Understanding How the Geithner Plan Works
(updated below)
I confess upfront that I'm an attorney, not an economist or finance expert, so take what I'm saying with a grain of salt. But I do have to grapple with these issues from time to time as a part of my job, so I feel I know enough about how this stuff works to at least follow the plot. And the more I read, the less sure I am that some of the criticisms being leveled at the Geithner plan by Paul Krugman and others are justified.
First, as I stated yesterday, I don't believe that nationalization of the big financial institutions (like Citibank) is a politically viable option at the moment, even if it would make sense from a policy perspective. Congressional approval would be necessary for such a plan and I just don't think the votes are there. The Obama administration would have to lay the groundwork for such an approach first, by trying all other options and by securing the necessary authority. And there's reason to believe that's exactly what they're doing now, by pushing the Geithner plan while simultaneous seeking greater authority to seize financial institutions.
Second, I think that some of the "bugs" that Krugman and others have pointed out in the Geithner plan are actually intended features of the plan. Krugman points to this analysis to demonstrate that the Geithner plan effectively functions as a "put" and incentivizes a rational investor to overpay for the toxic assets, with the FDIC ending up on the hook for the loss.
I don't question that analysis, but I'm pretty sure that's the idea (whether Geithner and company will admit it or not). It's a way of sweetening the pot for private investors and getting them to actually bid on these assets. There's a built-in premium. But as long as the premium isn't ridiculously large, I don't see this as being a major problem. If the assets turn out to be worth less than the bid price, the FDIC can, presumably, recover its losses over the long term by collecting higher premiums from the banks. And even if the bid prices on the assets are consistently higher than what they're actually worth, the process would still go a long way toward helping us assign actual values to the toxic assets--which is a major goal of the plan. Smart people like Krugman will be able to look at the bid prices, factor in the "put", and thereby determine what the actual market value of the assets is. This analysis may help the bidding process become more efficient and allow the Treasury to tweek the process to safeguard the government's interests. And, maybe more importantly, it will allow us to determine the true health of the major banks.
In other words, even if the plan doesn't result in clearing the banks of all their bad assets, it should, at the very least, make it clear to everyone that they are hopelessly insolvent and that receivership is the only viable option.
So I'm not so concerned by the potential for rational investors to overbid for the assets. I think that risk is built-in to the plan. What concerns me more is the prospect of sellers posing as buyers and hijacking the process. For example, what's to stop the banks from--either directly or through intermediaries--bidding the assets up all the way to their face value? Yes, they'd be guaranteed to lose money on the investment, but the bulk of the loss would be borne by the government, and in the process, the banks would be clearing their books of their toxic assets at face value. This would have the added benefit of allowing them to pretend that the remaining bad assets on their books are still worth their face value. In essence, they would be hijacking the bidding system to dump their losses on the government and disguise the value of their remaining bad assets.
To illustrate, suppose I own some bonds with a face value of $1000 but an actual value of much less than that. I then make a bid for the bonds of $1000, of which (under the Geithner plan) I must pay $70 and the government pays $930. The bonds later pay out only $500. In that scenario, I lost my entire $70 investment, but in doing so, I received $1000. I essentially unloaded my toxic asset for 93% of its face value, way more than it was worth. And in the meantime, I got to pretend that my other bad bonds were still worth their face value.
I'm sure that this possibility has occurred to the Treasury Department, so I assume they have some sort of plan for dealing with it. There need to be strict rules in place (backed by stiff penalties) prohibiting this kind of self-dealing. This plan can only work if the investors doing the bidding are genuine investors, i.e., people who want the winning bid to be as low as possible. If banks or their proxies are allowed to bid, they will bid up the price as high as possible.
UPDATE: I see I'm not the only person who has considered the obvious problem of sellers being allowed to participate as buyers. And if this scheme occurred to me, I guarantee you it has already occurred to every financial institution currently holding these toxic assets. This plan's only prayer of working is if the Treasury Department can maintain the integrity of the bidding process. And I think the only way to do that is to threaten the wrath of God on any institution or person who attempts this kind of arbitrage. It needs to be clear up front that anyone who attempts to game the bidding process at the behest of an owner of these toxic assets will spend many years in prison. The temptation here is just too large. Without draconion penalties, there's a real risk that the banks will artificially bid up the prices of their own bad assets in order to transfer their losses onto the government.
I confess upfront that I'm an attorney, not an economist or finance expert, so take what I'm saying with a grain of salt. But I do have to grapple with these issues from time to time as a part of my job, so I feel I know enough about how this stuff works to at least follow the plot. And the more I read, the less sure I am that some of the criticisms being leveled at the Geithner plan by Paul Krugman and others are justified.
