The Geithner Plan FAQ

http://delong.typepad.com/sdj/2009/03/the-geithner-plan-faq.html

March 21, 2009
The Geithner Plan FAQ

Q: What is the Geithner Plan?
A: The Geithner Plan is a trillion-dollar operation by which the U.S.
acts as the world's largest hedge fund investor, committing its money
to funds to buy up risky and distressed but probably fundamentally
undervalued assets and, as patient capital, holding them either until
maturity or until markets recover so that risk discounts are normal and
it can sell them off--in either case at an immense profit.

Q: What if markets never recover, the assets are not fundamentally
undervalued, and even when held to maturity the government doesn't make
back its money?
A: Then we have worse things to worry about than government losses on
TARP-program money--for we are then in a world in which the only things
that have value are bottled water, sewing needles, and ammunition.

Q: Where does the trillion dollars come from?
A: $150 billion comes from the TARP in the form of equity, $820 billion
from the FDIC in the form of debt, and $30 billion from the hedge fund
and pension fund managers who will be hired to make the investments and
run the program's operations.

Q: Why is the government making hedge and pension fund managers kick in
$30 billion?
A: So that they have skin in the game, and so do not take excessive
risks with the taxpayers' money because their own money is on the line
as well.

Q: Why then should hedge and pension fund managers agree to run this?
A: Because they stand to make a fortune when markets recover or when
the acquired toxic assets are held to maturity: they make the full
equity returns on their $30 billion invested--which is leveraged up to
$1 trillion with government money.

Q: Why isn't this just a massive giveaway to yet another set of
financiers?
A: The private managers put in $30 billion and the government puts in
$970 billion. If we were investing in a normal hedge fund, we would
have to pay the managers 2% of the capital and 20% of the profits every
year. In this case, the private managers' returns can be thought of as
(a) a share of the portfolio's total return proportional to their 3%
contribution, plus (b) a "management incentive fee" of (i) 0% of the
capital value and (ii) between 0% (if the portfolio returns 3% per
year) and 9% (if the portfolio returns 10% per year)--much less than
hedge-fund managers typically charge. the Treasury is only paying 0% of
the capital value and 17% of the profits every year.[1]

Q: Why do we think that the government will get value from its hiring
these hedge and pension fund managers to operate this program?
A: They do get 17% of the equity return. 17% of the return on equity on
a $1 trillion portfolio that is leveraged 5-1 is incentive.

Q: So the Treasury is doing this to make money?
A: No: making money is a sidelight. The Treasury is doing this to
reduce unemployment.

Q: How does having the U.S. government invest $1 trillion in the
world's largest hedge fund operations reduce unemployment?
A: At the moment, those businesses that ought to be expanding and
hiring cannot profitably expand and hire because the terms on which
they can finance expansion are so lousy. The terms on which they can
finance expansion are so lazy because existing financial asset prices
are so low. Existing financial asset prices are so low because risk and
information discounts have soared. Risk and information discounts have
collapsed because the supply of assets is high and the tolerance of
financial intermediaries for holding assets that are risky or that
might have information-revelation problems are low.

Q: So?
A: So if we are going to boost asset prices to levels at which those
firms that ought to be expanding can get finance, we are going to have
to shrink the supply of risky assets that our private-sector financial
intermediaries have to hold. The government buys up $1 trillion of
financial assets, and lo and behold the private sector has to hold $1
trillion less of risky and information-impacted assets. Their price
goes up. Supply and demand.

Q: And firms that ought to be expanding can then get financing on good
terms again, and so they hire, and unemployment drops?
A: No. Our guess is that we would need to take $4 trillion out of the
market and off the supply that private financial intermediaries must
hold in order to move financial asset prices to where they need to be
in order to unfreeze credit markets, and make it profitable for those
businesses that should be hiring and expanding to actually hire and
expand.

Q: Oh.
A: But all is not lost. This is not all the administration is doing.
This plan consumes $150 billion of second-tranche TARP money and
leverages it to take $1 trillion in risky assets off the private
sector's books. And the Federal Reserve is taking an additional $1
trillion of risky debt off the private sector's books and replacing it
with cash through its program of quantitative easing. And there is the
fiscal boost program. And there is a potential second-round stimulus in
September. And there is still $200 billion more left in the TARP to be
used in other ways.
Think of it this way: the Fed's and the Treasury's announcements in the
past week are what we think will be half of what we need to do the job.
And if it turns out that we are right, more programs and plans will be
on the way.

Q: This sounds very different from the headline of the Andrews, Dash,
and Bowley article in the New York Times this morning: "Toxic Asset
Plan Foresees Big Subsidies for Investors."
A: You are surprised, after the past decade, to see a New York Times
story with a misleading headline?

Q: No.
A: The plan I have just described to you is the plan that was described
to Andrews, Dash, and Bowley. They write of "coax[ing] investors to
form partnerships with the government" and "taxpayers... would pay for
the bulk of the purchases..."--that's the $30 billion from the private
managers and the $150 billion from the TARP that makes up the equity
tranche of the program. They write of "the Federal Deposit Insurance
Corporation will set up special-purpose investment partnerships and
lend about 85 percent of the money..."--that's the debt slice of the
program. They write that "the government will provide the overwhelming
bulk of the money ? possibly more than 95 percent..."--that is true,
but they don't say that the government gets 80% of the equity profits
and what it is owed the FDIC on the debt tranche. That what Andrews,
Dash, and Bowley say sounds different is a big problem: they did not
explain the plan very well. Deborah Solomon in the Wall Street Journal
does, I think, much better. David Cho in tomorrow morning's Washington
Post is in the middle.

[1] Too many people are saying that this was too much of an
apples-to-oranges comparison. What the private investors get is not a
management fee--it is an equity return, proportional to their equity
participation. On the other hand, the private investors do get the
ability to borrow non-recourse at a subsidized interest rate--and the
fact that the government's debt investment is non-recourse makes it
very equity-like.
My preferred way to cut the Gordian knot is to say that the "management
fee" the privates are getting is the difference between the profits
they will get and the 3 percent of the profits from the portfolio that
their putting up 3 percent of the money should get them--which I
calculate, assuming that the government charges an interest rate of 3
percent) to vary between 0 percent of the profits (if the portfolio
yields only 3 percent per year) to 9 percent of the profits (if the
portfolio yields 10 percent per year).
.

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