Why the Geithner plan won't work

Treasury Secretary Tim Geithner

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(Fortune) -- Treasury Secretary Tim Geithner on Tuesday unveiled a four-part bank rescue plan -- and two of those parts will achieve puny results at an epic cost to taxpayers.

At issue are the proposals to subsidize investors to buy so-called toxic assets and to force banks to rewrite mortgages on a massive scale.

In both areas, cheaper, simpler solutions would work far better.

To encourage private investors to buy bank assets, the government will offer a guarantee against losses as well as low-cost financing.

That's a good deal for the banks, a so-so arrangement for investors, and a potential rout for taxpayers.

Let's assume that these assets are approximately worth their value on the banks' books. That's possible, since many have been written down by 50% to 60%, and still boast strong cash flows. In fact, at those depressed "book" values, the banks are reluctant to sell.

But what happens when a new group of investors arrives armed with a big government subsidy? Let's say a mortgaged-backed security is being carried at $10 million. The vulture investors get a $9 billion government loan to buy it at a 3% interest rate, and a guarantee that the government will pay all losses over $1 million if the bet goes sour.

It's as if you or I could get a 3% mortgage and protection against a fall in the price of a new house. We'd pay a lot more for that house than what our neighbor paid without the sweetheart loan and guarantee.

Similarly, instead of paying $10 million, investors will offer the banks a big premium, say $11 million. At that number a Bank of America (BAC, Fortune 500) or Citi (C, Fortune 500) will sell. It's simply a great deal for the banks. Courtesy of the government, they're getting sumptuously overpaid for their tattered assets.

For investors, the deal isn't as appealing. The value of the low rate and downside protection is pretty much erased by the higher price. Still, let's assume America boasts enough adventurous vultures to grab these deals.

The real losers are taxpayers. Sure, the values of these assets could stabilize or even rise. But if they head south, it's taxpayers who will pay the bill. Taking that risk makes sense if the "insurer" -- in this case, the taxpayer -- gets paid for it. Under this plan, it's likely that the taxpayer will get absolutely nothing for shouldering tens of billions potential losses.

The Geithner plan would achieve a major goal of any rescue: Raising the banks' depleted capital, the raw material for making loans. Let's return to our example. Because of the government subsidy, private investors overpay by $1 billion, which our bank adds to its capital position. As a rule of thumb, $1 billion extra capital translates into $10 billion in credit card receivables or home equity lines. So far, it sounds pretty good for America.

Don't be fooled. The government can achieve the same objective far more directly, at far lower cost. It can directly inject equity capital in the banks without the complication of acting as a giant lender and guarantor. The best method is to purchase either common stock or preferred shares from the banks. Then, the taxpayers would either share in the banks' earnings -- and benefit from their revival -- or reap dividends.

The part of the Geithner plan that tries to address foreclosures contradicts the goal of raising banks' capital -- it will actually drain their equity and render them even weaker.

The real problem in the housing market is the rampant job loss. Most Americans whose homes are worth less than their mortgages keep paying. The Boston Fed found that during the crushing downturn in Boston in the early 1990s, only 6% of the underwater homeowners defaulted.

People default when they're pummeled by a life event like a divorce, a serious illness, and most of all, job loss. This go-round, the foreclosure rate will jump to as much as 15%, triggered by soaring unemployment.

Hence, the right plan should focus on crafting a break for people who've just lost their jobs, not the 85%-plus of Americans who keep paying even with negative equity.

But the Geithner plan is an invitation for people who don't need relief to get it anyway.

We don't know the details. But it probably bears a strong resemblance to an FDIC plan that reduces mortgage payments to fixed percentage of the homeowners' income. If homeowners are late with payments, they get a virtually automatic reduction. Hence, they have a big incentive to make their incomes look as small as possible and to pay late.

"The plan has a giant moral hazard problem," says Paul Willen, an economist at the Boston Fed.

Another possible proposal also centers on rate reduction: If a bank lowers rates by 1%, the government would lower it another 1% via a subsidy. "That would be incredibly costly and not do a lot of good," says Willen. "If you reduce someone's rates from 8% to 6%, you're probably subsidizing someone who would have paid anyway. You're not preventing a foreclosure."

It's not clear what modifications banks will be forced to make. Banks in general hate to modify mortgages because offering help attracts flocks of people who don't need it. But the government has been pointed in stating that banks that receive public money must rewrite home loans. That process will deplete their capital without doing much to slow the flow of foreclosures. That requirement is bound to shrink the banks' weak supply of capital.

The best formula for stemming foreclosures is a highly targeted plan to aid people who have lost their jobs. For this group, the moral hazard issue is less pronounced, since it's unlikely that Americans would risk unemployment to get a break on their mortgages.

Willen and three other Federal Reserve economists have introduced a proposal in which the government covers half or even all payments for people who lose their jobs until they find a new one. It's far more targeted, efficient, and taxpayer-friendly than the Treasury proposal.

We all thought the age of excess was over. That's until it took on a whole new life led by, of all people, not the victims but the righteous rescuers.