Geithner and Summers have now announced their plan to raid the Federal Deposit Insurance Corporation (FDIC) and Federal Reserve (Fed) to subsidize investors to buy toxic assets from the banks at inflated prices. If carried out, the result will be a massive transfer of wealth — of perhaps hundreds of billions of dollars — to bank shareholders from the taxpayers (who will absorb losses at the FDIC and Fed). Soaring bank share prices on the morning of the announcement, and in the week of leaks and hints that preceded it, are an indication of the mass bailout at work. There are much fairer and more effective ways to accomplish the goal of cleaning the bank balance sheets.

A major part of the plan works as follows. One or more giant investment funds will be created to buy up toxic assets from the commercial banks. The investment funds will have the following balance sheet. For every $1 of toxic assets that they buy from the banks, the FDIC will lend up to 85.7 cents (six-sevenths of $1), and the Treasury and private investors will each put in 7.15 cents in equity to cover the remaining balance. The Federal Deposit Insurance Corporation (FDIC) loans will be non-recourse, meaning that if the toxic assets purchased by private investors fall in value below the amount of the FDIC loans, the investment funds will default on the loans, and the FDIC will end up holding the toxic assets.

To understand the essence of the giveaway to bank shareholders, it’s useful to use a numerical illustration. Consider a portfolio of toxic assets with a face value of $1 trillion. Assume that these assets have a 20 percent chance of paying out their full face value ($1 trillion) and an 80 percent chance of paying out only $200 billion. The market value of these assets is given by their expected payout, which is 20 percent of $1 trillion plus 80 percent of $200 billion, which sums to $360 billion. The assets therefore currently trade at 36 percent of face value.

Investment funds will bid for these assets. It might seem at first that the investment funds would bid $360 billion for these toxic assets, but this is not correct. The investors will bid substantially more than $360 billion because of the massive subsidy implicit in the FDIC loan. The FDIC is giving a “heads you win, tails the taxpayer loses” offer to the private investors.

Specifically, the FDIC is lending money at a low interest rate and on a non-recourse basis even though the FDIC is likely to experience a massive default on its loans to the investment funds. The FDIC subsidy shows up as a bid price for the toxic assets that is far above $360 billion. In essence, the FDIC is transferring hundreds of billions of dollars of taxpayer wealth to the banks.

With a little arithmetic, we can calculate the size of that transfer. In this scenario, the private investors (who manage the investment fund) will actually be willing to bid $636 billion for the $360 billion of real market value of the toxic assets, in effect transferring excess $276 billion from the FDIC (taxpayers) to the bank shareholders! Here’s why.

Under the rule of the Geithner-Summers Plan, the investors and the TARP each put in 7.15 percent of the purchase price of $636 billion, equal to $45 billion. The FDIC will loan $546 billion. (All numbers are rounded). If the toxic assets actually pay out the full $1 trillion, there will be a profit of $454 billion, equal to $1 trillion payout minus the repayment of the FDIC loan of $546 billion. The private investors and the TARP will each get half of the profit, or $227 billion.

Since this outcome occurs only 20 percent of the time, the expected profits to the private investors are 20 percent of $227 billion, or $45 billion, exactly what they invested. Similarly, the TARP’s expected profits are also equal to the TARP investment of $45 billion. Thus, both the TARP and the private investors break even. As competitive bidders, they have bid the maximum price that allows them to break even.

The bank shareholders, however, come out $276 billion ahead of the game, while the FDIC bears $276 billion in expected losses! This transfer occurs because the investment fund defaults on the FDIC loan when the toxic assets in fact pay only $200 billion, an outcome that occurs 80 percent of the time. When that happens, the investment fund is “underwater” (holding more in FDIC debt than in payouts on the toxic assets). The investment fund then defaults on its debt to the FDIC. The FDIC gets $200 billion instead of repayment of $546 billion, for a net loss of $346 billion. Since this outcome occurs 80 percent of the time, the expected loss to the taxpayers is 80 percent of $346 billion, or $276 billion. This is exactly equal to the overpayment to the banks in the first place.

Soaring bank stock prices during the last week, and then again on the day of the announcement, demonstrate the bailout in action. From March 9 to March 20, the KBW bank index rose by 33 percent, while the overall Dow Industrials rose by only 11 percent, indicating how the rumors were especially good for the banks. This morning, bank shares across the board soared in value. Citibank has tripled in value since its low in early March. The value of the bailout dwarfs the AIG and Merrill bonuses, but since the bailout is much less obvious than the bonuses, the public’s reactions have been muted, at least at the start.

The plan should not go forward on such unfair terms. Under the law, Congress should apply the Federal Credit Reform Act of 1990, which requires budget appropriations to cover expected losses on government loans programs, which would presumably include the expected losses on FDIC and Treasury loans under the Geithner-Summers Plan. With proper credit accounting, the entire operation in our little illustration would require a budget appropriation of $276 billion, equal to the expected losses of the FDIC and Treasury. If the Administration goes to Congress for such an appropriation it will be shot out of the water. The public will not accept overpaying for the toxic assets at taxpayers’ expense. Thus, it is very likely that the Administration will attempt to avoid Congressional oversight of the plan, and to count on confusion and the evident “good news” of soaring stock market prices to justify their actions.

The Geithner-Summers plans for the FDIC are not the only off-budget transfers to bank shareholders taking place. Other parts of the plan support subsidized loans from the Treasury and, even more, from the Fed. The Fed is already buying up hundreds of billions of dollars of toxic assets with little if any oversight or offsetting appropriations. Since the Federal Reserve profits and losses eventually show up on the budget, the Fed’s purchases of toxic assets also should fall under the Federal Credit Reform Act and should be explicitly budgeted.

There are countless preferable and more transparent courses of action. The toxic assets could be sold at market prices, not inflated prices, making the bank shareholders bear the costs of the losses of the toxic assets. If the banks then need more capital, the government could invest directly into bank shares. This would bail out the banking system without bailing out the bank shareholders. The process would be much fairer, less costly, and more transparent to the taxpayer.

Banks that are already insolvent should be intervened directly by the FDIC, that is, temporarily taken into receivership. The shareholder value would be wiped out, except perhaps for some residual claims in the event that the toxic assets vastly outperform their current market expectations. As I’ve written before, the allocation of bank shares between the taxpayers and the current bank shareholders could be make contingent on the eventual value of the toxic assets (http://www.huffingtonpost.com/jeffrey-sachs/a-proposal-on-how-to-clea_b_166303.html), ensuring fairness between the shareholders and the taxpayers.

https://www.huffpost.com/entry/will-geithner-and-summers_b_177982