It may a horrible, terrible, no good, rotten and dirty plan but it’s the best we have for now…
Br. E.D. has a post on the next phase of figuring out how to salvage our banking system. He cites a number of people who express concern with the program. He is concerned with this program, and I think that is a fair position to take. Some of these concerns are valid. We the taxpayers will be taking a lot of risk and there are aspects of this program that concern me both theoretically and with respect to implementation. I will address some of these concerns later in this post.
Before I do that, I wanted to take a quick moment to disagree with E.D. and make some comments with respect to the people he cites in his post (if you have not read it, you will need to as I am not posting quotes or links):
First, I take Paul Krugman with a grain of salt. I mean, would we really be proposing this plan if there was nothing fundamentally wrong with the financial system? By now, it is no secret that there is a problem. I think Krugman’s problem is that the Obama Administration is hesitating to nationalize the financial system (as it should – more on that in a bit) Simon Johnson does make very good points, but those points aren’t relevant to dealing with the problem at hand. However, as we move forward and rewrite the rules governing financial markets, simpler, smaller and less dangerous is something worthwhile to consider. To Clay Risen’s points, many of the potential investors bidding for the assets were not the ones who overvalued them in the first place. Second, no one is expecting a return to the original market conditions he speaks of, at least no one I know that understands this business. Regarding Hilzoy’s comments, the prices are only “artifically inflated” to the extent that the government will be able to step in and provide the sort of acquisition financing not previously available. That’s a fair point; however, that does not suggest the elimination of downside risk as it is a repricing based on a newly-available capital structure. That said, he is free to call this a subsidy since pricing is being effectively pushed by having the government step in as a lender.
Furthermore, as I see it, our only other option is nationalization. After the flap with AIG bonuses, the populist uproar and opportunistic politicians pandering to the lynch mobs over something as simple as a compensation issue, am I suppose to trust that our government far greater and more difficult responsiblities? How am I supposed to have faith that the orderly breakup of a Citi or a Bank of America (using two recent examples) will not encounter political interference if those agencies overseeing the companies make decisions that are politically unpopular? Playing to the populist impulses is exactly what the government should NOT be doing. It crossed that line. I don’t trust them. Call me an ideologue for it for all I care, but the evidence has been played out before our very eyes. As disgusted as I am with AIG, I am more disgusted with Washington.
As painful as it is to say, I think the new Geitner Plan is the least worst alternative, and as I was asked to comment on the plan and provide some thoughts, I’ll move to that for now.
For those who have not delved into the specifics, what is going to happen is that there are going to be two programs in which either toxic loans or toxic securities will be pooled by financial institutions and sold to investors via a public-private joint venture with financing also provided by the government. For the program dealing with “Legacy Loans” (i.e. whole loans), private sector bidders will bid on pools of whole loans. The winning bidder may receive 1) 100%-guaranteed acquisition financing from the FDIC of up to 85% of the purchase price and 2) a government equity contribution of 50%. Therefore, assuming a $100 purchase price – $85 is funded in the form of a non-recourse loan guaranteed by the FDIC, $7.50 in equity is provided by the government (via TARP) and $7.50 in equity is provided by a private investor.
There is also a program for “Legacy Securities”, which represent the asset-backed securities rated AAA at the time of origination (any security prior to 2009). The process with this situation seems a little different in that the government, on a best case scenario, will provide 50% of the equity raised for an investment fund and provide senior debt financing for amount equal to the entire equity contribution of both the government and the investor. In this scenario, assuming a $100 purchase price – $50 (max) is provided by the government via debt (TALF), $25 is an equity contribution from the U.S. government and $25 is an equity contribution from a private investment fund.
Below are my concerns from largest to smallest:
1. Taxpayers are taking huge risks and there is a lot of downside risk.
2. Banks are not obligated to sell. Furthermore, under current market conditions, the differences in the opinion of value between buyers and sellers is very wide. This spread will narrow now because the government has stepped in to provide financing that was not available to any of investors before. Given high leverage and a low cost of debt capital, investors will be able to push prices up (if you want to call that a subsidy, that’s fair). The $64,000 question is whether or not that will be enough. No one knows. If not, then what?
