It turns out the Obama administration's solution to a problem caused by wildly speculative trading by hedge funds is to set up a hedge fund, to engage in some wildly speculative trading.
That's a bit of an exaggeration, but not by much. Treasury Secretary Tim Geithner announced this morning that the administration plans to use between $75 billion and $100 billion in money from the Troubled Assets Recovery Program as seed capital for a new $500 billion public/private fund to buy up the bad loans clogging up the balance sheets at banks around the country. (You can read the Treasury Department's fact sheet on the program here.) In essence, Geithner thinks the fund -- and the government's participation -- will persuade private investors to gamble that the loans will eventually recover enough value to make money selling them off once the economy is back on track.
The idea is to ensure that the government shares in the profits if the assets make money, but also to ensure that the taxpayers aren't stuck holding the bag if they lose. It's not entirely clear that the plan meets that goal, though. The FDIC would guarantee loans to cover some of the cost of buying the loans, and the Treasury would kick in 50 percent of the cash required in the deal.
In an example Treasury officials used, a bank decides it wants to sell off a pool of bad mortgages with a face value of $100. The government auctions the mortgages, and the highest bid is $84. The FDIC backs $72 worth of loans, meaning the public/private fund has to come up with $12, so Treasury kicks in $6 and private investors kick in $6.
If the mortgage can eventually be sold for more than $100, everyone wins -- the private investors get a big gain after risking only $6 of their own money, the Treasury gets the same gain, and the FDIC never has to take on the $72 in loans it guaranteed. But if the mortgage winds up losing money, the private investors are only on the hook for $6; the FDIC has to repay the $72 worth of loans regardless.
No one knows yet what sort of prices the actual auctions will set for some of the bad loans banks are desperate to unload -- so it's hard to say whether the public/private partnerships are likely to make money or lose it in the long run. Geithner, and apparently President Obama, expects the auctions to set realistic prices, and thinks most of the bad loans can eventually be turned into profitable assets.
And while it's never a good idea to judge policies solely based on the reaction on Wall Street, the stock market, at least for now, appears to agree with him -- major stock indexes were up nearly 4 percent within a few hours of the plan's release. Geithner sold the plan in a Wall Street Journal Op-Ed this morning, and Obama and Geithner will appear together later today to push the plan a little more.