Economics should be open

March 25, 2009

How to scam the Geithner Plan

Filed under: bank bailout, Uncategorized — howardchong @ 9:50 pm

Marginal revolution posts a good description of the weakness of the Geithner Plan, i.e. how to game it:
Which refers to the Public-Private Investment Program.

Here I’m just trying to make it REALLY clear how the scam works and that the beneficiary of the scam is the banks. I initially looked into this trying to figure out if I could game the system and get rich. The answer to that is no. The only ones who can win big, is the banks.

I tend to bury the lede, so up front: the message is: The banks will book at most a $7 cost for every $100 to sell the asset at the AAA-rated price. Some estimates of the “market value” are $60. So instead of getting a $40 loss, they just pay $7 to get this junk off their books.

The assets will be sold at pretty-close to whatever the bank values them, which I’d guess is about 80cents per dollar. They could get 100 cents per dollar, but I would bet that’s too fishy.

Details below.

Suppose there is a $100 asset that is worth much less. If it is sold for $70, then $60 is paid for by the government via a non-recourse loan (this is the 6-1 leverage they talk about). Then, $5 comes from me, the investor, and $5 comes from the government. After paying the loan, me and the gov’t go 50-50 on any profits.

If, after the time goes by, the asset is a total loss, my exposure is just $5. The government eats $65.
If the asset re-appreciates to $100, $60 of the loan gets paid back, and me and Uncle Sam split the gains 50-50. I get back $20, which is a $15 profit.
If the asset drops to $65, then there’s only $5 after the loan. I get $2.50, which is a $2.50 loss since I put in $5 at the start.

So, how do you value the asset. Simple. You put a probability distribution (i.e. belief) over what you think the value of the asset will be if held to maturity. The expected value of the asset is the “true value of the asset, given beliefs”. (Note, since we’re dealing with beliefs, the most optimistic will get it and there will probably be a winner’s curse component, but that’s not the biggest issue. The biggest issue is how banks can game it.) suggests that the true value is about $60 if held to maturity; see
His guess is as good an any’s.

But $60 will not be how much the assets go for under this deal. This will push up the price. This will push up the price exactly the way that insurance will push up the price. An equivalent way of pushing this deal is to offer free insurance to all buyers if the price drops more than 14% (which is 1/7).

With the “non-recourse loan” and the “public-private partnership”, which is really the same as insurance, the price will go up. To make it simpler (I know this isn’t simple, I’m trying my best to be clear), consider the following probabilities.

On a $100 asset:
10% chance of total loss
40% chance of $50 loss
50% chance of no loss.

Risk neutral value is 0.4*50 + 0.5*100= $70.

With the public private partnership, the chances of loss are the same, but the value of the asset goes up. If the price is 84 dollars, the split is $72 in on-recourse, $6 in my funds, $6 in matched equity.

10+40=50% of the time, I’ll lose the $6.
50% of the time, there will be no loss, so it’ll be $28 in profit after paying the loan. My share is $14, so I am up $8. So at $84 (where I pay $6), I will be up $2 half the time, or $1. The price where I’m neither up or down after running the probabilities is the risk-neutral price.

The risk neutral value price will be about $85 (algebra will give you an exact answer), which means the price will bump up from $70 to $85 under my toy-scenario.

The bank will write down the loss of $15 (from $100 to $85) and get the junk off the books. Which is how I think the Treasury HOPES it will work.

If the banks are allowed to participate in the auction, then they’ll just bid up to $100 (or more, but that probably won’t be allowed). The reason is that it will just cost them $7, they’ll get $7 matched and then $86 as a non-recourse loan. Even if they lose the whole $7, they’ll get $100 from the asset sale.

As an analogy, consider that you have a $1000 car and someone says, “For $70, I’ll give you $1000. If your car breaks, keep the $1000 and I’ll keep the junk car. If the car survives and is worth $1000, I’ll sell it back to you for $70”.

So, because of this, I don’t think the banks will be allowed to participate in the auction. Granted, they don’t have the $7 to spare, but they could easily say, “once you give us the $100, we’ll have plenty of money to spare.” But it would also look bad.

But some hedge funds and private equity firms DO have lots of money in the banks, so they may want to get in on the deal. Imagine that a hedge fund owns 10% of Citibank. Then for $7, they’ll get 10% of the $100, or $10. It’s a pure win deal. But if nobody has a big stake in Citibank, then this isn’t as big of a problem. However, I don’t see anything illegal about 10 hedge funds that each own 1% of the company getting together and bidding up the price of the toxic assets.

