Geithner’s Plan: Good in Theory
But unlikely to work in practice.
Subject to the leaked plan being correct, this works like a simple cash-flow CDO, where, to take the FDIC example, funding is non-recourse and equity is held by a joint venture between treasury and private investors. This is a GOOD idea, private investors won’t overpay because they are in a first-loss position, furthermore this crisis being of a systemic nature, correlation is high, this means equity is risky because yields are lower than normal relative to more senior tranches and would sell off sharply if conditions were to normalize, a rational investor will bid assuming low or 0 correlation.
So there is likely to be a gap between the mtm value of the toxic assets and what a rational investor would pay, reducing or eliminating the incentive for banks to participate.
This is a “pingouins sur la banquise” problem, only the truly starving for capital will jump.
Picture below:
A is the current mtm
B the likely bid, less than mtm
E the equity tranche 15% of total funds split 20% private and 80% treasury, this is a first loss tranche for the structure
L is FDIC non-recourse loan
Related:
Found so far, one intelligent post on the matter
Premature Punditry: the details matter
Add: One more: The Geithner Plan FAQ and one more: Geithner Made Simple
And plenty of nonsense by the usual suspects:
Geithner’s Toxic Asset Plan
This Time I’m Not the One Calling It a Subsidy
Despair over financial policy
March 22nd, 2009 at 4:56 pm
The reason you can dismiss the plan out of hand is becuase there can be no plan. There is only a scheme to get trillions of tax dollars to banks and favored banks while disguising the handout.
The scheme is to pay BAC or C $80 million for $100MM face of assets trading at $25million. The taxpayer would howl in rage at this transaction. So they create this diversion where the taxpayer pays $75.6 million and some private investor pays $2.4 million. All the attention now focuses on this $2.4 million as if without it the deal can’t get done.
For the $2.4 million, the ‘private investor’ has an option to accquire 20% of the coupon stream and 20% of any price appreciation. The most the investor can lose is $2.4 million.
As has been pointed out elsewhere, BAC/C have tremendous to subsidize this $2.4 million.
This has the all earmarks of the kind of deal First Boston/Saloman/Drexel would put together back in the day.
March 22nd, 2009 at 5:35 pm
barry:
the deal can certainly be done without private investors but that would be problematic for the pricing, remember the private investors are in first loss position there is absolutely no reason for them to overpay unless they are idiots. we will have to see the details to know how much of the coupon flow will go to the equity “partners” but I agree that it has to be substantial because this is a risky deal.
March 22nd, 2009 at 6:08 pm
JCK – Wouldn’t the strucure simply boils down to this:
1) Taxpayers pay $80 to bank for $100 face assets trading at $30 and worth, at best, $50
2) To disguise and confuse the situation, taxpayers pay $77.6 to the bank and give an option, supposedly worth $2.4, to the bank.
3) The option gives the bank 20% of any net interest income and 20% of any price appreciation on the asset.
This structure is such an obvious scam that even Rick Santelli, Mark Haynes, and Larry Kudlow would be outraged.
So Giethner was told to add another layer of indirection.
A hedge fund chips in the $2.4 and gets the option.
Some number crunching tells you that the hedge fund can quickly lose its $2.4 investment if default/recovery rates stray too far below 50% — so they are going to be reluctant to go in great numbers.
The realistic alternative is that the hedge fund flips the deal back to the bank for $2.5 (a quick $0.10 profit) in some manner.
The bank has gotten $77.5 in cash, no price risk on its mortgages, and an option on 20% of any income or gain.
Note that the 20% participation is not too far from the 30% current trading value!
March 22nd, 2009 at 6:12 pm
What do you think of this pls ?
http://fridayinvegas.blogspot.com/2009/03/private-public-partnership-is-scam.html
March 22nd, 2009 at 6:16 pm
Gosh, the funny comments get long
“The problem is one of perception.
1) The government wants to give the banks as much as $1 trillion from taxpayers
2) Banks have nothing worth anything remotely close
3) Taxpayers are not going to take a direct transfer with nothing in return
3) Treasury tries to concoct a scheme that will get the blessing of or at least confuse the media (CNBC, WSJ, etc.) that hides this direct transfer. Hank Paulson tried this and managed to give away several hundred billion dollars with praise from the likes of CNBC, WSJ and CNN.
4) In Geithner’s scheme, the Treasury lies to the taxpayer and says that the price has been set by the private sector and the taxpayer has the potential for upside.
5) Bottom line, taxpayers fork over $1 trillion to the banks and get maybe $200 billion back in five to ten years.”