First, as I stated yesterday, I don't believe that nationalization of the big financial institutions (like Citibank) is a politically viable option at the moment, even if it would make sense from a policy perspective. Congressional approval would be necessary for such a plan and I just don't think the votes are there. The Obama administration would have to lay the groundwork for such an approach first, by trying all other options and by securing the necessary authority. And there's reason to believe that's exactly what they're doing now, by pushing the Geithner plan while simultaneous seeking greater authority to seize financial institutions.
Second, I think that some of the "bugs" that Krugman and others have pointed out in the Geithner plan are actually intended features of the plan. Krugman points to this analysis to demonstrate that the Geithner plan effectively functions as a "put" and incentivizes a rational investor to overpay for the toxic assets, with the FDIC ending up on the hook for the loss.
I don't question that analysis, but I'm pretty sure that's the idea (whether Geithner and company will admit it or not). It's a way of sweetening the pot for private investors and getting them to actually bid on these assets. There's a built-in premium. But as long as the premium isn't ridiculously large, I don't see this as being a major problem. If the assets turn out to be worth less than the bid price, the FDIC can, presumably, recover its losses over the long term by collecting higher premiums from the banks. And even if the bid prices on the assets are consistently higher than what they're actually worth, the process would still go a long way toward helping us assign actual values to the toxic assets--which is a major goal of the plan. Smart people like Krugman will be able to look at the bid prices, factor in the "put", and thereby determine what the actual market value of the assets is. This analysis may help the bidding process become more efficient and allow the Treasury to tweek the process to safeguard the government's interests. And, maybe more importantly, it will allow us to determine the true health of the major banks.
In other words, even if the plan doesn't result in clearing the banks of all their bad assets, it should, at the very least, make it clear to everyone that they are hopelessly insolvent and that receivership is the only viable option.
So I'm not so concerned by the potential for rational investors to overbid for the assets. I think that risk is built-in to the plan. What concerns me more is the prospect of sellers posing as buyers and hijacking the process. For example, what's to stop the banks from--either directly or through intermediaries--bidding the assets up all the way to their face value? Yes, they'd be guaranteed to lose money on the investment, but the bulk of the loss would be borne by the government, and in the process, the banks would be clearing their books of their toxic assets at face value. This would have the added benefit of allowing them to pretend that the remaining bad assets on their books are still worth their face value. In essence, they would be hijacking the bidding system to dump their losses on the government and disguise the value of their remaining bad assets.
To illustrate, suppose I own some bonds with a face value of $1000 but an actual value of much less than that. I then make a bid for the bonds of $1000, of which (under the Geithner plan) I must pay $70 and the government pays $930. The bonds later pay out only $500. In that scenario, I lost my entire $70 investment, but in doing so, I received $1000. I essentially unloaded my toxic asset for 93% of its face value, way more than it was worth. And in the meantime, I got to pretend that my other bad bonds were still worth their face value.
I'm sure that this possibility has occurred to the Treasury Department, so I assume they have some sort of plan for dealing with it. There need to be strict rules in place (backed by stiff penalties) prohibiting this kind of self-dealing. This plan can only work if the investors doing the bidding are genuine investors, i.e., people who want the winning bid to be as low as possible. If banks or their proxies are allowed to bid, they will bid up the price as high as possible.
UPDATE: I see I'm not the only person who has considered the obvious problem of sellers being allowed to participate as buyers. And if this scheme occurred to me, I guarantee you it has already occurred to every financial institution currently holding these toxic assets. This plan's only prayer of working is if the Treasury Department can maintain the integrity of the bidding process. And I think the only way to do that is to threaten the wrath of God on any institution or person who attempts this kind of arbitrage. It needs to be clear up front that anyone who attempts to game the bidding process at the behest of an owner of these toxic assets will spend many years in prison. The temptation here is just too large. Without draconion penalties, there's a real risk that the banks will artificially bid up the prices of their own bad assets in order to transfer their losses onto the government.
posted by A.L. at 10:09 AM
8 Comments:
Your concern is echoed elsewhere too. See here: http://market-ticker.denninger.net/archives/894-Open-Letter-To-The-FDIC-Ombudsman.html
So even by your analysis the govt would be on the hook for miscalculations by others (if the bidders overpay). Wasn't this what caused the problem in the first place?
We should also keep in mind: "Beware the law of unintended consequences".
What if the highest bid is $1 instead of $1000. Will Citibank be forced to sell at $1 (since you say they cannot buy it)?
Never understimate the ability of the geniuses at Wall Street to come up with some fancy derivates/leverage/arbitrage which gives them huge profits and leaves the govt holding the bag.
So even by your analysis the govt would be on the hook for miscalculations by others (if the bidders overpay). Wasn't this what caused the problem in the first place?
