The Treasury's new plan to buy up to $1 trillion in toxic assets that are weighing down bank balance sheets can be a bit complex. But think of it as a used-car deal, and you can begin to understand how it might work.
The assets, which include mortgage-backed securities, have been considered so toxic that up to now, nobody's been willing to buy them.
Treasury Secretary Timothy Geithner unveiled a plan to bring in private investors — by getting the government to put up money, and share the risk. The hope is to get the bad assets off the books of banks and other financial institutions.
The announcement sent the stock market up this week, but it also prompted a lot of questions.
Host Steve Inskeep and NPR's Planet Money correspondent David Kestenbaum decided to act out a real-world scenario that might shed light on the mechanics of the plan.
David Kestenbaum: You're going to play the private investor and I have a toxic asset to sell you.
Steve Inskeep: OK, so I'm some billionaire with a lot of money.
DK: I have some pictures.
SI: This is the asset? It's a car.
DK: It's the closest thing I have to a toxic asset — a 1992 Toyota Corolla.
SI: Thank you for including the photograph of the odometer showing 103,787 miles on this. Well done.
DK: That's why I want to get rid of it. Steve, I'm going to make you an initial offer of $1,200.
SI: You've got to be out of your mind. I might pay $800.
DK: It's got a cassette deck, Steve!
SI: No, $850 — I'll pay you that much.
DK: Come on, Steve. I've got a family to feed.
SI: OK, $1,000.
DK: All right. Deal.
DK: So we just had a little auction. And that is basically how the price for a toxic asset — a mortgage-backed security — would be determined, though you'd have more people bidding. You get the basic idea. And the important part comes next, which is, how you pay for the car.
SI: Well, I know I agreed to $1,000, but I've got my wallet here and I don't quite have $1,000 in it. Do I have to put up the whole $1,000?
DK: No. You only have to put up maybe $200.
SI: Who's going to put up the other $800?
DK: The government is going to go in on this investment with you, and it's going to put in $200. And you and the government will co-own the car.
SI: $200 plus $200 — but it's a $1,000 car.
DK: You're right. We've only accounted for $400 of the price. The other $600 has to come in the form of a loan. In some cases under this plan, that loan would also come from the government.
SI: I guess this happens all the time in the financial markets. It's called leverage, where I invest a little money and borrow a bunch more. But in this case, it's the government that's lending me the money to make this purchase of this fine Toyota Corolla.
DK: Right. That is leverage. That is why investors like this plan. You get to buy a big expensive thing, the car, without a lot of money. And if that big expensive thing increases in value, you make big profits. Even if the thing decreases in value — this is a actually a really good part for you as an investor — if you take the car, you leave my driveway with it and it's a piece of junk and it dies, you don't have to repay the loan. It's what's called a nonrecourse loan.
SI: Why on Earth is that a good deal for the government to lend all that money and take so much more of the risk than that investor who puts in the $200?
DK: Here's the best-case scenario: The banks get the stuff off their balance sheets. Private investors — you — make money. And the taxpayers make money because they're going in on buying the stuff with you — the really smart investor. So if you made a good investment, you gain and we [the government] gain. And in the big picture, one of the central problems of this crisis gets a lot better.
SI: These bad assets go away; they get dealt with. Banks are free in theory to lend again. OK, what's the worst-case scenario?
DK: Well. There is actually a long list of potential snags. Critics, Paul Krugman, the New York Times columnist and Nobel laureate among them, say that the rules of the game are set up so that really the taxpayer is going to lose. The argument is basically that the government is doing so much to help the private investor, that the private investor has this incentive to swing for the fences — bid a higher price for the toxic assets that they're really worth or just take real chances. The investor may win on one and lose on nine and so he ends up doing well, but the government and taxpayer may lose money on the whole, because they take more of a hit for those nine investments that go bad.
SI: What does the Treasury Department say about assuming this huge risk?
DK: Tim Geithner said this week that there's definitely risk for the taxpayer. But he says this plan hands down is best of all the options that he looked at. David Beim, a professor of banking at Columbia University, also likes the plan. He says:
"I really think that we've got to do something about these assets. You can't just let them sit there festering. They will impact our banking for a decade if you do. That's what happened in Japan. So I do think the government is right to try and discover some kind of a market for these assets."
SI: How soon do we find out if this is actually working?
DK: One thing to watch is the credit markets — is lending back to normal? That's one test. And as far as the taxpayer does with these investments... we will actually find out one day. The government will have bought these toxic assets for some price. And in the future we'll find out. Just like when you buy that car: Was it a good deal or did I get ripped off?