CHESSNOID

The stock market rallied 7% across the board today.  This was a reaction towards the Geithner plan to buy toxic mortgages and a surprise bounce in the February housing sales number.

It is really nice to see a continued rally, but I have my doubts that this is the bottom. They have plans in place but I doubt they will work because it doesn’t deal with the true problems of the housing market. For some weird reason, the government doesn’t want the banks to disclose the true losses on the mortgages. I have to agree with economist Paul Krugman’s assessment of the new plan.

“The Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt,” the Princeton University economist said, citing weekend reports outlining the plan.

“This isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets,” he added.

Krugman called it a recycled idea of former Treasury Secretary Henry Paulson, who later abandoned the “cash for trash” proposal.

“But the real problem with this plan is that it won’t work,” he says, adding that bad loans may be undervalued because there is too much fear in the current climate.

“But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact,” Krugman wrote.

While the real economy is being hurt by the meltdown of the financial system itself, Krugman says this is not the first or the last time this has happened. And there are lots of roadmaps to get us out.

“It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books,” Krugman said.

Time is running out on the Obama administration to take control of the banks – and the crisis.

“If this plan fails – as it almost surely will – it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place,” he wrote.

I think Krugman is a supporter of Obama and his administration, but wants America to succeed and doesn’t think the plan has a chance of really working. I agree with the line “It’s just an indirect, disguised way to subsidize purchases of bad assets”. These debts are worthless and the government is trying to prop them up with a false value.  This is the primary reason why no one wants to buy it now in the private sector.  Why the government wants to pay over the true value for these toxic loans are beyond me.

Economist James Galbraith explains his assessment of why this plan is doomed from the beginning:

The trouble with the economy is that the banks aren’t lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it.  As consumers retrench, companies that sell to them are retrenching, thus exacerbating the problem.  The banks, meanwhile, are lending.  They just aren’t lending as much as they used to.  Also the shadow banking system (securitization markets), which actually provided more funding to the economy than the banks, has collapsed.

The banks aren’t lending because their balance sheets are loaded with “bad assets” that the market has temporarily mispriced. The reality: The banks aren’t lending (much) because they have decided to stop making loans to people and companies who can’t pay them back.  And because the banks are scared that future writedowns on their old loans will lead to future losses that will wipe out their equity.

Bad assets are “bad” because the market doesn’t understand how much they are really worth. The reality: The bad assets are bad because they are worth less than the banks say they are.  House prices have dropped by nearly 30% nationwide.  That has created something in the neighborhood of $5+ trillion of losses in residential real estate alone (off a peak market value of housing about $20+ trillion).   The banks don’t want to take their share of those losses because doing so will wipe them out.  So they, and Geithner, are doing everything they can to pawn the losses off on the taxpayer.

Once we get the “bad assets” off bank balance sheets, the banks will start lending again. The reality: The banks will remain cautious about lending, because the housing market and economy are still deteriorating. So they’ll sit there and say they are lending while waiting for the economy to bottom.

Once the banks start lending, the economy will recover. The reality: American consumers still have debt coming out of their ears, and they’ll be working it off for years.  House prices are still falling.  Retirement savings have been crushed.  Americans need to increase their savings rate from today’s 5% (a vast improvement from the 0% rate of two years ago) to the 10% long-term average.  Consumers don’t have room to take on more debt, even if the banks are willing to give it to them.