3. The Legacy Securities program speaks only of AAA-rated securities but not at all about the subordinate tranches (AA, A, BBB, etc.). The financial institutions holding the AAA-rated securities (insurance companies, pension funds, etc.) are not the focus of this program. The financial institutions that are holding toxic securities are holding subordinated tranches. It is those that need to be addressed in more detail.
4. I’d like to see more details on what rights either the government or the private investors will have in this joint venture. For while neither the government nor the private investor will have a controlling interest, how will certain major decisions be handled (i.e. when to sell)? I’d like to see these joint ventures retain as much flexibility as possible. This could get a little more complicated when we deal with the Legacy Loan program because investors who are looking to buy whole loans will, after getting control of the loan and moving into the senior lender position, may look to foreclose on the asset, take ownership of the asset and reposition for a sale. The potential upside in these types of transactions are very high, but at some point, the government could hold 50% interests in real estate assets and may need to address issues associated with owning and operating properties.
5. I hope the FDIC, prior to the process beginning, establishes firm criteria on which pools are subject to maximum financing levels and which do not. This is not the kind of thing you want to get into after a bidding process begins.
I know some of these concerns are bigger picture items while some of them are more technical with respect to the implementation of the program. However, I think there are all important and should be considered as we move forward with this plan. Again, I think this is the least worst option. It’s fraught with downside risk and difficulty but aside from letting everything take its natural course, an option not on the table, this is what we need to try.
Also, I’m sure I left some things or failed to mention a few critiques or responses, but I’ll leave this as it is for now and fill in those holes if there are questions or comments.
UPDATE: To Erik’s question below (trying to confirm the source – this came into my Inbox this morning and it appears to be from the FDIC)
There is a potential problem here.
Let’s say that I am a bank (“financial institution”) with $100 billion in “toxic assets”. I have them on my balance sheet at 80 cents on the dollar. The market has them marked at 30 cents. We do not know what the held-to-maturity performance will be, since that requires knowing the future, although for the moment let’s assume that they are cash-flowing at the present time.
What I (the bank) do know, however, is that if I sell them at 30 cents I take a monstrous loss – perhaps enough to force me under Tier Capital limits and thus render me subject to an FDIC enforcement action. I therefore will not sell for 30 cents so long as I have any belief whatsoever that the cash flow – or any government subsidy – will exceed that value.
If I, as a “financial institution” can participate as a bidder in these auctions I can foist off my loss onto the taxpayer. Here is how I can rig the game so as to avoid an otherwise-inevitable loss:
- I become a “bidder” and “bid” on my own assets at 75 cents.
- I am providing 5 or 10% of the money. The rest is covered by Treasury, The Fed and the FDIC via guaranteed bond issuance.
- The loan, ex my contribution, is non-recourse. That is, I can lose 5 or 10% of the total portfolio purchased, but nothing more.
Now the “assets” (a passel of CDOs?) turn out to be worthless. I lose 5% of $75 billion, or $3.75 billion that I put up, plus the other nickel on the original mark, but that’s all.
The taxpayer gets hosed for the remaining $71.25 billion dollars.
This can and will be done if the “sellers” of these assets are allowed to bid either directly or indirectly as it provides a means for banks to intentionally dump bad assets at a certain loss that is much smaller than their expected realized loss over time, shifting the rest of the loss to the taxpayer.
This program has the potential to shift literally $500 billion or more in losses onto the taxpayer, not through the operation of “bad luck” but rather through what amounts to a bid rigging operation.
Be aware that I, along with many others, have figured this out. Also be aware that as taxpayers and your ultimate boss, we do not intend to sit still and allow the public treasury to be looted in such a fashion.
The FDIC’s job is to prevent that sort of looting operation by prohibiting the sellers of these assets from having any financial interest in the bidding side of the equation, directly or indirectly, and I along with many others intend to hold you to that obligation.
I like the outline of this program if and only if it cannot be gamed in this or similar fashion. Provided that does not occur, this program has the potential to provide great benefit to both the banking system and our economy.
If, however, the financial institutions that created this mess in the first place are allowed by the FDIC and Treasury to use it as a looting operation to intentionally shift their bad assets onto the Taxpayer you can expect that we the people will hold our government to account.
Basically, the hope here is that the FDIC will prevent entities from bidding on their own assets (probably indirectly via funds or other investment vehicles), which is exactly what it should do. Whether or not banks can bid on the assets of other banks I do not know although my gut feeling is that they won’t.