Why Geithner’s Rescue Plan Spooked the Markets

Why Geithners Rescue Plan Spooked the Markets

Timothy Geithner to America: We’re going big, aggressive and expensive.

On Tuesday, the Treasury Secretary laid out general plans to fix the nation’s ailing financial sector. He called the Bush Administration’s efforts “late and inadequate” and pledged to do better. But his own approach seems to be a mix of what his predecessor, Hank Paulson, tried in the past, along with some new efforts. What’s more, Geithner indicated that the plans he is proposing would cost more than the $350 billion remaining in government rescue funds that were approved by Congress in October.

“Fixing the problems of the nation’s financial sector will require a substantial and sustained commitment from government,” said Geithner

Despite Geithner’s earnest commitment to spend heavily on a fix, Wall Steet was disappointed by the lack of details that he shared on the new programs. The Dow Jones industrial average fell nearly 382 points on Tuesday, most of it after Geithner made his speech. Investors may have also been spooked by his hint that the Treasury might need more money to solve the banking sector’s problems.

“I want to make clear that I am not hear today to ask for more money,” Geithner told Senators later in the day during congressional testimony. But, he added, “this is going to be an expensive problem.” He also emphasized how “complicated” the banking crisis had become.

Geithner’s new proposals include setting up an aggregator, or “bad bank,” to provide financing to encourage investors to buy up the troubled loans that are now sitting on bank balance sheets and causing huge losses for financial institutions. Geithner said he hopes to eventually spur as much as $1 trillion in investments in mortgage bonds and other loans that borrowers have either already fallen behind their payments on or may soon fall behind on.

In addition, Geithner said the government plans to spend at least $50 billion on a comprehensive housing program that would include an effort to modify loans and keep people in their homes. Paulson was against a large-scale home-loan modification program, saying it could be very expensive.

But Geithner also said the Treasury will continue and even expand some programs that are already in place, including putting more money in the banks that need it. Another plan, he said, is to greatly expand a program to restart the securitization of consumer loans. That program was launched by Paulson in November, but more than three months later, it has yet to get off the ground. Geithner said his plan was for that program to backstop as much as $1 trillion in consumer, small-business and commercial-real-estate lending. Absent from Geithner’s plan was a proposal to suspend so-called mark-to-market accounting rules, which have forced banks to take large losses on their bad loans, some of which are still current. Some prominent market watchers, including former presidential candidate Steve Forbes, have been calling for a change.

How much this will all cost, or how successful it will be, is unclear, but a look at just the “bad bank” proposal suggests that Geithner will need more than $350 billion to pull off his plans. While Geithner offered few details, the idea behind the “bad bank” is to encourage private investors to buy up the troubled assets now sitting on the banks’ balance sheets. As those loans decrease in value, the banks’ earnings take a hit, endangering a number of very large financial firms, including Citigroup and Bank of America.

The reason banks haven’t been able to sell these bonds is because investors believe those assets, mostly residential mortgages or bonds tied to home loans, are worth far less than the banks believe them to be. In order to get sales going again, the government will have to close that gap.

It may do so by offering loan guarantees to investors, saying the government will protect against losses beyond a certain point. Or the government may loan money to investors at very low rates, thus lowering the investors’ costs and making them more likely to be willing to take a risk on a security based on questionable mortgage loans. And why so few details on this plan As Geithner said shortly afterward on Bloomberg, “This is very complicated to get right.”

But whatever the government does will cost money, big money. According to Markit, a research firm that tracks prices of hard-to-trade mortgage bonds, the highest rated bonds tied to subprime home loans recently traded around $0.35 on the dollar. Figuring out what banks think those bonds are worth is much harder. The firms don’t put a precise value on each security, just what they think their total bond and loan portfolio is worth. But a recent story in the New York Times looked at one bond backed by 9,000 risky mortgage loans and found that the bank holding the bond valued it at 97 cents. While this bond is not strictly comparable to Markit’s index, the message is clear — you could drive a truck through the gap between market prices and the banks’ hopeful prices on their riskiest mortgage bonds.

Using that comparison as an example, even if banks swallow half the spread between the two prices, and investors get financing to potentially take on the rest, Geithner’s “bad bank” could cost $300 billion or so to spur a $1 trillion investment in subprime mortgage loans and bonds, which is what banks are hoping to offload. That doesn’t leave a heck of a lot for the loan-modification program or any of his other plans.

“The aspiration is that government funds can get leveraged up by using private investment to solve our financial problems,” says Vincent Reinhart, a former top economist at the Federal Reserve and a resident scholar at the conservative-leaning think tank American Enterprise Institute. “But that entails the government absorbing at least some of the losses of private investors, and that is going to cost money. We probably won’t know how much for years to come.”