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Is Geithner's Hedge-Fund Bailout Illegal?

It's certainly a creative workaround—and yet another windfall for the rascals who got us here.

| Tue Apr. 14, 2009 12:30 PM EDT

Indeed, Geithner's language in describing his bank-rescue plans often comes across as a delicate dance around the letter of law. For instance, he's conducting "stress tests" to determine what a bank might lose in a "deeper than expected" recession—taxpayers would then subsidize the bank's losses up to that amount. These stress tests are not much different than the annual audits bank regulators are supposed to conduct to keep banks honest in their accounting. But Geithner can't publicly admit that loads of bank loans are worthless without nationalizing the banks in question. So, using carefully crafted language to imply that the banks might only take such losses under unthinkable circumstances, Geithner can trample on the spirit of the law. Indeed, his criteria for a deeper-than-expected recession fall suspiciously close to present conditions—they cite an average unemployment rate of 8.9 percent, for instance, at a time when national unemployment stands at 8.5 percent and layoffs are accelerating.

Rep. Barney Frank (D-Mass.), chairman of the powerful House Committee on Financial Services, has acted to further expand this world of make believe. At a March hearing, Frank's colleagues browbeat US accounting officials into relaxing the rules that require banks to assess mortgage-backed securities at market rates; the change gives bankers leeway to value their inscrutable assets in the same mysterious way they currently value loans.

In a subsequent CNBC interview, Frank openly acknowledged that the purpose of letting banks value these securities themselves is to keep regulators at bay. "We do think the regulators should not have to automatically say, 'Oh, because these assets have dropped, you've gotta cut your lending right away,'" he said.

Treasury Department spokespeople did not respond to phone calls seeking comment, but the FDIC, which will help administer the loan-purchasing program, insists the plan is necessary and that loan values are the subject of controversy. "There's some uncertainty in the pricing and in their value in the marketplace," says spokesman Andrew Gray.

Why, though, would bank regulators need hedge funds to help them determine what loans are worth? Assessing loan quality, after all, is something they've done for decades. "The regulators will come in and say to the bank, 'You're carrying your loans at values that are not appropriate. Mark them down,'" explains Gerard Cassidy, a bank analyst with RBC Capital Markets.

Granted, this hasn't been happening much lately. Since the financial crisis took hold in earnest, the very accounting gatekeepers charged with protecting our economy from the aforementioned loan-value voodoo have proved excruciatingly slow to make banks write down their loans. This shirking of duties may bear some relationship to the fact that regulators are funded by the fees they levy on banks. When a few banks go under, they can shrug it off, but when banks fail en masse, it's a payroll disaster. One regulatory organ, the Office of Thrift Supervision, has gone so far as to fudge transaction dates on the books of highly leveraged banks to save them from nationalization.

It's not as if our government is no longer capable of evaluating a bank's financial position: When IndyMac was taken over last July, its accounting statements claimed the bank was "well-capitalized"—the strongest regulatory classification. But FDIC officials combing through its books have reported loss rates of around 80 percent on IndyMac's loans, and understanding those books can help regulators determine the health of other banks.

Bottom line: The notion that regulators need Wall Street to tell them the value of bank loans would be laughable if it weren't so reckless. These hedge-fund people, after all, were very much part of the problem. "We are in this crisis because the financial interests of investors caused them to deliberately set asset prices in a way that massively inflated values," Black says.

Even if Geithner has discovered the right mix of smoke and mirrors to push his plan through legally, it seems extremely unwise to reject our best safeguards against financial ruin. The S&L fiasco, after all, taught us that propping up banks and delaying nationalization costs taxpayers far more in the long run. "We have a mechanism to liquidate failed banks, and we know that it works," Graham says. "You shouldn't just throw out the things that have worked before."

Now take a deep breath and let's boil it all down. Our treasury secretary hopes to circumvent laws enacted to protect the economy by subsidizing a bunch of multimillionaire investors—ostensibly to help regulators fulfill their most basic job description—in a bid to prop up bankers who cooked their books to support a gambling binge and still refuse to admit they lost.

Or maybe they haven't. In a game thus rigged, there are only two sure-fire losers: you and me.

Zach Carter writes a weekly blog on the economy for the Media Consortium. His work has appeared in The American Prospect, AlterNet, and on CNBC.

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