There will also probably be some loopholes. The banks may not directly be allowed to participate, but would they be allowed to buy debt from another company who uses the debt to participate in the auction?

The one silver lining is that there is a cap on the amount of money that the Treasury can spend on this sale. So, maybe only 10% of the toxic assets will get bought under this scheme.

Although I portray this as bad, there’s nothing inherently wrong with this strategy, as it does recapitalize the banks (a stated goal), and this is what we want. But the notion that we’ll get a “market price” will not bear out.

The alternative, that the banks fail, is probably worse. Nationalizing the banks (and giving some bailout equity to the homeowners) is more along the lines of what I like.

Suppose the bank can buy the asset for $100. Let’s see what happens.
The government puts up about $86 in non-recourse, and $7 in matching funds. The other $7 comes from the bank.

Using the same probabilities as before

On a $100 asset:
10% chance of total loss
40% chance of $50 loss
50% chance of no loss.

50% of the time, I’ll lose all $7, and the other 50% of the time, there will be zero profit, so I’ll lose $0. So, in expectation, the buyer loses $3.5

However, if the bank is the buyer, I get the $100 in 100% of the cases and this crappy asset off my books. No write down needed. I have to spend $7 of capital which I will only lose half the time. Bank wins!

I am almost certain this game will get played, but the public won’t notice it. The reason is that the real auction system will have lots of intricacies and there won’t be one price. There will be one price for every class of toxic assets, maybe even a separate price for every asset. There may be hundreds or thousands of prices. Overall, the banks won’t be stupid enough to game it fully, so the average price may be something like 60-80 cents on the dollar. Since this is what people expect, nobody is going to complain very much. It’s also hard to say what these assets are worth if help to maturity; so if it ends up being 60-80 cents, we’ll declare victory. If it ends up being 40-60 cents, then the government will eat all the loss but will have averted crisis, also declared victory. Since we’ve defined the problem as not having banks fail, all paths lead to victory. And the only one exposed to high amounts of risk is the government… so nobody really loses (sarcasm).

It should be noted that this game can be played with any asset. So, look for companies to try to dump the worst bits of their assets (which is, from a business perspective, what they should do; it’s not shame on them for doing it, but shame on us for allowing it). And that will be mostly what is dumped. And if the voodoo works, this will convince “the market” that this is a “fair” price for the worst junk, so the market might start moving for the better junk.

There is maybe a way to fix this. That would be to group assets of a certain type and then randomly buy these assets from companies. That is, for Toxic Asset Class Q, there may be $10 billion across 10 firms. Have this private-public partnership buy up $1 billion and randomly pick which firm’s assets to take off the books. That way, this dilutes the link of getting subsidies for a specific company, but it does give liquidity to the marketplace in general.

Don’t take my probabilities seriously. They are probably too forgiving. In my example, the true price is $70. It seems like people think the true price (i.e., the current expectation of the stream of payments to maturity, and then the return of principal) is around $50.

But I’m confident that my general approach is correct, given my understanding of the bailout. Exact bailout terms may change, and a lot of the devils are in the details of the auction.

This is also oversimplified description of these assets. In reality, there is a stream of interest and principal payments. I’ve simplified it to something without interest payments (think zero-coupon bond). If you add interest, your calculation is more complicated because some loans will fail soon and some loans will fail later. But that complexity is just accounting (which we’re good at). What’ I’m talking about is mechanism design, which we might also be good at, but which is often overlooked.

Just my short thoughts. I could be wrong. I make about $12/hour (graduate school), and Geithner makes much more, so he probably knows why I’m wrong. I sure hope I’m wrong.


Full disclosure, I might go buy lots of Citibank stock. Or Bank of America Stock. This plan is going to make them a bunch of money. Only potential problem is they probably have too much “toxic assets” and won’t be able to unload it all. And, after not unloading it, if they have to mark-to-market their remaining assets, even at the inflated price, they still might not be liquid. An analyst following this should be able to figure out what they’re likely going to be able to sell and see if that helps them stay afloat.


1 Comment »

  1. […] There’s still the cheating issue, though. See¬† […]

    Pingback by Geithner plan arithmetic, excel worksheet, bundling all assets together « Economics should be open — April 2, 2009 @ 2:07 am

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