CrowdSourcing the Bank Recovery

I don’t believe Tim Geitner’s toxic asset auction plan will work to change the basic problem of bank insolvency, but that doesn’t stop me from appreciating the sheer brilliance and post-partisan nature of the approach.

Most commentators and economists are focusing on the way the plan distributes risk, perhaps unfairly – with the government guaranteeing most losses while giving hedge funds and investors half of the gains. But that misses the point of the whole thing.

The underlying problem with the toxic assets currently on the books of most banks is that no one knows quite how to value them. (Their market value is very low right now – lower than most believe it should be. This is what is meant by “mark to market.” In time, when things are better and the world is generally less risk-averse, they should be worth more. Most banks need their balance sheets to look better now, and they can’t while they have these – perhaps artificially – deflated securities on their books).

Were the government to simply go in and buy them all, the Treasury Department would have to hire a huge staff of accountants to look at each and every toxic asset – every single loan package and bond and bond fund, and come up with what it is worth. If that were even possible.

While this would give government all the winnings if and when the securities become worth what they are really worth, they would be saddled with a huge actuarial task, and would surely arrive at numbers that banks feel are unfairly underestimating the securities’ true worth.

Geitner’s plan is less about spreading risk than it is about finding a more efficient way to evaluate all those issues. So why not crowd source?

The government assumes a hunk of the risk – the hunk that no one else wants to assume – while letting a huge army of investors bid and fight over the profit potential. His hope is that those people will do the necessary homework on all this stuff, since it is some real money they are staking.

Thus, Obama’s team comes up with entrepreneurial socialism, or market-based welfare. The scores of investors bidding on all these securities become a giant unpaid (but insured) bunch of bidders.

That’s the brilliant part.

The stupid part is that it’s not a real marketplace, so the invisible hand of collective market genius just won’t take effect. While the market may, in the best of circumstances, have some of the self-regulatory features of nature, we can’t expect it to act like nature when so many of the underlying rules have been rigged. Auction-determined prices will not reflect underlying value when some large percent of risk has been removed. And the percentage of risk assumed by government remains the same, regardless of the riskiness of the toxic asset. So, playing the game properly, investors should go for the highest odds instead of the lowest. Unless they don’t.

In the end, if these folks really and truly believed in the wisdom of the crowd, they would accept the fact that the market no longer values this stuff in the present.

Banks made a bad bet. Over time, it seems, banks came to believe that the terrible assets they were pawning on the rest of us actually had some value. They broke the cardinal rule of pyramid scheming and decided to maintain an account in the pyramid. They believed their own hype, or the guys who made up the hype died, leaving a generation of bankers who forgot how the scam of hand-me-down interest was supposed to work. It was actually a game hot potato: you’re supposed to get rid of it as fast as possible, and make your money on the commissions.

The fact that they were left holding stuff as crappy as the rest of us is the price of doing business.

The real market has crowd-sourced this fact already.