It’s been over a week since Treasury Secretary Tim Geithner announced his Public-Private Partnership Investment Program designed to help the banks dump their “toxic assets”. As of late, the plan has received some much deserved criticism. Upon closer review, It’s my opinion that the plan won’t work in its current form because it fails to address one major question.

“What if the banks colluded to create a market price for these assets that is much higher than their actual value?”

Let’s not forget that we still have some very smart people working at this nation’s banks and they are working around the clock to find out the best way to take advantage of these new government programs. Although banks wont be allowed to bid on their own assets as part of the auctions, what is going prevent banks from setting up special entities to bid for them in the auctions or paying a hedge fun a “management fee” to bid for them on their behalf?

Let’s say that through this partnership a bank is able to sell an asset at 60 cents instead of the 30 cents that they probably are worth. If the bank only put up 5 cents worth of equity, the taxpayers would be on the hook for the remaining 25 cents of losses. If we didn’t have the partnership, and the government made the mistake of purchasing the assets at 40 cents, the taxpayer would only lose 10 cents.

Potentially, by using the “market” to price these assets, the taxpayer could stand to lose alot more money as opposed to a plan where the government would be the sole purchaser of the assets at “its” price. Its clear that the banks are incentivized to game the system to create a fake market for these assets.

The Financial Times reported yesterday that many banks that have received government aid are planning to participate in the auctions of each other’s assets.

The Khan Academy, a ‘not-for-profit organization, has posted the following great ‘chalkboard’ commentary on YouTube describing how the banks might game the system.

The fact that the banks are trying to purchase each others “toxic assets” is not surprising. None of them is going to write these assets down to their “real market value” which is why there has been little to no trading in the secondary market. If the banks were to sell or mark down their toxic assets to the “real market level”, many would be insolvent. In that scenario, the common shareholder is wiped out and those banks would have to be nationalized to prevent a collapse of the financial system — an area our government does not want to go.

So we are left with the Geithner plan, a plan that looks good on the outside but could have disastrous implications for taxpayers if these loopholes aren’t fixed. Until the govt is prepared to wipe out shareholders and nationalize the banks, the taxpayer is going to be holding the bag. Unfortunately, I don’t see any way around it.

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