Heads-I-win, again

Some advocates of Tim Geithner’s toxic asset plan don’t just see it as a mechanism to clean up US banks’ balance sheets. They also hope it will reveal the fundamental value of these assets. The idea is that prices have not only been depressed because the loans are dud, but have also been distorted by the lack of liquidity in the market.

The US administration is playing up this notion. Sheila Bair, chairman of the Federal Deposit Insurance Corporation, which is helping finance the scheme, told the Financial Times: “We are trying to tease out the liquidity premium”. Their motivation is easy to understand. If illiquidity is the problem, then taxpayers aren’t necessarily overpaying when they help private investors buy up these assets.

There almost certainly is an illiquidity discount in the market. But the idea that the Geithner scheme will remove that discount and reveal fundamental value – as measured by, say, discounted cash flow - is misplaced.

The Geithner plan will certainly drive up market prices. It will achieve that by giving investors buckets of government money to play in the market on a non-recourse basis. This massively skews the odds in investors’ favour. They will receive half the profits if things go well. But if their bets turn sour, they will absorb as little as 2.3% of the losses. The rest will land on taxpayers’ shoulders. Such an asymmetric incentive will encourage investors to overpay.

Now, of course, it is possible that the distorted incentive will pump up prices by no more than the illiquidity discount is driving down prices. But this would be a fluke.

Advocates of Geithner’s scheme shouldn’t rely on such a miracle to justify what they are doing. They are on much safer ground if they simply argue that buying troubled assets from banks at higher prices than have recently prevailed will make them stronger.