Tim Geithner's testimony at his confirmation hearing gave few clues about what the new administration will do to revive the nation's effectively bankrupt financial system. He obliquely criticized the operation of the bank bailout, in which he was a key player as president of the Federal Reserve Bank of New York, but said little about how he would improve it.
The $700 billion plan has only kept America's large banks from outright insolvency. Bad bets by banks, many related to the sub-prime crisis, have produced staggering losses. The original Paulson plan was to use the money to buy up these securities in order to get them off the banks' books. But, as one senior congressional source told me, "there's not enough money in the world" for that approach. The securities, which have no current market value, proved both impossible to price and substantially larger than $700 billion. So Paulson turned to direct infusion of capital into the banks.
But other than keeping zombie banks alive and protecting the economy from even worse catastrophe, the plan is widely adjudged a failure. It hasn't normalized credit markets or produced a resumption of lending flows. And as the recession has tightened its grip on the rest of the economy, bankers contend there are fewer good lending opportunities-creating a vicious circle of a plummeting real economy and escalating losses at banks.
Paulson has also been widely criticized for his hands-off attitude and the near-total lack of transparency of the Treasury's decisions. The Treasury does not have the staff to monitor a rescue on this scale, which has never been done before. What's more, Paulson was ideologically opposed to the kind of hands-on monitoring or aggressive supervision that Congress is demanding of the much smaller-scale aid to the auto companies. In exchange for the taxpayer assistance, there have been no serious reviews of bank business plans or salary and compensation patterns. Merrill Lynch even paid large bonuses as it was being merged into Bank of America, which now has become the latest large bank to require an emergency infusion from the Treasury.
Basically, the government has two options. It can intensify the supervision of the banks getting aid under the Paulson plan and ask for a lot more in return. It's not at all clear that this would work. Or the government can nationalize most large banks and park bad assets in what some call a "bad bank," leaving the banking system with sound balance sheets and a capacity to function normally. Shareholders in the bank stocks, which have already lost most of their value, would be wiped out. Eventually, as the real economy recovered, the government would recover some of its money as the securities found buyers. The good-bank/bad-bank approach could be used with or without explicit government ownership, but it would be far cleaner and simpler if government took over the failed institutions.
This was more or less the model used in the government's mop-up of the savings-and-loan meltdown of the 1980s, when government created a Resolution Trust Corporation to take over failed savings-and-loan institutions, divide their investments into ones that could be salvaged versus total write-offs, and return the industry to health. That operation cost taxpayers between $300 billion and $500 billion, depending on whether you count the interest on the additional debt incurred by the government. But at least taxpayers got their money's worth.
Geithner was vague on whether he and the administration would support this approach. "It is possible that ... will be part of the solution going forward," he told the committee. "The good-bank/bad-bank-type solution has been present at the solution to most financial crises around the world, and it is very important that you look carefully that they are going to be as effective in this context as they have been in some past cases."
In response to a question from Sen. Chuck Schumer, who warned that a good-bank/bad-bank approach could cost trillions of dollars, Geithner again ducked, saying only that the details would be "enormously complicated."
For a rescue of the entire banking system to work, the new administration will also need a much more aggressive strategy for refinancing distressed mortgages and braking the slide in housing prices. Only if housing markets normalize will the securities based on sub-prime mortgage loans regain even some of their value. Even normal mortgage markets also depend on more predictable housing values. Here again, Geithner spoke only in the most general terms, promising that the president would "lay out a comprehensive plan for addressing the housing crisis in this country, which has been so central to the recession and its basic causes."
It's understandable that Geithner, at a confirmation hearing, would not have a full-dress plan ready to go and that, under fire for failing to pay $34,000 in payroll taxes, he would try to avoid saying anything terribly controversial. On the other hand, the new administration has known since Election Day that it had a dire financial crisis on its hands, that the Paulson approach wasn't working, and that something far bolder would be required. President Franklin D. Roosevelt, by this point in his presidency, had hit the ground running.
Obama's team has only been in office for a few days, but with the exception of Geithner, most of the senior economic officials were also senior Obama advisers during the campaign. As for Geithner, he knew he was short-listed for treasury secretary, and he had the entire experience of the failed Paulson approach to think through how to do the job more effectively.
It's also revealing of the degree of national crisis that the Senate Finance Committee was extremely gentle with Geithner. Though his tax story of "careless mistakes" did not hold water -- he was explicitly advised by his former employer, the International Monetary Fund, that Social Security taxes were owed -- the committee gave him a pass. And no senator dug deeply into the bogus story that the Treasury and the Federal Reserve declined to rescue Lehman Brothers because they lacked the explicit authority. They had no authority for the much larger bailout of American International Group, either.
Everyone, from the Senate Finance Committee to Wall Street itself, which rallied on the news that Geithner was having an easy hearing, has placed enormous faith in the new treasury secretary. "To some, he is not only the best choice, he is the only choice," said Sen. Chuck Grassley, the committee's ranking Republican. Soon, the Obama administration will have to show its hand. When the plan finally does materialize, it had better not disappoint.
