WASHNGTON — The Obama administration's long-awaited plan to help banks dispose of so-called "toxic assets" so they can resume lending was greeted Monday with a huge rally on Wall Street, but its longer-term success remains far from certain.
The Dow Jones Industrial Average closed up 497.48 points, or 6.8 percent, at 7775.86. The S&P 500 finished up 54.38 points, or 7.1 percent, at 822.92. The Nasdaq rallied 98.50 points, or 6.8 percent, to close at 1555.77.
As the past 14 months of recession have made painfully clear, however, a one-day stock rally doesn't mean the worst is over. Treasury Secretary Timothy Geithner's plan remains fraught with uncertainty over whether it'll work.
Geithner detailed a public-private partnership to spend $75 billion to $100 billion in taxpayer money to help raise up to $1 trillion to snap up distressed mortgage bonds and other assets that are now shunned by investors and crippling the financial system.
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"I'm very confident this scheme dominates all the alternatives," Geithner said shortly before the 9:30 a.m. opening bell for trading on the New York Stock Exchange.
The potential for huge gains attracted big names such as Pacific Investment Management Co., of Newport Beach, Calif., the world's largest bond trader. The company said "count me in" within hours of the Geithner plan's unveiling.
"From PIMCO's perspective, we are intrigued by the potential double-digit returns," founder Bill Gross said in a statement. He said that banks, investors and taxpayers could all gain. "This is perhaps the first win/win/win policy to be put on the table and it should be welcomed enthusiastically."
If the investments lose value, however, taxpayers will share the losses, perhaps disproportionately.
"The value of cheap multi-year government financing is quite significant, as is the government's promise to put a floor under losses at 10 percent or 20 percent of what the investor puts up. It is possible that these incentives will cause investors to overpay for the assets, with most of the eventual losses flowing to the taxpayer because of the downside protection offered the investors," wrote Douglas Elliott, a research fellow at the Brookings Institution, a center-left research organization in Washington.
"For example, it could be rational for investors to offer 40 cents on the dollar, calculating that they would benefit sharply if the price went to 50 cents, while the government would absorb most of the losses if the value fell to 30 cents on the dollar," Elliott wrote.
Nobel Prize-winning economist Paul Krugman shares that view. He called Geithner's plan "cash for trash" in a New York Times column on Monday. The plan is a one-way bet, Krugman said, arguing that "if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt."
Given the anti-Wall Street mood in Washington, underscored by Congress's attempts to slap a 90 percent tax on some financial executives' bonuses, handsome returns to well-heeled Wall Street investors could provoke a backlash — a threat that could scare away potential investors.
"You want to write the story that the hedge-fund manager walks away with $200 million? That's going to play real well," said Howard Simons, president of Rosewood Trading, an economic research firm in Glenview, Ill. "Given what we've just seen (with American International Group) why would anybody be involved in that?"
Curtis Arledge, a managing director for asset manager BlackRock, expressed confidence that the rules of the game won't change suddenly because of political pressure.
"I think Treasury understands it very well," Arledge told CNBC, confirming that his company has been raising money from private investors to bid on the so-called toxic assets.
If the plan doesn't work, the next step might be nationalizing some banks, as some high-profile analysts have advocated, including former Treasury Secretary James Baker, pointing to Sweden's successful exercise in the early 1990s.
Geithner rejects the parallel.
"We're the United States of America. We are not Sweden," he said, arguing that the U.S. financial system is much larger and more complex than any other and includes the world's largest capital markets and many nonbank financial institutions.
President Barack Obama, flanked by Geithner and Federal Reserve Chairman Ben Bernanke, said the plan will take time to work.
"It's not going to happen overnight. There's still great fragility in the financial systems. But we think that we are moving in the right direction," Obama said.
Under Geithner's plan, taxpayer money and private-sector investment will flow together into a Public-Private Investment Program. The Federal Reserve and the Federal Deposit Insurance Corp. will help provide low-cost financing to subsidize purchases of distressed bank assets. The Fed will bolster purchases of mortgage-backed securities, pools of mortgages that are bundled and sold to investors as mortgage bonds. The FDIC will support financing for purchases of problem bank loans.
Private companies — hedge funds, private-equity funds and perhaps pension funds — will bid against one another for distressed assets, and that will set market prices. As markets unfreeze and housing-related securities begin trading again, assets could gain value, and taxpayers would share in profits.
Private investors can put down $6 and get a $6 match from the government. If they purchase assets with a face value of $100 for, say, $84, the Fed or the FDIC would then provide low-cost financing for $72 — all but the $12 invested by the public-private partners. If the purchase price is low enough, investors could see returns of 20 percent or higher once they resell the assets when trading in them resumes.
"In each case we're going to put capital alongside capital from private investors with financing from the government. So private investors will share the risk alongside the taxpayer, and the taxpayer will share returns alongside private investors," Geithner explained.
Some critics welcomed Geithner's plan, but with regret.
"Part of me as a former Treasury person says this has taken us a long time to get to where we should have been," said Kevin Jacques, a veteran Treasury economist who now teaches finance at Baldwin-Wallace College in Berea, Ohio.
The original Bush administration Wall Street rescue plan last September envisioned purchasing these assets, but switched instead to direct capital injections into banks, leaving the toxic assets to rot.
"In some ways the order has been wrong in the program so far. I would have been getting the bad assets, toxic assets, off the balance sheet and then injecting capital as necessary," Jacques said. He said that selling the assets now at low prices would force the banks to post steep losses, and so they'll probably need more bailout capital on top of what they've already received.
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