Economics should be open

April 2, 2009

Geithner plan arithmetic, excel worksheet, bundling all assets together

Filed under: Uncategorized — howardchong @ 1:58 am

So, Stiglitz and Krugman have come out against the Geithner Plan, as have I.

 

As a quick exercise, I made an excel worksheet that values a toxic asset under the Geithner plan and under risk neutrality.

You can find it here:  http://are.berkeley.edu/~chong/filesforblog/Geithner%20Arithmetic.xls

If you play around with the percentages, you’ll note, as Krugman has in the NYTimes, that the government is effectively giving investors a free put option.

I’m assuming a 7-to-1 leverage ratio and a 50-50 match.

Do note that this makes clear how the price gets inflated and where the government eats the loss (when the asset price falls more than 12.5%).

However, it completely assumes that the market doesn’t have a good sense of what percentages to put in for the probilities of value for the asset. The holders argue they won’t sell because nobody will buy given the probabilities they believe to be true. The buyers argue that the market is really risky and that these probabilities are too high. It’s like when I go to buy a used car. I always look at the faults and try to say, all these things will probably break in a year. And the seller says, “This is a great car.” If it’s so great, the seller should keep it and hold it to maturity!

One thing that the Geithner plan does get right is that they mandate that the buyers must put these assets in a buy-and-hold strategy.

One thing Geithner may not have considered is how to bundle the assets. He needs to bundle as many assets together as possible!

For example, if the asset is a single mortgage, the probabilities will be nonzero only for  $100 (if they pay it) and $0 (if they default). But if you bundle 1000 of these, you start getting probabilities that aren’t so extreme. (you’d have a binomial distribution distribution). Whether you are buying a block of 1000 or a single mortgage doesn’t matter normally, but the Geithner plan has a non-recourse loan that is  MUCH more valuable if you buy each one separately.

It could be argued that the government exposure is actually going to be quite small if they bundle assets together enough. There is the problem that there is too much correlation across assets so bundling might not work. In that case, the government might want to throw some negatively correlated assets in with the sale.

There’s still the cheating issue, though. See https://opensourceeconomics.wordpress.com/2009/03/25/how-to-scam-the-geithner-plan/

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