Rube Goldberg Alert

A "Hawk Alert" is a warning message, as Calculated Risk explained almost two years ago --

that the credit repositories print on a report when some combination of facts or transactions trigger one of its potential fraud algorithms. It does not prove fraud, but it is designed to make your average human underwriter sit up straight and start poring over documents at a much greater level of detail and skepticism than might be usual.

We need something like a "Hawk alert" to make President Obama to sit up and take notice, if the growing criticisms of Tim Geithner's $1 trillion bank rescue plan are accurate. But since "hawk alert" has already been taken, let's call it a "Rube Goldberg Machine Alert."

Corporate finance advisor Yves Smith offers a brutally frank description of Geithner's plan: "a lot of bells and whistles to finesse the fact that the government will wind up paying well above market for crappy paper."

In other words, the Geithner plan leaked to the press looks just like an elaborate Rube Goldberg machine -- something with too "many components... and a lot of moving parts" that are vulnerable to failure.

Nobel Prize winning economics professor Paul Krugman explains:

[Geithner's] plan proposes to create funds in which private investors [hedge funds and the like] put in a small amount of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad ... assets. This is supposed to lead to fair prices because the funds will engage in competitive bidding.

But it’s immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities.

For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.

What's more, James Galbraith, economist son of the late, great economist John Kenneth Galbraith, says it just won't work:

[S]ome of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation—something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.

Geithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.

Now, we should acknowledge that economics professor Brad Delong thinks the whole thing might turn out okay -- as long as the Treasury Dept. makes $5 for every $1 dollar invested. And DeLong is a smart guy, too.

For the sake of the nation, we hope he's right. But we have one special reason to doubt it that almost no one else has mentioned.

One of the many problems with the Frankenstein monsters Wall Street created -- known as residential mortgage-backed derivatives (RMBD) -- recently was explained by law and economics professor William K. Black: the basic loan file paperwork and data on tens of thousands of mortgages which were sliced-and-diced-and repackaged into RMBDs no longer exist:

[T]he big banks often do not have the vital nonprime loan files now. That means that neither they nor the Treasury know their asset quality. It also means that Geithner's "stress tests" can't "test" assets when they don't have the essential information to "stress." No files means the vital data are unavailable, which means no meaningful stress tests are possible of the nonprime assets that are causing the greatest losses.

No files? Enormous piles of debt "secured" by something that doesn't exist any more? Yes, we realize this sounds too weird for words.

But we've seen that reality unfold right before our very own eyes. The facts of the case were simple:

• Fact: A mortgage debtor stopped making payments three years ago, then split town, abandoning the residential property.
  
• Lawsuit: The mortgage-back securities claimant with the RMBD finally got around to filing suit against the dead-beat debtor.
  
• Other creditors: Other creditors stepped up -- this is where someone we know came into the picture -- and claimed that they should have priority. In effect, they demanded 'first dibs' on the property. "Show us your loan contract," the competing creditors said.
• Reply: The RMBD claimant then admitted, 'We don't know where the mortgage file is -- or if it still exists. We have no mortgage contract or promissory note we can show you.'
  
• Court: The judge let it be known that the RMBD claimant would have to prove it holds a top-priority mortgage and promissory note or, otherwise, all the other creditors would win.
• Result: Mortgage-backed securities claimant decided to pay off all the other creditors of the long-gone debtor, so that they would drop out the lawsuit.

How much of your own money would you risk to buy an aircraft hangar full of RMBDs, especially when you can't know how many of them will end up costing you -- as in the above real-life example -- far more money than they're worth.

Exactly. And that is one sure reason we know of to indicate that Treasury Secretary Tim Geithner's plan to "partner up" with private investors probably won't work to the taxpayer's advantage. As Paul Krugman says late today, "The whole point about toxic waste is that nobody knows what it's worth."

Sure, the hedge funds will "partner up," all right. But only if it means "heads the taxpayers lose, tails the hedge funds win. "