Reconsidering the Geithner Plan

When Tim Geithner first released his plan to clear toxic assets off the books of banks, I mounted a tentative defense of the plan, arguing that it was probably the least bad option that was politically feasible at the moment. I did, however, have one major concern:

What concerns me . . . 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.

I noted at the time that the only way to avoid this hijacking of the system was to have stiff rules against buyer participation in the bidding process:

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.

Since I wrote that, I've become less optimistic about the feasibility of adequately policing the bidding process. In an article at the Huffington Post, Jeffrey Sachs airs some of the same concerns:

Suppose. . . that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total. Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank's net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K.

As Sachs goes on to observe, schemes to rig the bidding could be even less direct (and therefore harder to police):

[T]he gaming of the system doesn't have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi's assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same.

It's that last possibility that really highlights the inherent risks here. The Geithner Plan sets up the sort of arbitrage opportunity that hedge fund managers salivate over. In other words, we don't just have to worry about the banks and their proxies gaming the system. Suppose, for example, that a hedge fund decided to buy up a lot of cheap bank stocks. Then, as a purchaser under the Geithner plan, the fund bids up the toxic asset prices to unreasonably high levels, thereby giving the banks a windfall (and establishing a false "market price" for the assets). This would almost surely cause bank stocks to rise, which would more than offset the amount paid by the fund in the bidding process. Thus, the hedge fund would make off like a bandit and the government would get the tab.

There are a million other potential scenarios like this, many of them using shells, pass-through entities, and derivative contracts to obscure what's going on. The bottom line is that the Geithner Plan creates perverse incentives for banks and other savvy market players to dramatically overbid for toxic assets, knowing that they'll make up the losses on the other side of the ledger. This can happen either through bank self-dealing or through smart arbitrage maneuvering by third parties. Unless the Treasury Department is prepared to announce and enforce clear rules (with stiff penalties) for gaming the system in this way, it is virtually guaranteed that the integrity of the bidding process will be compromised by those with an incentive to do so.

Tom Maguire has a post going through some of the oversight provisions included in the Geithner plan. I think he's right that the plan as outlined should be able to prevent the most obvious forms of self-dealing (such as Sach's Citibank scenario). I also think the major banks would run a significant political risk if they were caught openly gaming the system. What worries me more are the true third parties, crafty hedge funds who participate in the bidding on one side and manage to hedge themselves through some sort of direct or indirect interest in the value of the banks on the other side. Thanks to the magic of derivatives, these hedge funds wouldn't even have to directly invest in the banks. They could, for instance, buy swap contracts tied to the value of various bank stocks. The point is--and I think Tom is a little too dismissive of this--however this system is set up, there will be a significant risk that someone will try to game the system. Treasury will have to be hyper vigilant if it wants to prevent this from happening.

UPDATE: Over at TNR, Noam Scheiber asks "is gaming the Geitner Plan necessarily a bad thing?" Responding specifically to Sachs' Citibank example, he writes:

But is this really such a bad thing? It sounds a lot like a good bank/bad bank model, in which we recapitalize Citibank to the tune of $925,000 and take the toxic asset off its books and stick it in another entity--a "bad bank"--created for that purpose. As I've said before, there may be moral objections to such an arrangement. (It is offensive that taxpayers have to bail Citibank out.) And the Geithner plan may not have enough money to recapitalize all the banks this way. But that's different from arguing that it can't work.

I think Scheiber is missing the point pretty badly here. Even if your plan is to do a good bank/bad bank model and have the government buy up all the bad assets, you still don't want the goverment to be paying the banks near face value for assets that are worth pennies on the dollar. The banks would make out like bandits under that scenario, all at the taxpayers' expense. No one thinks that the government should be buying these assets at those prices. All that would do is ensure that the taxpayers bear virtually all of the banks' losses.

Plus, a major objective of the Geithner Plan is to facilate price discovery, i.e., to use a genuine (non-gamed) bidding process to help determine what these assets are actually worth. If you permit the banks and other interested parties to rig the bidding process, you will get no useful insight whatsoever into what the actual market value of these assets should be. If you want to set up a system in which the government pays the banks near face value for their toxic assets, there are far easier ways to do it.

The Geithner Plan, by its own terms, will only work if the bidding process results in the assets being purchased at somewhere near their actual perceived value. There will of course be a premium built-in to the price due to the nature of the leverage being provided by the government, but if the bidding process isn't being manipulated, the final bid prices shouldn't be anywhere near the full face value of the assets.