american-dollar-toilet-paper.thumbnail.jpgI’m going to discuss the administration’s plan to take toxic assets off the banks, then talk about what this and other moves this week (such as the Fed announcing $1.15 trillion in new spending) tell us about the administration’s plans for the financial sector and the economy, and how I believe they’re going to play out, as well as what the political power realities now are.

There are three parts to the plan to take toxic assets off the bank’s hands, of which, we mostly have the details of the first part, where the FDIC will form "private/public" partnerships to buy up assets. The plan has the FDIC loaning up to 85% of the cost of purchase as a non-recourse loan, which is backed up only by the value of the loan. Of the remaining 15%, the Treasury will lend up to 80%. The remaining 3% of money must be put up by the private partners. The government will share in any profits or losses of the underlying security, though we don’t know what percentage goes to the private investor or the public.

Think of this in simple terms. If I want to invest in securities, why would I want a 3% partner whom I have to split the return with? If the government is investing 97% of the money, why are they even bothering with private partners? Why not just pony up another 3%? Oh sure, there may be some occasions on which the private partners put up more, but if the government thought they could get more, why are they offering 97% financing, with 85% being a complete write-off, if the asset goes down rather than up?

There are two possible answers I can see:

The first is that they want "price discovery." They need some market set prices for the toxic waste. Of course, such prices could exist tomorrow. As the Times notes, private investors are willing to pay 30% of face for these assets. Banks want 60%. Banks can’t afford to allow a 30% valuation, because then most of them would be forced to revalue their books and that would make them formally bankrupt. However, if purchasing is highly subsidized and largely no risk "heads the taxpayer takes most of the loss, tails the private investors make money," then prices will probably be higher than 30% because investors won’t be taking the majority of the risk, and will be required to put almost no money down (3% only, which is about 33 to 1 leverage, insane in-and-of itself). Now, if the government just ponied up 100% of the money, it wouldn’t really be considered "price discovery," it would just be a government purchase at inflated prices. But if there are "private investors" involved, the administration may figure that it is legitimate price discovery. And, if they get some good prices, they can then have the banks use those values for price discovery. . . and voilà – they aren’t bankrupt (or at least, not as bankrupt. Degrees do matter).

The second is simpler. The involvement of a small amount of private money is a fig leaf allowing the government to get as much toxic waste off the banks books as possible, with the majority of the risk and cost being born by the taxpayers, with a good part of the profit potential being given to private investors. In this scenario, this is just a cynical move to take private losses from the banks and put them into public hands with a good chunk of the upside still being in private hands. Privatize the profits, socialize the losses.

What’s fascinating about this to me is less what they’re doing (we knew the general details earlier) than the fact that as Taibbi has noted they’re completely bypassing Congress, and yet spending huge amounts of money.  Say what you will about Paulson, he at least asked for the money from Congress. Bear in mind that there is only about $350 billion or so of Paulson’s TARP money left. The treasury portion of the FDIC plan, assuming full loaning, is about $120 billion. The rest of the money will be used for parts 2 and 3 of the plan – a dollar-for-dollar match with a few securities firms to buy up trash, and the remainder to be used in combination with the Fed to expand lending on some types of securities.

What this means is that $850 billion is coming from the FDIC. The FDIC hasn’t been given $850 billion in new money by Congress, last I heard.

And this week, the Fed announced that it would spend $1.15 trillion – $300 billion to buy treasuries, $750 billion to buy mortgage backed securities guaranteed by Freddie and Fannie, and a $100 billion of Freddie and Fannie debt.

So, $2 trillion of new spending, none of it approved of by Congress. One might argue that the Fed has the right to print as much money as it feels like, and Congress gave it that right in the past, and that the FDIC, since it can set premiums on members, can spend its money how it chooses, but there is no question that, at the end of the day, the government of the US is on the hook for $2 trillion more of spending, loans, and guarantees, and there is no question that Congress wasn’t asked.

This week, we heard that the deficit was up to $1.8 trillion, and there was much squealing and rending of hair as a result. But that number is totally fictional. The Fed, Treasury, and FDIC, over the last year or so, have spent, loaned, guaranteed, and issued trillions of dollars more (not sure how many trillions at this point. Probably in excess of $10 trillion.)

Not to put too fine a point on it, but that’s a lot of money. The underlying assumption, as Krugman noted today, is that nothing is fundamentally wrong with the economy (something I’ve said myself, in the past). Get past this crisis, the values of all the toxic waste will go back up to bubble valuations, and the government will be able to unwind all its positions, and while there will be a cost, it won’t be that big.

Now, if you think that there are things fundamentally wrong with the economy, and that fundamental changes are needed to fix said economy, then you aren’t going to like what the administration is doing, because it’s not clear to you that the values of these assets are going to recover enough, and it is clear to you than the US economy needs a fundamental restructuring. And the administration is not doing that. There is no move to reinstate a full-fledged renewed Glass-Steagall. There is no move to break up too-large-to-fail banks and to forbid investment banks, brokerages, and commercial banks from being under the same roof. There is no fundamental restructuring of the tax system to rein in compensation everywhere so that executives don’t have incentives to burn down their companies for ready profits which can be turned into multi-million dollar bonuses. It’s not just recipients of funds which need a 90% tax rate, it’s everyone (though I’d start the rate at a million, not 250K.) And so on (the list of changes is much longer).

Meanwhile attempts to solve the problem by simply throwing money at it are going to start running up against macroeconomic reality. Inflation is not everywhere and always a function of money supply, but if you print enough money (and the Fed has) it’s going to show up somewhere. In the case of the US, it is going to show up in the dollar starting to decline, and in riptide inflation – deflation in some areas will continue, but in other areas inflation will start to take off (for example, in energy prices.)

In the end what we have is an administration which has side-stepped Congress to do what it wants to do, and spent money without specific Congressional authorization. Their plans appear to mostly consist of throwing money at the problem and taking bad assets off the hands of the private sector, while making sure that if there are any profits, the private sector gets a good chunk of them, despite only putting up a tiny amount of money.

In other words, they’re trying to create a secondary bubble. If they can do so they figure they can pay back enough of the money due to improved asset prices. If they fail, the US will be as close to bankrupt as a sovereign country can get, though since everyone else will be bankrupt, too (everyone’s throwing money at the problem) we can all just pretend that no one’s bankrupt, I suppose.

But one way or the other, the rich will have had much or most of their bad debts taken off of them and put onto the backs of taxpayers. Mission accomplished, I suppose. Privatize the profits, socialize the losses.