Jeffrey Sachs, one of the early critics of Tim Geithner’s Public-Private Investment Partnership scheme, is admitting he was wrong about the program–it’s far worse than he thought.
The worst problem is that it is completely open to being scammed by banks because it allows the banks selling the toxic assets to be buyers as well. This creates the potential for a daisy-chain scam: a bank creates an off-balance-sheet entity that buys bad assets for far more than they’re worth, using money borrowed from taxpayers. When the assets turn out to be worthless, the bank-created entity then defaults on the loan. Because the loan is non-recourse, the government is left holding the worthless assets and is out the entire amount of the loan. In effect, the plans lets banks write themselves checks straight from the US taxpayers.
Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset. All of the previous articles consider the case of true outside bidders.
Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.
Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank’s net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K. Since the total of toxic assets in the banking system exceeds $1 trillion, and perhaps reaches $2-3 trillion, the amount of potential rip-off in the Geithner-Summers plan is unconscionably large.
…And the gaming of the system doesn’t have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi’s assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same.
Does that sound far-fetched? It shouldn’t. As we made clear weeks ago, the government has told the banks they are more than welcome to be buyers under the plan. The Financial Times reported that Citigroup (C), Goldman Sachs (GS), Morgan Stanley (MS) and JP Morgan (JPM) are all interested in buying toxic assets under the plan. Citi and Bank of America (BAC) are already loading up on toxic assets in anticipation of this scam.
Is all that enough evidence that the Geithner plan is enabling a huge rip-off? Apparently, not for everyone. Over at The Big Money, Chadwick Matlin says the critics are jumping the gun.
“First, we don’t know that the banks are colluding,” he writes. “Profit motives suggest that they would, but political pressures suggest they may not be.”
Two points on this objection. First, we’re not sure we’d bet very much of political pressure beating profit motives. Second, and more importantly, while it’s true we don’t know for certain that the banks are preparing to scheme and collude to loot the Treasury, we’ve got plently of circumstantial evidence. And that’s all we’ll ever have because the Geithner plan lacks oversight and transparency that would allow us to actually know what’s happening. We might not know the banks are colluding but that’s because the program has no mechanism to detect collusion, much less avoid it.