The days of giving defense contractors a blank check are over, President Obama said last month, referring to the cost overruns, delays, and opacity that often ensue when the government contracts with the defense industry to supply some product or service. Thats good news. But the president is about to create a similarly cozy world of private-public cooperation in the financial industry. The Treasury Departments Public-Private Investment Fund (P-PIP) is supposed to fix the financial system. But as its currently designed, P-PIP could fail at that task while running into the very problems that have long plagued defense purchasing.
Washington long ago co-opted the defense industry (or vice versa), with government awards of big jobs to nominally private contractors often insulated from real competition. Its easy for these contracts to go bad. The government sets itself up for failure when it doesnt have the necessary knowledge of complex technology and the like to make sure that its getting a good deal from the private sector. On long-term contracts, the government often changes its mind about what it wants or needs midway through the process, thus holding itself hostage to cost increases after its too late to change contractors if the price gets too high. Such contracts are usually cost-plus, meaning that the government, not the contractor, has to pay for higher-than-expected technology, materials, and labor costs.
The Coast Guards fleet-modernization program provides a good example. In 2002, the government outsourced the responsibility for building a new fleet to two big, long-term contractors. For this ambitious experiment in privatization, originally tagged at $17 billion, taxpayers have suffered cost overruns of more than 40 percent for things like a half-billion-dollar ship with structural flaws. The Coast Guard has since tried to reassert control over the remaining projects so that it can get something built right.
The Obama administration is about to make the same mistake with the financial world, and on a similarly giant scale. To help bad banks get bad debt off their books so that they can start lending again, Obamas Treasury Department will select financial firms, hopeful of turning a big profit, to purchase the debt. Treasurys plan to finance these purchases could reach $1 trillionand possibly, as independent analysts have noted, even more. These sums rival the governments ongoing commitments for defense acquisition, which total $1.6 trillion, according to the General Accounting Office.
Treasurys first mistake is limiting participating firms to up to five already huge asset managers with vast experience in the securities for sale. (Treasury backtracked slightly on Monday, announcing that it may add more, and smaller, managers later.) Just as in the defense-contracting world, the government is accepting as its partners contractors who probably already know one another and think exactly alike. And by choosing long-term asset managers rather than just letting bidders buy securities, the government opens up the possibility that if it wants to expand the program with the same contractors in an emergency, theyll be able to win even more generous terms for new asset purchases.
Treasurys second mistake is offering these chosen contractors huge amounts of government money to play with. Just as cost-plus contracts limit defense contractors financial risk, the generous financing that the government will give these asset managers, with no requirement to pay it back if the securities perform poorly, will limit the asset managers risk. That, in turn, magnifies an existing problem: that the government still doesnt seem to know much about the bad securities on banks books (just as it often doesnt know much about the technology its buying from defense contractors). The whole point of the P-PIP experiment is to discover the value of these securities, but letting a few big, look-alike firms use public money to put a price on them at auction wont shed light on what the real private sector thinks theyre worth.
And the administration is making yet another mistake, one that afflicts all types of big-government ventures: its obscuring its main policy goalin this case, getting bad assets off banks booksby adding unrelated social-policy goals. In its latest update of the P-PIP criteria, Treasury notes that it will encourage small, veteran, minority- and women-owned businesses to partner with the big private-asset managers it selects for the program, urging the big guys to invite the minorities and ladies to be junior partners in their funds or to provide services like trade execution and valuation. Historically, big contractors hiring of female and minority subcontractors and partners to make their government funders happy has bloated project costs unnecessarily and hurt the quality of the work, since race or sex isnt a good indicator of whether one can execute trades or value securities effectively. Moreover, such engineering would distort the all-important pricing of the mortgage-backed securities by adding political, rather than economic, inputs to the bidding process.
Instead of P-PIP, Treasury should hold a real auction, in the manner of auctioneers selling off foreclosed houses. It should invite anyone who would qualify as a sophisticated investor under other circumstancesusually, anyone with more than a million in the bankto come to a virtual auction of discrete pools of securities, spend a few days looking them over online to assess their potential worth, and make a bid.
To protect taxpayers further, Washington shouldnt offer bidders a set amount of federal financing for every dollar of securities that they purchase. Rather, if it continues to insist on providing federal financing for these securities purchases, it should at least ask each bidder to submit a bid based on how much taxpayer financing he would require if his firm were to pay a particular price for a particular security. That way, the governmentand the publiccould more easily distinguish between the value that bidders are putting on cheap federal guarantees and the value that bidders are putting on the securities themselves.
Washington might argue that the logistics of vetting hundreds of thousands of likely bidders for potential waste, fraud, and abuse would be prohibitive. Its true that shady characters would slip into a big pool. But so what? Bid rigging and collusionor, more charitably, group-thinkare less likely when youve got a crowd of participants from all backgrounds who dont know one another than when youve picked five giants whose executives see each other at fancy restaurants every week. And careful government oversight of just a few contractors has its own dangers: the regulated can easily capture their regulators. Further, minorities and women, still underrepresented at the top of the financial world, occupy greater numbers at the bottom, giving them a chance to participate on their own merits, rather than as members of favored groups.
The White House may fear a real auction because, undistorted by complex government machinations, it could force Treasury to deal head-on with what is now a two-year-old question: what to do with banks that prove insolvent after selling off bad assets at their real prices. But theres no way around that problem. The sooner we admit it, the sooner we can take measures that have a chance of fixing the financial system.
Nicole Gelinas, a City Journal contributing editor and the Searle Freedom Trust Fellow at the Manhattan Institute, is a Chartered Financial Analyst.