.

The funds would be eligible for a guarantee from the Federal Deposit Insurance Corporation (FDIC), which would backstop their purchases of bad loans. This FDIC guarantee would be capped at a 6 to1 debt to equity ratio--but remember that half the equity came from the TARP, so private investors would actually have $12 of taxpayer funding for every dollar of their own money they put in. That's a huge amount of taxpayer risk for every dollar of private risk-taking, which creates an incentive for funds to overbid at auction, taking a chance that loans may overperform expectations because taxpayers are on the hook for downside risk.

The second part of the new plan, the Legacy Securities Program, provides federal matching funds and non-recourse loans to buy mortgage-backed securities and asset-backed securities, the infamous housing derivatives that have blown up the financial system. This plan would provide equity-matching funds from the TARP to private investment funds, and then provide non-recourse loans from the Federal Reserve's Term Asset-backed-securities Loan Facility (TALF) up to the amount of capital raised. So we'd be looked at about $3 of taxpayer money for each dollar of private investment. That's a lot less risky than the 12 to 1 ratio on the loan side, but the taxpayer is still picking up most of the downside risk, because the loans don't have to be repaid if the assets fall in value.

The private half of the public-private plan is great--it accesses private funds and uses competition to set prices, a much better strategy than relying on the wisdom of federal bureaucrats. The public half, however, the incentive to get private capital involved, would be much better done through tax reductions than direct investment and FDIC backstops. The government should exempt investments in toxic assets from capital gains taxes and set up easy-to-use vehicles, like ETFs, to allow all Americans to participate, tax-free, in investing in our financial system. That type of approach could unleash a similar amount of capital without exposing taxpayers--without their consent--to huge downside risk.

The Geithner-Obama plan could work--if toxic assets don't take another tumble and stick taxpayers with a staggering multi-trillion dollar bill. It's a high risk gamble, and unfortunately, the taxpayers' whose money is at stake are being forced to ante up whether they want to or not.

Phil Kerpen is director of policy for Americans for Prosperity.

Phil Kerpen is the founder of American Commitment Action Fund, on the web at www.BookerFAIL.com.