Tim Geithner's Toxic-Asset Plan: 8 Things You Need to Know

The Treasury secretary releases more details of key program designed to revive the financial system

It's not usually a good idea to handle toxic waste without a hazmat suit. But amid the most terrifying financial crisis since the Great Depression, the Obama administration is relying on folks in jackets and ties--bankers and investors--to rid the financial system of its most radioactive sludge. Treasury Secretary Timothy Geithner on Monday released the much-anticipated details of his plan to mop up as much as $1 trillion of the illiquid assets that have been at the heart of the painful credit freeze that took hold back in the summer of 2007. Under the terms of the plan, Uncle Sam will use capital and attractive financing to encourage private investors to buy up these assets, putting additional risk--as well as upside potential--onto the shoulders of taxpayer. "Simply hoping for banks to work these assets off over time risks prolonging the crisis in a repeat of the Japanese experience," Geithner said Monday in a Wall Street Journal op-ed piece.

Here's what you need to know about the plan:

1. What are toxic assets? In the context of the financial crisis, toxic assets generally refer to loans or mortgage securities tied to the real estate boom. The value of such assets--huge quantities of which are now sitting on the balance sheets of banks everywhere--has been hammered by the housing crash. Since there are so few buyers in the market for these assets, it's been nearly impossible to tell how much they are worth. As a result, they remain stuck on banks' books, eroding capital, constricting credit and undercutting confidence. The disposal of these assets is essential to a turnaround in the financial system and the economy as a whole.

2. So how does Geithner plan to get rid of the toxic assets? Geithner's plan involves the creation of several public-private partnerships that could purchase as much as $1 trillion of toxic asset from banks. Uncle Sam would put up to $100 billion from the Troubled Asset Relief Program (TARP) alongside private capital and then use government financing to jack up its purchasing power. Asset purchases would be made in three specific ways. First, the Federal Deposit Insurance Corp and the Treasury Department would provide financing guarantees and matching equity for investors to purchase illiquid loans. Secondly, the Treasury will choose up to five asset managers with applicable experience to attract private capital, which the government will match and leverage with government financing. The asset managers would then use the funds to purchase eligible mortgage-backed securities. Finally, the government will expand a previously-announced program to include certain mortgage-backed securities.

3. What are benefits of this approach? The Treasury Department argues that the plan holds several advantages over other approaches. First, it enables taxpayers to share some of the risks associated with these assets with the private sector. At the same time, by using government resources and private capital, the plan offers taxpayers more bang for their buck. Finally, since the assets will be auctioned off to the highest bidder, the plan reduces the risk that the government will pay too much for the toxic assets. "With the private sector establishing pricing, there is more validity to the price," says Mark Vitner, a senior economist at Wachovia. "The market is not going to overpay."

4. Will investors participate? The plan only works if investors participate. And on account of the government's generous subsidies, Vitner expects them to jump in. "This is going to present a good opportunity to pick up some assets at attractive prices," he says. But Congressional efforts to recover $165 million in bonuses from AIG might keep some would-be investors on the sidelines, blunting the program's overall effectiveness. Mark Zandi, chief economist for Moody’s Economy.com, argues that these concerns won't derail the plan's success. "The working logic in Washington is that if you get TARP money, you are going to get oversight," Zandi says. "If you don't get TARP money but you are in partnership with the government, you won't get the same oversight."

5. Will banks participate? While calling the program a great deal for investors--since Uncle Sam in taking on most of the risk--Richard X. Bove of Rochdale Securities says the plan is "a mixed blessing" for banks holding such assets. "The banks will be able to sell assets that they might prefer not to hold, but the pricing may not be attractive enough to allow them to do so," Bove said in a report Monday. "Therefore, the new program is too one-sided. It offers significant benefits to the buyers, but limited incentive to the sellers. It may have to be revised for this reason."

6. How much of a dent does $1 trillion put into the toxic asset problem? Zandi estimates that there are between $2 trillion and $2.5 trillion of problem assets on the balance sheets of U.S.-based financial institutions. That means even if the program succeeds in sponging up the full $1 trillion, there will still be a massive amount of toxic assets out there. But if the program proves successful, the Obama administration can always go back to Congress for more cash to expand it, he says.

Dean Baker, the co-director of the Center for Economic and Policy Research, argues that removing toxic assets alone won't solve the banking crisis. Higher delinquencies for commercial loans, credit cards, car loans, and student loans will trigger additional problems for lenders whether they get rid of these assets or not. "[Loans] are going to go bad both because it is a real bad economy [and] also because people don't have the backdrop of their housing equity like they would have in other times," Baker says. "[The Obama administration's] thought is that they are going to get banks back on an even keel, but it's extremely unlikely."

7. As a taxpayer, should I feel good about this plan? Zandi says the plan is sound from a taxpayer's perspective. "There's nothing good about any of this," he says. "[But] we're making the best of a very bad situation." However, Pete Kyle, a professor of finance at the University of Maryland, argues that by financing the purchase of these highly illiquid assets, the administration is sticking taxpayers with a huge risk. "There is a really good chance that the government will lose a lot of money on the loans because they will not be repaid," Kyle says.

8. When will the program get moving? A plan this sweeping and complex as this will take some time to get off the ground, so banks won't be able to unload these assets right away. "Implementation seems likely to be at least a few months off, given the time required to start other such programs," economists at Goldman Sachs said in a report.