Sunday, March 29, 2009

Making Sense Of The Geithner Plan

Original Link:

For those of you who watched Obama’s press conference last night (liveblogged here), you may have noticed a conspicuously untouched topic: the administration’s new bank bailout plan. The President did touch on it briefly during his opening remarks, but not a single reporter asked a question about the plan.

This was weird since this plan is, I think, far more controversial than the proposed budget. Josh Marshall at TPM thinks it “means that most of the reporters think that issue is largely behind us now unless…the market or any clear economic realities say otherwise. For better or worse.”

Economists don’t feel the same way.

Before getting to their reactions, it’s important to understand what the Geithner plan is trying to accomplish. In short, it is attempting to take the ‘toxic’ real-estate assets off of the banks’ balance sheets, allowing them to become comfortably solvent and able to function normally (i.e. loan money). [Note: when I write banks, I mean that broadly, encompassing bank/investment firm conglomerates like AIG]. The issue with these assets is that we don’t really know what they’re worth. One way of dealing with that is through nationalization and splitting the banks into good and bad parts, reprivatizing the “good bank” quickly and slowly selling off the assets in the “bad bank.” (See my previous post here for more on nationalization).

Tim Geithner has decided on another path: allowing private investors (e.g. hedge funds, mutual funds, pension funds) to value the assets by buying them at auction, trusting the markets to properly price them.

This is being called the “Public Private Partnership Investment Program.” Public-private means that the government will be creating incentives for the private industry to buy up these toxic assets by handing out a lot of non-recourse loans (loans only secured by the collateral - meaning that if the toxic real-estate assets purchased lose value, the government/taxpayers lose money). Sometimes, the government (through the FDIC) will loan up to 85% of the auction price with the Treasury than matching the private industry dollar for dollar for the remaining 15%.

To help make sense of this, here’s a sample investment scheme provided by the Treasury:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

The government is essentially assuming much of the risk - if the assets turn out to be worth more than their purchase price, everyone wins (banks, investors, and taxpayers). But if they turn out to be worth less? The banks still win because they got the toxic assets off their balance sheets, private investors might lose a little bit ($6 in the above example), and the taxpayers get rocked by huge losses.

Here’s a very sensible explanation by an economics blogger named “nemo”:

Let’s flesh [out the above Treasury example] by repeating it 100 times. So say a bank has 100 of these $100 loan pools. And just by way of example, suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. (These numbers are made up but the principle is sound. Nobody knows what the assets are really worth because it depends on future events, like who actually defaults on their mortgages.)

Thus, on average the pools are worth $50 each and the true value of all 100 pools is $5000.

The FDIC provides 6:1 leverage to purchase each pool, and some investor (e.g., a private equity firm) takes them up on it, bidding $84 apiece. Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools but only puts in $600 of its own money.

Half of the pools wind up worthless, so the investor loses $300 total on those. But the other half wind up worth $100 each for a $16 profit. $16 times 50 pools equals $800 total profit which is split 1:1 with the Treasury. So the investor gains $400 on these winning pools. A $400 gain plus a $300 loss equals a $100 net gain, so the investor risked $600 to make $100, a tidy 16.7% return.

The bank unloaded assets worth $5000 for $8400. So the private investor gained $100, the Treasury gained $100, and the bank gained $3400. Somebody must therefore have lost $3600…

…and that would be the FDIC, who was so foolish as to offer 6:1 leverage to purchase assets with a 50% chance of being worthless. But no worries. As long as the FDIC has more expertise in evaluating the risk of toxic assets than the entire private equity and banking worlds combined, there is no way they could be taken to the cleaners like this. What could possibly go wrong?

Sounds scary, right? That’s because it is. The real danger here is that Geithner and the Obama administration are making the wrong guess about these assets. There are basically two possibilities. One is that we have a confidence problem in the markets, pushing down the value of the toxic assets through inflated fears of defaulting borrowers. If this is the case, the Geithner plan should work well, because it would become clear that the assets are actually good and the government would reap the benefits.

The other possibility is that the value of these assets is going down because there was a huge real-estate bubble (there was) and will settle even lower as more defaults hit home. If this is the case, the taxpayers will lose a lot of money.

Another serious issue is that this plan will create incentives for investors to overbid what they believe the value to be because of the large government subsidy coming their way. Private firms can still make good expected profits by paying more for the loans than they would under an unsubsidized purchase. Paul Krugman has more on this here.

So what do economists think? Many hate it (Nobel Prize winner Joseph Stiglitz says the plan “amounts to robbery of the American people”), some think it’s ok but is only a stop-gap measure on the road to later nationalization (NYU’s Nouriel Roubini and Matthew Richardson say “Secretary Timothy Geithner’s new toxic asset plan is a serious step in the right direction…”), and a couple think it’s a winning plan.

Their beliefs mostly rest on their assumptions about why the assets have lost so much value already (confidence issues vs. bubble burst), but even most of those who support it still think we’re going to end up nationalizing the banks. Some say that this a political move designed to prime the pump for a later nationalization - I hope they’re right, because heavily subsidizing private investors, creating huge moral hazard issues, and putting taxpayers at risk of big losses (without transparency, by the way, since Geithner’s plan doesn’t need approval by Congress) is unpalatable as a long-term solution.

Even if it works, the too-big-to-fail banks will still have been bailed out without any real punishment or restructuring. Will we really have the political capital/energy/desire to make sure this doesn’t happen again soon?

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