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The main problem with the Obama Administration's "financial stability plan" announced on Feb. 10 is that it doesn't come clean to the American public about how the losses from the financial meltdown will be divvied up. In an effort to come up with a politically appealing plan, President Barack Obama and his team obscured the answer to the most important question: Who loses?
Although Treasury Secretary Timothy Geithner repeatedly promised that the new plan would be transparent, it was precisely the lack of transparency that contributed to the stock market's negative reaction. Stock averages fell as Geithner was speaking, and were down 4% to 5% in late trading.
"It was scary watching him," says R. Christopher Whalen, managing director of Institutional Risk Analytics, a consulting firm. "The markets are tough. As long as they sense that there's bull—and indecision—they're going to reject it."
In a nutshell,Geithner promised a stringent "stress test" of banks' balance sheets; more aid to banks through a new Financial Stability Trust; up to $1 trillion for a public-private partnership to buy banks' bad real estate assets; up to $1 trillion to support student, auto, consumer, small business, and commercial-mortgage lending; and a major effort to lower the rates and monthly payments on home mortgages.
The biggest plus in Geithner's plan is the sheer size of it. "It's much better than Bush-Paulson because it's owning up to the scale of the problem," says Harvard University economist Kenneth Rogoff, referring to the Troubled Asset Relief Program, or TARP, devised by former President George W. Bush and former Treasury Secretary Henry Paulson.
But the new plan was deliberately short on detail, especially on the much anticipated public-private partnership. The Obama Administration hopes to get private investors to start buying up the toxic mortgage-backed securities that are clogging up banks' balance sheets. But it's not clear what would make those private investors suddenly want to buy assets that until now they have treated as radioactive. Adds Rogoff: "I don't see how you're going to get confidence in the markets with a plan that's so difficult to penetrate."
Many economists argue that some of the biggest U.S. banks are in such bad shape that the only reasonable alternative is to nationalize them. That would mean ejecting their top executives, wiping out their shareholders, and forcing creditors (other than government-insured depositors) to take a big hit. Once in full control of the banks, the government could strip out their bad assets for sale later, give them a huge injection of public funds, and then spin them back out to the public.
Geithner did not address the possibility of nationalization. But private investors remain well aware of the possibility; they won't put more capital into banks if they fear they could lose it in future government takeovers. That creates a standoff between the private sector and the public sector—and paralyzes the banking system at the worst possible moment.
Charles Calomiris, a Columbia University economic historian who has studied banking crises, says the key mistake of the Obama Administration is trying to come up with a plan that emphasizes political palatability over economic reality. To buy support, Calomiris says, the plan emphasizes "very careful investments over a period of time with a lot of upside potential for taxpayers, and with all sorts of limits on what bankers can do."
The problem with that approach, Calomiris says, is that it doesn't do enough to make the banks truly healthy, and just prolongs the crisis. He favors taking strong action to improve banks' health dramatically and quickly by guaranteeing them a floor price on their real estate assets, even though such action would be criticized as a giveaway. Says Calomiris: "What makes sense economically doesn't make sense politically, so I'm not very optimistic."
Of course, making banks healthy doesn't have to mean enriching their executives, shareholders, and debt holders. In fact, Whalen, the Institutional Risk Analytics analyst, says common and preferred shareholders of the most troubled banks should be wiped out entirely, while the banks' creditors (excepting depositors) should take a substantial hit as well. He faults the Geithner plan for saying nothing about making creditors absorb some of the pain. One possible reason: Many of the owners of the banks' debt are foreign commercial banks and central banks that would suffer serious damage from a big writedown of their holdings. Whalen faults Geithner for not speaking frankly about these issues, saying, "We have to talk to people in a real way."
The result of gliding past such questions is that the Obama plan looks like an evolution of the Bush plan rather than a clean break. To hear Geithner criticize the way things were done before, it would have been hard to guess he was a key partner of the Bush Administration in his previous job as president of the Federal Reserve Bank of New York. In his speech, he said that in the past, "Policy was always behind the curve, always chasing the escalating crisis."
The question is whether that is still the case. As much as he wants to be an agent of change, Obama risks repeating the mistakes of his predecessor.
Coy is BusinessWeek's Economics editor.