March 22nd, 2009 at 6:16 pm
AJ:
I have to go out and am short in time, but let me point out that “taxpayers” aren’t buying the assets at 80, a SPV buys the assets and the 15% equity stake is held by private/treasury in a 20/80 ratio which means that coupon and pootential gain and losses accrue to the private investors and the treasury and the rest is funded non-recourse.
I don’t quite understand why you expect private investors to pay 80 for assets trading at 30…
March 22nd, 2009 at 7:46 pm
JCK,
AJ is essentially correct. The taxpayer is $77.5 for the asset. The taxpayers contribution is both the direct investment of about $9.5 and the non-recourse loan of $68. The private investor chips in the rest (around $2.5). That is the private investor’s only risk in the deal — the loan is non-recourse. All the govt can do sell the asset and to recover the loan — they can’t go after the private investor.
Private investors will only pay $80 for assets worth $30 if they get a side deal from a bank. The bank wants to sell assets at $80. The let the market know that they are a $2.75 bid for the structure. A private investor bids $80 (and has to only put out $2.50) for the structure at an auction.
The investor then sells the asset to the bank for $2.75 (can be execute via a TRS if needed).
Bank has gotten $80 for assets trading at $30 and paid out $2.75 for a net cash inflow of $77.25. The investor has made $.25 for a days work. The taxpayer is at risk for the full $77.25 and also now has to share the coupon flow and any price appreciation with bank!
Nice work if you can get it!
March 22nd, 2009 at 9:56 pm
I presume that the second ‘m’ in your ‘mtm’ refers to ‘model’, i.e. level 3. Otherwise why would anybody sell at B if MTM is A (A>B)? Clearly, the market price C (whether you consider it firesale, forced transaction or whatever) will in general be larger than B, so there’s an implicit subsidy of B – C.
March 22nd, 2009 at 10:05 pm
Grrr: “…smaller than B, …” Sorry.
March 22nd, 2009 at 10:25 pm
barry:
my post is based on the idea that the deal is legal and serves a purpose in this case to improve the capital position of the banks by selling assets outright. one can always speculate about some fraudulent scam, technically implausible and pointless since it achieves nothing of what is wanted. you cannot sell assets that are pledged as collateral unless you repay the loan in full since the non-recourse clause kicks in only at the term of the loan, and if you do a trs the scam still doesn’t remove assets from the bank balance sheet. it would be completely stupid for a bank to sell assets worth 30 at 80 only to buy them back at 80 and then be forced to take further writedowns down the line if markets don’t improve or defaults converge towards mtm.
March 22nd, 2009 at 10:37 pm
carlomagno:
well the price is higher if there is a buyer as opposed to no-buyer, no-price, that’s not a subsidy.
March 22nd, 2009 at 11:59 pm
The fact that the seller doesn’t like the bid price is not the same thing as there being no (potential) buyer; at the right price there is – remember Merrill’s CDO deal with Lone Star.
Like all such schemes floated in the past, this one only “works” from the banks’ point of view if it allows them to avoid marking to what they could realistically get in the market (whether that market is “fair” as in “fair value” is another matter). Moreover, the additional writedowns have to be small enough to avoid significantly impairing the banks’ capital. Given that the private investors are paying mostly with OPM (they put only 3% of their own money in the deal) and the risk/reward structure, they can afford to be generous.
March 23rd, 2009 at 12:25 am
JCK,
1) Hedge Fund buys assets with face of $100MM for $80MM
2) Bank gets $80MM for assets and assets are off its balance sheet
3) Hedge Fund only has to put up $2.5 million the rest coming via non-recourse loan (using the mortgages as collateral)
4) Hedge Fund only exposure is $2.5 million
5) Hedge Fund is well within its rights to hedge this exposure by engaging in a TRS with the bank
6) Bank pays $2.6 million to Hedge Fund over five years and gets all net income and gains from mortgage
7) Banks has $2.6 million call option on its book — not $80MM in mortgages
8) Taxpayers have full risk of $80MM less $2.5 million kicked in by Hedge Fund
QED
March 23rd, 2009 at 2:05 am
Barry:
3) no, equity 3% hedge fund, 12% treasury, 85% non-recourse
6) no, and if the bank did get all net income and gains from mortgage then it is “long” that asset
what you show is a fraudulent scam, not impossible, but implausible
March 23rd, 2009 at 2:39 am
Jck, Barry,
Do you think this will work ?
Are there hedgefunds willing to participate ? Last month there were talks of stress testing the banks. Was it over ?