Look, I could be wrong about this, but here's what I think the plan is. The government wants get the assets off the banks books, so that we can once again have some confidence in the solvency of the banking system, but the government doesn't have the capital to just buy everything on its own (or the expertise to determine the right price). So instead, we're trying to entice private investors into buying this stuff off the banks books. In order to do that, we have to structure the bidding process in a way that that gives the private investors some cushion room to make a profit (and protection against loss). That cushion/protection is being provided by the FDIC. If private investors end up underpaying, the FDIC and the investors share in the profits. If the investors overpay, the FDIC absorbs any loss above the principal invested by the investor.
Hopefully, however, the FDIC can eventually recoup its losses (if any) by collecting premiums from the banks (as opposed to raise people's taxes).
The key is to structure the process so that any incentives to overbid are kept within a reasonable range.
I don't know if this will work, but that's the plan.
First off, a ritual disclaimer: IANAE. So grains of salt and all that.
I doubt there are many critics of the plan who don't realise that the whole point is to create overvalued prices for the toxic assets. Krugman certainly does.
There are all kinds of reasons why one might nevertheless object to this plan. It represents a societal transfer of wealth, potentially on a massive scale, to precisely those who are responsible for the disaster in the first place. It socialises much of the risk for private parties and privatises much of the gain. It moreover does so by in some ways encouraging precisely the type of behaviour that created the crisis in the first place, and by generating substantial moral hazard. It is not the private investor who will be overpaying for these assets, it is the government. Private investors, with a minimal investment, can now acquire substantial market power leverage. The plan replaces bondholders (who knew about default possibilities) with taxpayers as the loss-bearers in all of this. It gives large incentives to bidders who have assets comparable to the toxic ones being bidded on to bid the prices up as high as possible; and in auctions, of course, the highest bidder wins.
For toxic securities, the plan may provide information helping us to judge what those assets are "really worth"; but for toxic loans, with virtually no downside risk for investors, it will provide none. The $500 billion on offer is only a fraction of the estimated $3-4 billion required for a proper recapitalisation of the banks. And, crucially, the entire plan hinges on there being some substantial upside to these toxic assets. If, as many believe, the big banks are fundamentally insolvent because the assets are genuinely of little worth, not merely undervalued, then the plan not only will not work, but will make the ultimately necessary actions far more difficult and far more expensive. It is worth considering that banks with direct ownership of the title to foreclosed homes (but lacking staff to manage them), and which are in fact willing to sell them at a heavy loss, have actually been dumping them at below market rates -- perhaps indicating something about how they really view some of their own assets.
Indeed, far from imagining the toxic assets to be substantially undervalued, and that things will get better once the market "regains its senses", it is perfectly plausible that things may be even worse than we think down the road. If the economic crisis is as profound and as serious as it by all lights appears, then future months -- with higher unemployment, higher default rates, further housing price declines, a potentially looming commercial real-estate market meltdown, and so on -- will probably involve many more loan writedowns to come, and make the picture even darker than it currently is for the holders of these assets. Prime candidates for assets which haven't yet been written down but almost certainly will be at some point are commercial real estate, credit card debts and prime mortgages.
Some other consequences: it may well prevent large-scale criminal prosecutions of the widespread fraudulent activity that helped generate the crisis. If it fails, it may well make things much worse, having demonstrated that even a heavily subsidised programme with little downside failed to secure purchases of these assets at prices the banks would accept (which in turn says something about their real position). It also means that if nationalisation of the banking system is indeed required later on, it will be a much weakened banking system that we will need to deal with. And if the plan works, it seems that the fundamental restructuring (and perhaps downsizing) that the banking system seems to require would likely not happen, at least in any profound sense. And if the systemic weakness, and structural and regulatory weaknesses, are not dealt with once and for all, the effectiveness of the current and future stimuli, for instance, will be considerably undermined, and we are likely in for a long Japanese-style experience, with a number of false moments of hope along the way.
Just a few of the many reasons why many might reasonably continue to consider the "features" to be "bugs" after all.
"i dont know what that means...what does that mean?.......FUCK IT! I'LL DO IT LIVE!!I'LL DO IT LIVE! THIS FUCKING THING SUCKS!" -bill o'reilly
@ -=- @ ==**====**=
runescape power levelingClearly about the changes between Death Knight, please visit a the wow-lvl website specialized in selling wow gold. runescape goldwarcraft gold Items. runescape goldThey are able to provide a world of warcraft gold service at first time when it came out. runescape accountsand wow gold service. The price of Buy Wow Gold for the two new races is as the same as the original races. It is an unimaginable price. runescape goldwow powerleveling service. welcome to Compared with other wow gold suppliers, we are in advantage of selling the cheapest wow gold.
★* ★ ★
=================
How do you keep the bondholders from colluding and bidding up to full marked value? If an institution is realy shaky, they currently stand to take big haircuts. So if each large bondholder wins one tranche at a high price, they are only out a small sum and all together they are saved the large haircut from nationalization.
Wade
Post a Comment
Links to this post:
Create a Link
<< Home