This is very interesting. It sheds a certain amount of light on the actual objectives of the public-private investment plan that Tim Geithner is trying to push as a solution for the banking crisis.

It’s all about finding the least painful place to stash the losses from the collapse of the housing bubble and the subsequent destruction of leveraged financial procedures.

For every borrower, there’s a lender. When people default on their mortgages (or when they become statistically more likely to default because of deflation), the lenders face losses too. Most of those prospective losses are locked up inside the packages (“securitizations,” or MBS) that are now such a large part of the asset portfolios of major banks.

What makes these assets “toxic” is that they can’t be sold or marked to market, because the current value of a typical mortgage is now a small fraction of its face value. So the largest banks are stuck holding these assets.

But observe that the vast majority of mortgages won’t default. There’s a reason why everyone wants to invest in mortgages: ordinary consider it a matter of morality to pay their debts. So if a bank paid $100 to buy a mortgage that’s now priced in the market at $15 or $20, they have the option of holding the mortgage for the next five years or so. Adjusting for default risk, they might end up realizing $85 or $90 (in nominal dollars) at the end of that period.

I’m oversimplifying the picture considerably, but that’s the nut of the banking crisis. Because it’s no longer possible for banks to raise new capital, they’re stuck with the balance sheets they have. In many cases (Citigroup being an exception), it’s indeed a plausible strategy to sit on their existing asset portfolios, accept relatively low returns on those assets, and wait for them to mature. In the meantime, of course, those banks have no ability to create new credit, which could have been used to finance economic growth.

Now Tim Geithner wants to change that dynamic, and artificially elevate the prices at which mortgage-backed assets can trade today. In theory, that would make it somewhat easier for banks to sell off their most putrid paper, thus improving both their anticipated earnings and their capital positions.

Now as the Business Insider story points out, banks and other financial institutions are smacking their lips over the possibility of buying up MBS from other banks. What could possibly make that an attractive thing to do?

You guessed it: the taxpayers will finance the purchases, and guarantee any losses. Nobel-winning economist Joseph Stiglitz is absolutely correct when he says that the Geithner plan doesn’t sell assets to private investors. It sells options on assets. The upside for the buyers is unlimited, and there is no downside. It’s an easy decision. (It’s also massively inflationary, but Geithner hopes you’re not paying any attention to that part.)

At the end of the chain, Geithner hopes this will result in more bank lending, but that’s not a necessary consequence of this game. What is a necessary consequence, is that the taxpayers will be committing a huge amount of money to allow banks to continue to wait another few years for their mortgage portfolios to mature. That’s money that will either be printed afresh, or else borrowed or taxed away from existing uses.

At the end of the day, the picture remains the same. Someone has to take the hit for the deflation of the housing bubble. As I said, the problem is to find the least painful place to stash the losses. The genius of the Geithner plan is that it shifts that pain to the people who are least in a position to complain about it: you, the taxpayers.

The inevitable result, of course, is less private capital available for growth, because it’s all tied up financing overpriced mortgage paper.