I doubt if private investors will participate (unless FED/Tsy does a Ponzi Scheme and hoodwink the private investors) ;-)
March 23rd, 2009 at 3:31 am
AJ:
I am skeptical, the plan is fine with me, but there is a gap between what rational people will pay for the junk and what banks think it’s worth. I see this more has a backstop for capital, if some banks are forced to sell assets, there is a plan and cash to absorb some junk at a (low) price, but they (the banks) won’t sell unless they absolutely have to. What is missing is some brute of a regulator that would force the banks to raise capital or else your junk will be bought at 10 cents on the dollar or something like that.
March 23rd, 2009 at 8:29 am
Not to beat a dead horse:
3) treasury + non-recourse (FDIC) = taxpayer = 85% + 12% = 97%
6) Bank’s capital exposure is only 3% (taxpayer has other 97%)
AJ
Look at the history of the past 25 years in the US. Banks and investment banks have thrived almost entirely on the financial largesse of the taxpayer. In the 1980s, the investment banks but literally made billions by selling toxic waste assets to the S&L industry. When that industry dried up, many firms (First Boston, Salomon Brothers, Drexel, AG Becker etc.) lost their independence.
Bank of America (as it exists now) was essentially a creation of the US government. In 1990, the Resolution Trust Corporation, have what was then NCNB, nearly all the thrift assets in Texas with a put option. Any bad loans, bonds, etc. could be sold back to to the government. Billions in what should have belonged to the taxpayer was transfered to the shareholders of NCNB. Current managment of BAC has managed to destroy that legacy!
Let us see if the 2009 is any different.
March 23rd, 2009 at 9:45 am
Can you clarify the following:
“this means equity is risky because yields are lower than normal relative to more senior tranches and would sell off sharply if conditions were to normalize, a rational investor will bid assuming low or 0 correlation.”
why would they sell off if conditions normalize (by which I presume you mean improve?)
March 23rd, 2009 at 10:41 am
the market seems to love this plan.
the logic is simple:
government absorbs the lion part of the risks.
->high leverage (6 instead of previously rumoured 5)
->higher bidding prices for toxic assets
March 23rd, 2009 at 11:08 am
You say, with regards to a cashfow CDO, that “correlation is high, so equity is riskier. ” I thought if you owned equity, you were long correlation and so exposed to less risk ?
March 23rd, 2009 at 12:10 pm
The Nit Picker:
“I thought if you owned equity, you were long correlation and so exposed to less risk ?”
yes, you are long correlation, you are only exposed to less risk if correlation stays high but the whole point of the exercise is to reduce systemic risk and therefore drive correlation lower. if correlation does go down, you lose money.
Dan:
high correlation means you are making one single bet so there is little difference in spreads between equity and other tranches. when correlation drops the expected losses shift towards the equity tranche and “cheapens” it (i.e. yield increase).
March 23rd, 2009 at 1:30 pm
I wonder if the Treasury can somehow prevent the gaming described above by stipulating that investors that participate in these trades cannot take any sort of insurance on their positions and cannot sell them before some time
Dont know how you enforce all this, but the worry that people can game the system is real
March 23rd, 2009 at 2:14 pm
Not so sure:
I have not read the whole detailed plan but at first sight this looks heavily regulated by the FDIC at least for the “legacy” loans. FDIC runs the auctions and supervises the asset managers, better than having the SEC ;_)
March 23rd, 2009 at 3:02 pm
If I owned these assets, which I don’t but as a taxpayer soon will, I would be glad to participate, overpay, and buy credit default insurance. Even paying over 100% for the credit insurance would be a huge win with the leverage.
AIG’s financial products group could get a good bit of profitable business selling default insurance. The mind boggles!
March 23rd, 2009 at 3:32 pm
Taking your analogy of a cashflow CDO further, Is this structure is not a CDO squared?
March 23rd, 2009 at 5:38 pm
not at first sight, we are talking loans and mortgage pools not tranches of CDOs or synthetics which are specifically excluded from the TALF program.
March 23rd, 2009 at 6:17 pm
“this crisis being of a systemic nature, correlation is high, this means equity is risky because yields are lower than normal relative to more senior tranches and would sell off sharply if conditions were to normalize, a rational investor will bid assuming low or 0 correlation.”
The logic here seems quite densely constructed to my slow-working brain. If I try to deconstruct it, I think what you’re saying is that current prices of equity tranches reflect a high correlations relative to a “normal” state due to current greater-than-normal systemic risks. However, if the Geithner plan is a success, then systemic risks will be mitigated and correlations will come down. Equity tranches being long correlation, the prices thereof would be expected to drop in the state of the world where the Geithner plan succeeds, all else equal. Thus, a rational bidder would conservatively assume the success of the plan (lower correlations) and thus place a low bid consistent with this success. Did I read that right?
