Saturday, March 28, 2009

Geithner’s Smoke and Mirrors

I’m not an economist. I don’t even play one on TV, but I have some serious problems with Treasury Secretary Geithner’s new public/private toxic asset purchase plan. So I thought I’d throw them out there and see if I’m the only one.

My first problem with his plan is that there is no guarantee that banks will offer to sell.

There has been a lot of talk about mark to market. My understanding is that most (although not all) of the loans and asset backed securities (ABS) held on banks books have to be carried at the market price. That means they are worth (in accounting terms) only what they can be sold for.

It is common wisdom to say that mark to market isn’t working because the markets are “frozen”. But it is not true that the market for these securities is not functional. Banks can sell 100% of their ABS at any time they want to. The obvious truth of this can be demonstrated as follows:

I hereby offer to buy all of Citigroup ABS for $1. Anyone from Citi who is interested, just give me a call.

Why do I think my phone isn’t going to be ringing off the hook? Obviously, because Citi doesn’t want to sell them at that price. The same is true of a wide variety of investors who would be willing to purchase the securities, but the sellers want more than buyers are willing to pay.

Assuming that large banks and large institutional investors have roughly equivalent market knowledge, I can only assume that the banks have not fully marked down their assets to market price. If they had, then an asset they hold on their books at $100 could be converted into $100 cash and they would have no disincentive to sell.

Secretary Geithner said that his plan will use the market to induce “price discovery”. But the market already has discovered a price, the banks just don’t like it.

If sellers want more than buyers will pay, to make a transaction happen you need to either make a) the seller take less or b) the buyer pay more. If you choose a) then a bank holding an asset on its books at $100 sells at a lower price, say $60, and the bank would be replacing a $100 asset (securities) with a $60 asset (cash). Add eight or nine zeros to that transaction and the FDIC will send you a lovely card that says “Surprise! You’re insolvent” and the bank is taken into receivership.

So, for obvious reasons, Mr. Geithner chose option b. Treasury, the Fed and the FDIC will offer loans and a profit sharing arrangement to try and entice the buyers into paying more.

But what happens if the generous purchase terms are insufficient to produce a price higher than the banks book value of the assets? The banks either still won’t sell, in which case, the plan will have no effect, or they will sell but have to take additional write downs pushing them farther towards insolvency. This would make banks even more desperate to build up capital reserves and make the problem worse because banks would have even less money to lend.

And what happens if it does produce a price above book value? This is my second problem with the plan.

Boiled down, my understanding is that the plan works like this: An investment company puts up $1 then the government will loan them $6 more to buy bank assets. If there is a profit, the investor splits it 50/50 with the government. But if there is a loss, the loans are non-recourse. That means that the investor only looses his $1. He doesn’t have to pay back the other $6.

The investor gets 1/2 of the profits but only takes 1/7 of the losses. Put another way, the taxpayer gets 1/2 of any profits, but pays 6/7 of the losses.

That’s one hell of an incentive for investors, and may work. But this produces a contradiction. The more effective the incentives, the more investors will pay for the assets above what they believe they are really worth. But the more the investors pay above market price, the greater the chance that the securities really are worth less than was paid for them.

Stripping away the complexity, it seems to me that this plan is designed to bribe investors to pay the banks far more than anyone thinks these assets are worth so the banks will have more money to lend.

Maybe a miracle will happen and 5 years from now these assets will turn out to be worth even more than the inflated price paid for them. But if Mr. Geithner believed that, then why not cut out the middleman and have treasury buy the assets directly? We’re going to be on the hook for the vast majority of the losses either way. Why not get all the potential profits? Tim Geithner is not a stupid man, so why would he structure it that way?

I’m afraid the answer is politics.

If he went to the Congress and said “Please give me a trillion dollars so I can buy toxic assets that the market thinks are worth $600 billion”, or even more honestly “let’s just give the banks $400 billion so they can start lending again”, Congress would say No. Not to mention the taxpayers with pitchforks and torches waiting for him at the door.

But by structuring it as a public/private partnership with loan guarantees, he doesn’t have to ask Congress for a dime. Plus, the “private” part makes it sound like it’s not another government bailout.

Unfortunately, it is.

It’s a backhanded way to funnel extra cash into the banks by overpaying for their bad assets. And when it turns out that yes, we did pay more than they were worth, and there are losses (as is more likely than not given that we start from the assumption that we are paying more than the markets think they are worth), the FDIC will be drained dry to cover them. At that point, Congress will have no choice but to pay the costs, and bailing out the FDIC a few years from now won’t create the public backlash that bailing out the banks now would.

I would have been much happier if Mr. Geithner had been honest and said “Look, these assets are probably undervalued because the markets are scared. Banks can only sell them right now for $600 billion, but the hold to maturity value is probably around $1 trillion, so let’s buy them for $900 billion and take the gamble that we might loose some money. The banks will have more cash to lend, and who knows, we might even turn a profit.”

But I’m just an unemployed bookkeeper. I might be wrong.