When a Nobel Prize winning economist like Paul Krugman looks at an economic plan and is unsure what it entails, it’s a lesson to the rest of us to be cautious in how strongly we express our own opinions. The immediate question that came to my mind after listening to Tim Geithner (and reading his plan (.pdf)) was what order he was going to do things.

He wants the Treasury Department to do a ‘stress-test’ (named for the medical test) of all the banking institutions that have ‘assets’ in excess of $100 billion.

Forward Looking Assessment – Stress Test: A key component of the Capital Assistance Program is a forward looking comprehensive “stress test” that requires an assessment of whether major financial institutions have the capital necessary to continue lending and to absorb the potential losses that could result from a more severe decline in the economy than projected.

During testimony before the Senate Banking Committee, Geithner expanded on this idea and explained that the Treasury will look at banks’ assets under a variety of different assumptions (from optimistic to pessimistic). Banks that fare poorly under pessimistic assumptions will be eligible for cash infusions.

While most banks have strong capital positions, the Financial Stability Trust will provide a capital buffer that will: Operate as a form of “contingent equity” to ensure firms the capital strength to preserve or increase lending in a worse than expected economic downturn. Firms will receive a preferred security investment from Treasury in convertible securities that they can convert into common equity if needed to preserve lending in a worse-than-expected economic environment. This convertible preferred security will carry a dividend to be specified later and a conversion price set at a modest discount from the prevailing level of the institution’s stock price as of February 9, 2009.

The way I read this, banks that convert preferred securities into equity would be essentially nationalizing themselves a bit at a time. That seems to be how this plan could be interpreted as a stalking horse towards nationalization. On the other hand, Geithner proposes another program to help scoop out all the toxic assets (now called ‘legacy assets’) that are sitting on these banks’ books.

2. Public-Private Investment Fund: One aspect of a full arsenal approach is the need to provide greater means for financial institutions to cleanse their balance sheets of what are often referred to as “legacy” assets. Many proposals designed to achieve this are complicated both by their sole reliance on public purchasing and the difficulties in pricing assets. Working together in partnership with the FDIC and the Federal Reserve, the Treasury Department will initiate a Public-Private Investment Fund that takes a new approach.

• Public-Private Capital: This new program will be designed with a public-private financing component, which could involve putting public or private capital side-by-side and using public financing to leverage private capital on an initial scale of up to $500 billion, with the potential to expand up to $1 trillion.

• Private Sector Pricing of Assets: Because the new program is designed to bring private sector equity contributions to make large-scale asset purchases, it not only minimizes public capital and maximizes private capital: it allows private sector buyers to determine the price for current troubled and previously illiquid assets

In the Banking Committee hearing yesterday, Sen. Mark Warner (D-VA) posed the question I wanted to ask. Sen. Warner wanted to know whether Treasury was going to do the stress-test on banks before or after they set up the Public Private Investment Fund. It could make a big difference which order they do those two things. Let me try to explain why.

Banks have a ton of money tied up in ‘shitpile’, which is essentially a grouping of assets that has some inherent value but which no one is currently willing to buy at any price. The Public Private Investment Fund is an effort to fluff up those assets and assign them some value north of zero. The more successful that effort is, the better the bottom line for the banks will look when they undergo a stress-test. If you mark them to market at zero, then all these banks are likely to be insolvent, as Paul Krugman notes:

3. Stress test: everything depends on how this is actually implemented. What happens if, or more likely when, a major money center bank is stress-tested and found to have negative net worth? One possibility is that the auditors are told to come up with a different answer; that’s a big concern. The other is that the bank is effectively nationalized; as I read the language that could be achieved as part of the public capital injection.

Yet, when Geithner responded to Sen. Warner’s question he offered a third possibility. I don’t see that a transcript is yet available, but paraphrasing Geithner, he said that we could do the stress-test and the public-private toxic scoop-out concurrently. He emphasized that the stress-test would involve analysis using a broad spectrum of assumptions (including worst-case assumptions). And we know the worst-case assumptions are complete insolvency. What Krugman refers to as “com[ing] up with a different answer”, Geithner refers to as fixing the problem. Using the Public Private Investment Trust, Geithner hopes to set a higher floor for the value of the ‘legacy assets’, thereby improving the worst-case scenario. It would seem, then, that the stress-test should come after the Investment Trust is set up and functioning. Yet, Geithner said they could be performed at the same time. It’s precisely this kind of ambiguity that is frustrating all the analysts today.

A simple way of thinking about this is that the banks would probably be judged insolvent if we did a stress-test on them today. But if we can improve the housing market, inject new capital into the banks, and raise the value of their legacy assets below zero, many of these banks will no longer be insolvent. By tackling all of these problems concurrently, Geithner hopes to raise the banks out of insolvency. But for those that are still insolvent given a fairly negative set of assumptions, they will have the option to essentially nationalize themselves voluntarily through the conversion of preferred stock to equity.

That is my best guess of what Geithner is really trying to do, and it might work without excessive waste of taxpayer dollars. On the other hand, there are risks in delay and in the way the plan is perceived politically.