Yesterday, Treasury Secretary Geithner presented an outline of his approach to regulating the financial system. The four pillars of that approach seem to be:

1. Increased power and regulatory centralization to deal with the problem of systemic risk


2. Increased protections for consumers and investors buying financial products


3. Closing regulatory gaps by shifting that organizes regulation based on financial functions, not types of financial institutions


4. International coordination among regulators

This all sounds good to me, and an improvement over where we are today. But reading Geithner's discussion of systemic risk - the topic he focused on yesterday - I kept thinking it had been too long since he read Frog and Toad to his children.

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$165 million, of course, is less than one-tenth of one percent of the total amount of bailout money given to AIG in one form or another. Yet it may turn out to be the $165 million that broke the camel's back.

The AIG bonus saga neatly encapsulates many of the problems that we have identified with the financial system and with the bailout to date.

• The bonus contracts - which have still not been released to the public - reflect the instinct of Wall Street to favor its employees over any other stakeholders. In the companies I worked at, it was common practice that all bonus plans were contingent on overall company performance: if the company had no money, you didn't get any, either. Even our commission plans for sales people included the caveat that the plan could be changed by the CEO at any time for any reason. The fact that AIG did not similarly protect itself shows the Wall Street habit of putting itself first, or a failure to recognize the possibility of a bad year, or, most likely, both.

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There is nothing inherently wrong with convertible preferred stock. In Silicon Valley, for example, venture capitalists almost always invest by buying convertible preferred. The idea is that in the case of a bad outcome, the VCs are protected, because their shares have priority over the common shares held by the founders and employees. Say the VCs put in $10 million for 1 million shares, and the founders and employees also have 1 million shares, so the company immediately after the investment is worth $20 million. If the company liquidates for $15 million, the preferred shares have a "preference," which means they get their $10 million back (often with a mandatory cumuluative dividend as well) first, and the common shareholders take the loss. However, in a good outcome, the VCs can exchange their preferred shares one-for-one for common. So if the company gets sold for $100 million, the VCs convert, and they now own 50% of the common stock, so they get $50 million.

When I heard that the government was going to give future capital as convertible preferred stock, and perhaps change some of the previous capital injections to convertible preferred, I thought this was a good thing. It would give the taxpayer more upside potential, and it would also give the government the option to take over the banks simply by converting its preferred stock to common whenever it wanted.

But the key in the Silicon Valley example is that the VCs have the option to convert or not. The Treasury Department's new Capital Assistance Program has this precisely backwards.

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In this brief interval before the new housing plan is announced, I'll try to sneak in a comment on the auto bailout, and the plans submitted by GM and Chrysler yesterday. This may be an obvious question that many people have thought about, and got some discussion in December, but: Why does Cerberus (the private equity firm that owns Chrysler) need money from the government?

Let's take this step by step. Assume GM has a viable restructing plan, but it needs $30 billion to execute the plan, after which it will be a viable standalone business. Even on that assumption, given market conditions, they would be unlikely to be able to sell $30 billion in newly-issued stock or raise $30 billion through bonds or loans, because of information asymmetry: put simply, no one would believe them. Therefore, they can only get the money from the government, because the government is the one institution that will provide a below-market loan because of the public interest (saving the auto industry and either hundreds of thousands or millions of jobs, depending on whom you believe).

Now, with Chrysler, which is asking for $5.3 billion in new loans (on top of the $4.3 billion already committed, and in addition to another $6.0 billion from the Department of Energy's alternative energy funding program - see page 16), there is a difference: The people writing the plan and the people who could provide the money are the same people, since Chrysler is majority-owned by Cerberus, so there is no information asymmetry.

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Counting down to the announcement of the Geithner plan, the New York Times has this account of how it came into being (and why it should be called the "Geithner plan," although maybe Larry Summers is hiding behind him):

In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.

Mr. Geithner, who will announce the broad outlines of the plan on Tuesday morning, successfully fought against more severe limits on executive pay for companies receiving government aid.

He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.

I'm not a huge fan of executive compensation caps, as I think they are something of a sideshow. But I think the general approach of playing nice with banks and their shareholders is a mistake, because it leads to intransparent subsidies like the privately-financed bad bank is sure to be. (If the government is guaranteeing assets bought by private investors, as is widely rumored, it's still a subsidy; it's just not as obvious as writing a check.)

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I don't envy President Obama's economic team. When it comes to fixing our banking system, there is no easy solution.

