Geithner recovery plan too cautious?

The Obama administration’s policy on the US financial crisis represents a high-stakes experiment: It will test the notion that a careful and cautious plan can also work forcefully and fast.

Treasury Secretary Timothy Geithner argues that this experiment is better than any alternative, but doubts surfaced this week among congressional lawmakers and leading economists as he testified about his plan on Capitol Hill.

An overriding Treasury objective is to avoid repeating the economic distress that followed the bankruptcy of Lehman Brothers last fall. Secretary Geithner’s plan involves providing capital from taxpayers to at-risk banks, as well as using public-private partnerships to buy bad debts off their books.

This plan carries risks, however. The effort to patch up the banks this way could be very costly and slow – or it may falter for lack of funds, given the public mood of bailout fatigue.

“These elaborate schemes are time consuming, nontransparent, and may not work,” says Pete Kyle, a finance expert at the University of Maryland in College Park.

“We want a fast [economic] recovery,” Mr. Kyle says. But that’s not likely to happen in an economy weighed down by bank losses, he says.

Both Geithner and his critics agree that a healthy supply of bank credit is vital to the economy.

The industry’s condition has been weakened severely by the decline in real estate values – the collateral for many loans – and more recently by defaults linked to unemployment and weak business conditions.

Bank losses in the US will total $1.6 trillion from 2007 to 2010 – and the industry will need $275 billion to $500 billion in fresh capital as a result, according to estimates in a report issued by the International Monetary Fund (IMF) this week.

“Even if policy actions are taken expeditiously and implemented as intended, … economic recovery [is] likely to be protracted,” the report said.

Geithner emphasizes the importance of avoiding further financial-market turmoil. Taking over insolvent banks in order to restructure them is seen by many of his critics as the textbook response to financial crisis, but for big banks he has cast this only as a last resort.

“We will take all sensible actions,” he told a bailout oversight panel Tuesday. But “we will be careful and pragmatic,” seeking the approach with the least risk to the overall economy, he added.

Even as he spoke, lawmakers on Congress’s Joint Economic Committee had decided to solicit views from prominent economists with a very different take.

A former World Bank chief economist, a former IMF chief economist, and the president of the Federal Reserve Bank of Kansas City all made the case for a tougher approach to big banks – possibly including temporary takeovers by the government.

Joseph Stiglitz, the former World Bank economist and Nobel Prize winner, said on Tuesday that the Treasury plan to buy bank assets will result in a transfer of wealth of from taxpayers to the firms, because of incentives that will boost the price banks can get for troubled loans.

Concerns about the Geithner bank plan have been loud enough that President Obama decided to address them directly in a speech on the economy last week. He drew a distinction between the way the Federal Deposit Insurance Corp. (FDIC) intervenes at small or mid-sized banks and the way larger banks should be treated.

“We believe that preemptive government takeovers are likely to end up costing taxpayers even more in the end," Mr. Obama said. "It's more likely to undermine than create confidence,” Obama said.

A prompt response, not a preemptive one, is the appropriate course, many finance experts say. A financial crisis tends to grow more costly over time, and to impose higher costs on the economy.

The hearing at the Joint Economic Committee was focused on how to set up a framework – lacking in current law – for regulators to intervene when large and complex financial institutions are in trouble. In the Lehman Brothers case, this meant the firm entered a messy bankruptcy process that rattled credit markets worldwide.

“Allowing large financial firms to fail can seriously damage our economy,” Rep. Carolyn Maloney (D) of New York said as she opened the hearing. “On the other hand, unconditional support for large failing firms can be just as dangerous …. Allowing firms to escape the consequences of bad business decisions could prompt even riskier behavior.”

She and others in Congress are trying to develop a new legal framework so policymakers will have a choice between the extremes of bankruptcy and bailout for large firms.

Whether government takeovers are a step along the way or not, finance experts say that the banking industry needs more capital in order to pave the way for solid economic growth in the years ahead.

The IMF forecasts that banks will be charging off bad loans this year and next at a pace not seen since the 1930s.

With voters souring on the rising tab for financial bailouts, one risk is that the needed capital won’t be available from government. Still, it’s possible that the results of so-called “stress tests” of major banks, to be released soon, could provide political cover for Obama to seek more money from Congress. Geithner also says the Treasury has untapped rescue funds exceeding $100 billion.

The stress tests could also draw a brighter line between healthy and weak banks, making it easier for the healthy ones to raise capital from private investors.

Kyle suggests that the Treasury call on banks – even healthy ones such as JP Morgan Chase – to raise lots of capital now, so they’ll be able to lend despite the rising loan losses.

The healthy banks may not like this, because it would dilute the value of stock owned by their current shareholders. But failing to take strong action, Kyle says, “perpetuates and worsens the recession that we’re in.”