This morning, the U.S. Treasury unveiled its new plan to rescue the financial system by partnering with the private investors to purchase up to $1 trillion of "toxic assets" (now called "legacy loans" and "legacy securities"). The problem I see with the plan is that with the Treasury, FDIC, and Fed heavily subsidizing risk-taking by private investors, it creates a moral hazard problem.
The plan is broken up into two programs. Under the first program, private investors will bid on toxic loans through an auction process. In the example that the U.S. Treasury department uses, a bank has a pool of $100 face value residential mortgages, an auction is held, and the highest bidder is $84. The FDIC would provide guarantees $72 of the financing, while the Treasury and private investors each pitch in $6. In other words, taxpayers are on the hook for more than 90% of the investment if it goes sour. Not only does this mean that private investors could end up up making careless decisions, but knowing that they are bidding with other people's money, it could artificially drive up asset prices in the auction process. Under the second program, private fund managers raise money to purchase toxic securities and that investment gets matched by Treasury money. On a theoretical $100 private investment, Treasury will pitch in up to $300, bringing the total available for purchasing securities to $400.
The one area that isn't clear to me right now is what kind of upside U.S. taxpayers are getting for taking on a majority of the risk. This program has all the makings of welfare for wealthy hedge fund managers.
Either way, the market seems pleased with the plan for now. As I write, the Dow is up 262 points, which will probably give Tim Geithner a reprieve for the foreseeable future.
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