I've been sick the past few days, but someone pointed out this article in The New York Times a few days ago that has a concrete illustration of the problem: a bond that an unnamed bank is holding on its books at 97 cents, but that S&P thinks is worth 87 cents (based on current loan-default assumptions), and could fall to 53 cents under a more negative scenario . . . and that is currently trading at 38 cents. Assume for the sake of argument that all of our major banks are insolvent if they have to mark these assets down to market value. The crux of the issue is that any scheme in which the banks receive more than market value is a gift from taxpayers to bank shareholders, and any scheme in which they are forced to take market value is one that the banks will not participate in. Let's look at a few possibilities:

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The fiscal stimulus debate is currently hampered by confusion over its objectives. On the one hand, one purpose of the stimulus is to generate economic activity quickly in order to boost aggregate demand and break the recessionary spiral we seem to be in. On the other hand, people rightly worry about the capacity of the government to spend large amounts of money quickly without wasting it, and argue that the money should be put to productive use, rather than paying people to dig holes and then fill them in again. (This is why you see (at least) two versions of criticism of the stimulus plan: on the one hand, the criticism is that the government is incapable of putting money to productive use; on the other hand, the criticism is that money for things like electronic health records will not be spent in time to have a short-term effect.)

My opinion is that both are valid purposes. There probably is a limit to the number of tens of billions of dollars the government can spend next month without wasting some of it. But given the projected duration of the output gap (the difference between potential and actual GDP, meaning that the economy is performing below its full-employment capacity), I think there is also value in programs that take several quarters to disburse their money - as long as those programs are also good investments.

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Many people have many expectations for Barack Obama. Although I generally write about economics, the issue I am most interested in hearing about from the new president is torture. And this is the speech that I want to hear him give:

Our nation today faces the most serious set of challenges it has faced in several decades. We are in the midst of a financial and economic crisis that has already cost millions of people their jobs and threatens the livelihoods of tens of millions more. We are fighting two wars thousands of miles away, with a military that is strained from over seven years of heroic efforts. We still face the constant threat of attack from terrorists who want to destroy our society and our way of life every bit as much as they did in September 2001. And on top of this, we face the long-term threats of global warming and maintaining the promise of financial security for an ever-growing population of retirees.

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Back on January 2, the Treasury Department announced something called the Targeted Investment Program. I missed this at the time, along with (according to a quick search - thank you Google Reader!) all of the economics blogs that I read. The press release admitted that this was a program announced after the fact to cover the second Citigroup bailout (the first was under the Capital Purchase Program, the main bank recapitalization plan). In essence, the program says that if Treasury thinks a financial institution is at risk of a loss of confidence, Treasury can invest in it under any terms they want. This is very similar to the Systemically Significant Failing Institutions Program, also announced after the fact (in November) to cover the second AIG bailout, which reads almost identically, except instead of talking about a "loss of confidence" it takes about the "disorderly failure" of a systemically important institution.

This isn't a power grab by Treasury - they already had this power under the EESA (the main bailout bill passed in October, commonly known as TARP). And I happen to agree that if a systemically significant institution - the kind that whose failure would have a major impact on countless other institutions - is going to fail, it should be bailed out. However, I think these programs have two major failings.

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Bloomberg has a new story out comparing the investment terms achieved by TARP with those achieved by Warren Buffett when he invested $5 billion in Goldman back in September. The results aren't pretty for the U.S. taxpayer: the government received warrants worth $13.8 billion in connection with its 25 largest equity injections; under the terms Buffett got from Goldman, those warrants would be worth $130.8 billion. (The calculations were done using the Black-Scholes option pricing formula, which has its critics, but which I think is still a good way of estimating the relative difference between similar options.) That's on top of the fact that TARP is getting a lower interest rate (5%) on its preferred stock investments than is Buffett (10%), which costs taxpayers $48 billion in aggregate over 5 years, according to Bloomberg. The difference in the value of the warrants themselves is due to two factors: (1) Treasury got warrants for a much smaller percentage of the initial investment amount; and (2) those warrants are at a higher strike price - the average price over the 20 days prior to investment, while Buffett got a discount to market price on the date of investment.

The comparison isn't a new one - we recommended that TARP emulate Buffett back in October - but Bloomberg's analysis has put the performance gap in striking perspective. Simon has a quote in the article, using the word "egregious," but the really harsh words came from Nobel prize-winner economist Joseph Stiglitz, who said, "Paulson said he had to make it attractive to banks, which is code for 'I'm going to give money away,'" and "If Paulson was still an employee of Goldman Sachs and he'd done this deal, he would have been fired."

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