You thought Bernie Madoff's $50 billion Ponzi scheme was impressive? Well, economist Jeffrey Sachs explains how the Geithner bailout plan could fraudulently transfer trillions of dollars from taxpayers to bankers if the banks game the system with front companies.
The Geithner plan is supposed to encourage private investors to buy up the toxic assets, thereby creating a market where none existed. In order to do that, the government will loan the private investors the overwhelming majority of the money they need to buy this crap. The private investors will only have to come up with a fraction of the cost of the assets out of their own pockets.
Sachs' worry is that there is nothing to stop the banks that are holding the toxic assets from creating straw companies to buy up their own bad assets with our money.
The plan was supposed to create an incentive for banks to price their toxic assets fairly in order to appeal to private investors who were highly motivated to scour the refuse pile for the hidden gems that Tim Geithner believes are hidden in the detritus. If a bank prices its toxic assets ridiculously high, the argument goes, private investors will find a competing bank that's charging a more reasonable price for its dreck.
This public-private partnership strategy is supposed to be better than having the government buy up the toxic assets at some arbitrary price. Maybe it is. A direct buy is a bad option too, because a) nobody knows what a fair price is, and b) the banks are guaranteed to overprice their assets and gouge the government.
Sachs asks us to consider the following scenario: A toxic asset on Citibank's balance sheet has a face value of $1 million, but it's actually worth nothing. (In real life it would have some value, but we're simplifying.)
Suppose Citibank creates what we'd normally call a front company, a legal fiction to disguise who's really doing business with whom. Let's call it the Citibank Public-Private Investment Fund (CPPIF).
Under the Geithner plan, there's nothing to stop CPPIF from buying the asset at Citibank's ridiculously inflated asking price of $1 million. The government lends CPPIF a total of $925,000 and Citibank kicks another $75,000 to make a cool million.
What happens next? Citibank gets $1 million dollars for a worthless piece of paper. CPPIF now owes the government $925,000, but if it quietly goes bankrupt, so what? Citibank made $925,000 on the deal (the $1 million it got for the toxic asset, minus the $75,000 it fronted to CPPIF to buy it).
If this plan is going forward, Congress better be drafting legislation to stop banks from buying up their own overvalued assets with our money through front companies. But if Congress is going to start regulating what kinds of companies bailed-out banks can invest in, why not just nationalize the banks already?