Geithner’s Toxic Debt Hedge Fund

US Treasury Secretary Timothy Geithner has revealed the government’s much-touted toxic debt recovery plan that hopes to cleanse the tainted assets held by the country’s major financial institutions. Initially, the plan calls for the Treasury to use $75 to $100 billion from the Troubled Asset Relief Program (TARP) which gives the government “purchasing power” of $500 billion of the affected assets. If this first phase proves effective, the government says it could use up to one trillion dollars to solve the ongoing banking crisis.

Plan Highlights

The Treasury, the Federal Deposit Insurance Corporations (CDIC), and the Federal Reserve will work together on this initiative and will provide investment capital to help private investment firms buy the ear-marked assets from the banks and will also guarantee the safety of their investments. Essentially, Geithner is counting on the backing of the government – combined with the availability of lending capital –to entice private firms to buy and manage the damaged assets held by the banks.

Fully one half of the money reserved for this proposal will be used as part of the so-called “Legacy Loans Program” to be administered by the FDIC. This money will be used to buy a pool of assets from the banks and private fund managers are expected to supply the rest of the money for the pool. The FDIC will guarantee financing for the investors to a maximum of six times the amount pledged. The other half of the money will go to the “Legacy Securities Program” and will be used to shore-up the value of asset-backed mortgages that can no longer be traded as investors have no confidence in the original mortgages used to create the securities.

The World’s Largest Hedge Fund?

Obviously, Geithner’s plan is to transfer the risk associated with the bank-held assets to other investors thereby providing the banks with sufficient liquidity in hopes that the banks can return to more normal lending practices. Since the crisis took hold, credit has all but dried-up as few investors have been willing to deal in these assets – at least not without some form of guarantee for the safety of their funds. Cue the Federal Treasury.

Geithner has made it clear that the government believes the sale of these assets is critical to restore confidence in the system and this is the first step to what officials claim will be the way to recovery. However, as much as I want to see a recovery, I can’t help but thinking this scheme is essentially a massive hedge fund. Consider the parallels – like a typical hedge fund, this plan will be offered to only a select group of investors. In the case of the toxic debt purchase – five private investments firms will be determined by the end of April – at which point the firms will be given time to raise funds for which they will receive matching contributions from the government. Investments will be highly-leveraged – in this case at a six-to-one ratio – to maximize returns. Unlike privately-managed hedge funds however, the risk for this scheme is held solely held by the investors; public money is also involved and this little fact could cause some problems for the government.

Taxpayer Fury

At a time when the average taxpayer needs a scorecard to keep track of all the bail-outs and rescue plans being offered, this one comes hard on the heels of growing protests over the AIG bonus payments. The anger over the news that AIG executives gave themselves hundreds of millions of dollars in bonuses out of the more than $170 billion in bailout money AIG received gave rise to public protests over the weekend. In fact, this issue is well on its way to becoming a political scandal as questions of “who knew what” and “when they knew it” are being asked of top officials. While this may have a ways to go before becoming a “you’re doing a heckuva job, Brownie” type moment, when the President has to come out and say he still has “absolute confidence” in the abilities of his top officials as he did for Geithner a couple of days ago, you know someone is being prepped for tossing under the bus.

There really is a sense now that if this recapitalization of the banks does not result in positive and tangible results, the chances of the Obama administration securing more money from Congress could be seriously down-graded. Republicans naturally oppose these moves, but even some key Democrats are questioning the effectiveness of these programs that have already added more than two trillion dollars to the national debt with little to show for the costs incurred.

About the Author

Scott Boyd has been working in and writing about the financial industry since the early 1990s. As a technical writer and project manager with several of Canada’s leading financial institutions, Scott has produced educational materials for investment system end-users including portfolio managers and traders. Scott now administers and contributes to OANDA FXPedia and regularly provides commentaries for the OANDA FXTrade website.

This article is for general information purposes only. It is not investment advice or a solicitation to buy or sell securities. Opinions are the author’s — not necessarily OANDA’s, its officers or directors. OANDA’s Terms of Use apply.