Geithner's perception problem

Will Treasury Secretary Tim Geithner's plan let big investors rip off taxpayers?

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NEW YORK (Fortune) -- Where Tim Geithner sees a confluence of public and private interests, some people see a torrent of potential abuse.

The public-private investment plan Geithner outlined last month would provide cheap federal funding for private investors to buy bank assets. The arrangement aims to set a market price for banks' troubled loans and securities, avoiding government price setting -- the source of much criticism of Henry Paulson's original Troubled Asset Relief Program.

But while market participants embrace private-sector pricing, some fear the Geithner plan - known as the Public-Private Investment Partnership plan, or PPIP - could pave the way for chosen financial firms to rip off taxpayers.

In one oft-discussed scenario, some worry that big private sector firms such as bond manager Pimco, to take one popular example, would overpay for mortgage-securities purchases that in turn push up the value of its existing bank investments.

Another concern is that banks selling loans into the program could participate in the auctions at the same time as investors, bidding up prices for similar loans.

In both cases, skeptics of the Geithner plan fear that investors will deliver a too-good-to-be-true price to the selling banks and stick taxpayers with potentially large losses.

Officials have said they're aware of the conflict worries, and some lawyers -- citing regulators' experience in cleaning up the savings and loan crisis of the late 1980s -- say they believe officials will appropriately avoid any possible conflicts. But the government's difficulties in managing the financial crisis of the past two years have fed some of the skepticism.

"Perceived conflicts are just as dangerous as real ones in an environment of intense distrust," said David Kotok, chief investment officer at Cumberland Advisors in Vineland, N.J. "It isn't Pimco's fault that this kind of distrust is now ubiquitous in financial markets worldwide. That comes from a failure of supervision and a lack of transparency."

How effective the Geithner plan will be in preventing abuse will be decided in large part by rules the government hasn't yet written.

Officials at the Treasury, the Federal Reserve and the Federal Deposit Insurance Corp. will oversee the PPIP and its constituent parts. The FDIC, which is overseeing the Legacy Loans Program that aims to find buyers for troubled bank loans, is accepting public comment on its plans through April 10.

After that, investors and bankers will be on the lookout for the formal rules governing the plans -- a process that is likely to take some time.

"I think they'll get the conflicts questions straight," said Chip MacDonald, an Atlanta-based financial institutions partner at law firm Jones Day. But putting together guidelines governing issues ranging from asset eligibility to conflict rules "is going to take a while to do, and the more bells and whistles you put on the longer it takes to implement."

In the meantime, there are some arrangements that are already raising eyebrows. Take the Treasury's Legacy Securities Program, which would appoint five private sector managers to raise investor funds to buy banks' troubled mortgage-backed securities.

Once the managers raise the money, the Treasury will provide matching funds and the Fed will provide financing. All told, the government money could effectively triple or quadruple the private-sector investors' buying power.

More buying power -- and a government promise to soak up losses if the purchased securities go sour -- should push prices higher and give banks an incentive to sell their securities giving them more capacity to lend into a weakened economy.

Doing so could help to clear the balance sheets at institutions ranging from Citigroup (C, Fortune 500) and JPMorgan Chase (JPM, Fortune 500) to the tiny Crazy Woman Creek Bancorp (CRZY) of Buffalo, Wyo. So far, so good.

But if the securities plan looks like a good bet to work for the banks, some observers say it may work all too well for the program's private sector managers - including one that has already drawn scrutiny for their opportunistic investment stance and their close ties to the government.

The Treasury specified that the firms eligible to act as managers in the legacy securities programs must have at least $10 billion in assets, a "demonstrated capacity" to raise at least $500 million from private investors and be based in the U.S.

While Treasury may have been focused on making sure it had managers with sufficient firepower to raise substantial capital, the specifications will also sharply reduce the universe of participating managers.

"The criteria for fund managers for the Legacy Securities Program are quite stringent and may significantly narrow the pool of potential managers," lawyers at Davis Polk & Wardwell wrote in a note to clients last week.

Among the firms that will qualify and have declared their interest in participating as managers are Pimco, the bond fund manager owned by German insurer Allianz, and BlackRock (BLK, Fortune 500), the asset manager that's 49%-owned by Bank of America (BAC, Fortune 500) and 33%-owned by Pittsburgh's PNC (PNC, Fortune 500).

Pimco, run by the highly visible Bill Gross, has been a big booster of the Geithner plan. "This is perhaps the first win/win/win policy to be put on the table and it should be welcomed enthusiastically," he told Reuters last month, after Geithner made the announcement.

It was far from the first time Gross' views were heard on the policy front. He has been an advocate over the past two years of many of the tactics the government has used in the economic crisis, ranging from lower interest rates to fiscal stimulus to a federal takeover of Fannie Mae (FNM, Fortune 500) and Freddie Mac (FRE, Fortune 500).

All along, it has appeared that Pimco was positioning itself to profit from the adoption of those suggestions. Indeed, Gross wrote earlier this year that his investing strategy in a deleveraging world involves figuring out what governments will buy and then beating them to the punch.

"For now, our Ponzi-style economy and its policy remedies encourage bond investors to mimic Uncle Sam and its global compatriots," he wrote in his January market commentary on Pimco's web site. "Buy what they buy, but get there first."

In this case, Pimco has again gotten there first, by being a big buyer of bank debt over the past year. Prices of bank debt would likely rise if the Geithner plan succeeds in removing troubled assets -- and the prospect of further losses -- from bank balance sheets.

Pimco wouldn't comment for this story. But Gross told Fortune in February that he isn't influencing public policy for the benefit of Pimco's investors.

"The policy prescriptions I've proposed were a realistic attempt to assist the markets," he said. "In my eyes, they had nothing to do with bailing out our positions."

To some observers, the most important motives lie not with the private investors but with the Obama administration, which already seems to be shying away from asking Congress for more bailout money.

Observers say the decision to fund a major part of the financial stability plan through the Fed and the FDIC shows how little political wiggle room the administration has right now. So the last thing officials want is another scandal along the lines of the AIG bonusgate.

"If they write loose conflict of interest rules, they're potentially laying a political trap for themselves," said Robert Litan, a former White House staffer who is now a senior fellow at the Brookings Institution in Washington. "They don't want to run this in a way that will cause them any more problems than they already have."