By Michael Pomerleano

In an article this month, “Promising signs of progress in the ‘Bad Bank’ Plan” I wrote that the approach sketched out by Tim Geithner, US Treasury secretary, deserved consideration and support from the policymaking and financial communities for the following reasons:

1) This design ensures that troubled assets are worked out in the private sector. The government bureaucracy has neither the expertise nor the motivation to make decisive decisions on the resolution of troubled assets.

2) The proposed approach secures private equity capital, while providing government working capital. The programme further ensures that the incentives of the managers are aligned with the public interest since the managers’ own money is at risk.

3) The programme creates capacity and competition in the private sector to deal with the enormous impaired assets problem.

However, the programme presented by the Treasury on Monday is a disappointment. The programme is exceedingly generous to the private sector. The Treasury is acting as a rock bottom “discount” hedge fund; it offers assets to the private sector for a minimal amount of equity capital (the private sector is asked to contribute 3-5 per cent equity, with the Federal Deposit Insurance Corporation and the US Treasury shouldering the rest), and non-recourse financing at subsidised government interest rates.

The programme ends up as an enormous wealth transfer to Wall Street. We can make an educated guess on the value of the transfer. The value of the investment (as distinct from the equity participation) for the private sector can be represented as a call on the $1 trillion of assets.  We can calculate the premium for the hypothetical call.  The assets are highly volatile, and as known from option theory, the higher the volatility, the higher the value of the option.

On top of that, unless there is a stated expiry for the assets (which there isn’t), a “reasonable” term to maturity is two or three years, considered a very long option. Obviously the longer the call, the higher is the option value.  Finally, option theory is only really valid provided that the associated hedging strategy is available.

Otherwise the options are costlier. It seems fairly safe to say that there might be limited but not complete hedging strategies to offset the risk(s) the private sector takes on via this (implicit) call in the ABX markets. The value of the “implicit call” is high – and an estimate in the range of 15-20 per cent is reasonable. However, the private sector is asked to contribute 3-5 per cent equity. Without any appropriation the government is transferring to the private sector the option balance of 15-17 per cent. The prospective beneficiaries are the banks, the hedge funds or the mortgagees. Who is going to benefit? My guess is that the hedge fund industry will be the biggest winner.

Is The Summers-Geithner toxic asset plan viable? Maybe, but it has serious drawbacks. I am not sure the largesse is warranted.  It would have been desirable to see a far more robust risk sharing programme. Finally, the programme is not a “magic bullet”: it will take time to implement and will only partially address the soundness of the banking system.

Michael Pomerleano is advisor on financial stability to the Bank of Israel, on external service from the World Bank