I read through the Treasury Secretary Geithner’s plan last night, and saw the reactions on the train this morning. At base it’s an incentive plan to pull private capital off the sidelines, and help remove toxic assets from the larger bank’s balance sheets; to this end they pledge about a trillion dollars:

$150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program’s operations

This all comes on top of the Fed expanding the TALF, by about a $1T last week also to buy up toxic assets. So the question is: will it work?

Yes, but not in an ideal manner.

All banking crisis result from either: solvency, liquidity, or confidence problems. This one has all three. Most banks held (consolidated debt obligations) CDO’s, backed by US mortgages, which at the time where AAA rated bonds, as part of their capital reserve. As the subprime, then Alt-A, mortgage market imploded these bonds lost value, and hence banks needed to raise capital, or go insolvent. However, all of the banks had CDO’s as part of their capital reserve, but none of them knew exactly which mortgages where backing which bonds. So those assets became illiquid, and kept losing value, leading to insolvency. Since no one has any clue how to straighten out who has what, where, and how bad, we have the confidence problem.

The key thing both TALF and this program target is the illiquid nature of these mortgage backed COD’s. Simply, by saying “we’ll buy ‘em”, the Fed and Treasury create a market, and allow banks to unload part of these assets. Liquidity solved. The problem is that these are thinly traded; there are not a lot of buyers and sellers’, so figuring out the right price is going to be difficult, if NOT impossible. Because location and age of the mortgages make a huge difference in their valuation, aka not all CDO’s are the same. For example, Sub-prime SE Florida ’06 vintage mortgages have in something like a 70% default rate, whereas NE prime from say ’02, are still in the low single digit default range. Yet, either, neither, or both of these could be in the same CDO.

All that has a bearing on how many, and WHICH, CDO’s banks might sell versus hold, which in turn effects ‘the markets’ read on solvency, and hence confidence in these bank’s fiscal futures. If they can get enough Toxic assets off their balance sheets, and raise enough money from their sale, solvency will be (re)assured, and confidence will return. And under this plan, in combination with TALF and the stimulus, this will happen.

The question is how much will this actually cost the government/ the tax payers? Because the money we are talking about here is not being ‘spent’ in the way you typically thing about it being spent, it’s put ‘at risk’. Meaning we buy-up all these assets, but we also get the assets, which are worth something, but as I said we don’t know how much, and in some ways can’t know, until after-the-fact. We are not going to lose the total amount, because many people will still make their mortgage payment, and eventually, much of the loan will be recouped.

We could even PROFIT! If the government bought the assets at a discount, I highly doubt this will happen, maybe 5% likelihood. Getting the price right we will get a break even return, 25% likelihood. More likely, we get the price right and pay some premium, to entice private capital into the market, 40%. If this happens we are out the premium, which I would put in the 20% range, and that’s our, tax-payer loss: $500 billion on the high end. This is based on the current payout by AIG to its counter-parties with an asset mark down of 20%.

This is the worry: we get the price wrong, and then we still pay a premium for enticement. In this case we lose 70%, if you believe the current market price of 30% of principal: $1500 billion loss. I don’t think this will happen, but it could, 30% chance.

So yeah, it’ll work… but at a price we don’t (can’t) know.

Ideally, this wouldn’t be the plan. In my cold-heart of hearts I think the Swedish model of Bank Nationalization/Re-capitalization/Privatization-minus toxic Assets is the best approach. Basically, what Ritholtz, Rublini, and Rogoff have all recommended. The government takes over the bank, like the FDIC does; they continue operations as normal, while they pour over the books. They classify the reserve assets by risk, if they are insolvent two things can happen. Either you sell the bad bank to a good bak with extra capital, or the government fire-sales the toxic assets, stock-holders then bond-holders take the loses, in that order. And on the other end you get healthy (solvent) banks.

Now this ain’t free either, and it carries risks of inciting further panic if not done properly. But the government is privy to lots more information, and can better control costs. The risks are lower for the money the tax-payers are putting into the banks.

However, after last week’s faux-rage over the AIG bonus’ (0.0001% of the money CURRENTLY at risk) I don’t think our government is as good as the Swedish. I don’t think they can handle a nationalized solution, and it might be far riskier, because of the associated political risks, then the new Geithner Plan.

I will say this: above all else though. Those idiots who are calling the Obama Administration a Socialist Empire in the making should take note of the Extreme steps they have been taking to keep the banks in private hands, despite a good amount of cover for the nationalization option. Maybe they are susceptible to their socialism! critics, maybe they really believe in free markets, but a real Socialist would never ever allow for the Geithner plan to be proposed in a serious manner. EVER!