Memo to Obama: Six reasons to cancel your $1 trillion toxic waste plan

Original Link: http://finance.yahoo.com/tech-ticker/article/216690/%22Happy-Talk%22-Won%27t-Solve-Crisis-Galbraith-Says-Much-More-Govt.-Action-Needed

by Peter Cohan

President Obama: It's not too late to cancel the plan you're floating to use taxpayer debt and a sliver of private money to buy $1 trillion in toxic waste from banks. Why cancel it? Because it won't solve the problem and it will waste more taxpayer money. I know nothing about politics, but my hunch is that people won't be too happy when they find out that more of their money is going to enrich further hedge funds and private equity firms whose partners make bigger bucks -- one of them made $3.7 billion in 2007 alone -- than the bankers who got $16 billion in bonuses from taxpayer pockets in 2008.

Here's what the toxic waste plan looks like to me. Three of the world's wealthiest investors came up with an idea to use taxpayer money to enrich themselves even more. These three have already played the U.S. for suckers:

PIMCO's Bill Gross who already talked the U.S. into bailing out his investments in Fannie Mae (FNM) and Freddie Mac (FRE) and now manages two big government investment programs,

Berkshire Hathaway's (BRK.A) Warren Buffett whose 20 percent stake in Moody's (MCO) makes him strangely mute about Moody's role in giving toxic waste AAA ratings which fueled the financial crisis, and

Goldman Sachs Group's (GS) Lloyd Blankfein whose firm got $12.9 billion in bailout money from American International Group's (AIG) $170 billion bailout fund.

Their plan is simple: private investors get the profits from buying toxic waste and taxpayers cover the losses. How so? The FDIC would run an auction for a lender to sell, say, $10 million worth of residential mortgages. If the winning bidder -- a hedge fund or private equity firm -- paid $8 million, the FDIC would lend money to pay for those mortgages and then would cover 75 percent of the investor's losses. Treasury would contribute 80 percent of the rest of the cost of the loans.

As I see it, this means that hedge funds and private equity firms will pay virtually nothing for the assets, the taxpayer will incur most of the losses and all the profits, if any, from buying these assets will go to the hedge funds and private equity firms. And since the FDIC and the so-called Public Investment Corp. -- the public/private partnership that will buy the assets -- can only buy $500 to $750 billion worth of the loans, you'll create two other programs whose details have not been worked out.

What's wrong with this idea? Here are six things that come to mind:

It's too small to buy enough of the toxic waste. If my estimate is correct, there is $13 trillion worth of toxic waste -- mortgage-backed securities and collateralized debt obligations -- that's been issued. This $1 trillion program only buys up 8% of that total. This is not enough to make a difference.

It does not deal with the pricing problem. As the example above suggests, pricing toxic waste is an enormous problem. Most banks have booked it at 60 cents on the dollar but it's really worth five cents. If the banks sell it at five cents, they take a 55 cent loss which they have to make up for by raising new capital equal to the amount of the write-off in order to maintain regulatory capital levels. If investors buy at 60 cents, it will leave taxpayers with an enormous loss. The pricing problem could make the whole idea a non-starter since neither buyer nor seller will agree on a price.

It's a government program for the already wealthy. Berkshire Hathaway, PIMCO, and Goldman Sachs are already very wealthy and your program will grant such investors government contracts to manage these assets. And it looks like they could get to invest as well so there's a good chance they'll have inside information from their advisory role that they can use to enrich themselves further.

Taxpayers are likely to lose money. This plan is too heavily skewed to enrich the private interests who will invest in these assets. As the example above illustrates, the government will take the risk if private investors overpay and the collateral for the government loans is illiquid and likely to be worth little -- therefore government loan losses will likely be high as well.

Lack of detail could spook investors. In February 2009, Treasury Secretary Timothy "job is secure" Geithner offered the outlines of a plan that was weak on details. After his speech, the stock market fell 380 points. As it stands now, the leaked plan is vague on details of pricing toxic waste and on how the other two programs will work. It might be better to complete those details before announcing another vague plan to investors.

Money that could be lent directly will go into a black hole. Perhaps the worst part of the plan is that it's not going to get credit flowing into the economy. By creating new banks, the money being used to prop up the zombie banks could be lent directly to those individuals and businesses who would be in a position to use that money wisely and pay it back. Instead, the hundreds of billions of dollars from your toxic waste proposal will go to zombie banks that will not get enough toxic waste relief to boost lending.

President Obama, toxic waste is a problem but the bigger issue is getting money into the hands of people who can use it to fuel economic growth. Instead of propping up zombie banks, we need to get capital into the economy directly. This toxic waste removal plan will not achieve that goal and it creates more problems than it solves.

Back to the drawing board.