Assuming I got that right (big assumption, I admit), I’m not sure I agree with the “all else equal” part. I have to ask, would a rational investor not also consider the other effects of a state of the world where the Geithner plan succeeds? I would think that if Treasury were to succeed at curbing systemic risk, not only would correlation normalize, but so too would credit spreads. I’m not smart enough to predict the direction or magnitude such a change would have on a prototypical equity tranche. But I would argue that by the time the private investor got around to submitting a bid, other market participants would have already figured out how to incorporate the likelihood of success into both the correlation surfaces and credit curves.
March 23rd, 2009 at 7:14 pm
the only thing you can predict if correlation normalizes is that relatively, equity will widen against more senior tranches, but that says nothing about the level of interest rates or credit spreads, some will narrow and some won’t, it is difficult to interpret what’s “in” the market because many markets specially short term like libor or cp are false markets, distorted by c.b. interventions.
As a bidder, assume the worst for your position: correlation improves, senior tranches volatility drops and credit spreads don’t tighten, that gives you a margin of safety.
March 23rd, 2009 at 8:38 pm
“the only thing you can predict if correlation normalizes is that… equity will widen [relative to] senior tranches.”
OK (maybe). But how is that germane to the question I posed? I asked about the all-in state of the world conditional upon diminished systemic risk. Higher correlations may be a predictable outcome thereof, but I posit that it is not the only outcome. If systemic risk is reduced, credit spreads must tighten. Said differently, systemic risk is not defined as correlation.
“As a bidder, assume the worst for your position…”
Assume it’s worthless and bid $0?
March 23rd, 2009 at 10:04 pm
Sandrew:
“If systemic risk is reduced, credit spreads must tighten. Said differently, systemic risk is not defined as correlation.”
in credit markets, high correlation is an indicator of systemic risk, and low correlation of idiosyncratic risk, this is not correlation as it is generally understood, it refers to the relative level of tranche credit spreads in a closed system such as a CDO, for the underlying assets credit spreads, high correlation means the dispersion of the spreads is narrower than when correlation is low. It doesn’t follow that because correlation drops, asset credit spreads tighten, they don’t have to, instead what happens is that the dispersion of asset credit spreads widens. So to go back to your question in your first comment “Did I read that right?” no, sorry, it is implicit in the maths of correlation that the dispersion of asset credit spreads tightens/widens irrespective of the change in the average level of asset credit spreads. and diminished systemic risk leads to lower correlation not higher (your last comment which i assume is a misprint).
“As a bidder, assume the worst for your position…”
Assume it’s worthless and bid $0?
we deal in probabilities, in competitive markets or auctions, if you are certain that 15% of the assets will default then you bid the discount value of the coupon flow until the expected time to default, 0 is the price only for instantaneous default. the assets have some book value now and to get a margin of safety, I would discount it based on some scenario of what could happen in the future and on what i think in my source of risk, right now there is no market for toxic assets so you have to make one…my view is that I would assume future low correlation + lower volatility reducing the value of the put option on the non-recourse loan and price accordingly. the level of credit spreads can be ignored, reason being that the assets are bought, not for sale and funded to term, and whatever spreads over funding and guarantees is locked to term, what matters for the risk of the equity position is correlation i.e the dispersion of credit spreads in the asset pool, not the level.
March 23rd, 2009 at 10:34 pm
In defense of Krugman: I just wanted to say that I kind of agree with Krugman and don’t think that his post was nonsense. In effect, Krugman believes that the large macroeconomic problem is insolvency (i.e., like Japan in the 90s or Sweden). The Geithner plan, as FT notes, only solves problems of illiquidity. Insolvency means that a large swathe of the assets on the banks’ books are worthless. No matter how long you wait, no matter how much you try, they are worthless or worth a significantly less amount than their book value. This can be in the form of horrible second mortgages, houses in areas that won’t see population growth (think, Detroit) such that their will not be demand for housing, or unsecured loans from now-bankrupt consumers (e.g., bad credit cards). While historically these instruments were wildly successful, they no longer are.
So, if the problem is insolvency, the Geithner plan can only work if the bidders overpay for the assets and the loss is taken on by the government. On the flip side, the banks who were insolvent, who got overpaid through the auction, get all the upside. Thus, Krugman’s thinking is that, no matter what, the government has to take the losses (either through nationalization or through overpayment). If that is the case, why not keep the upside?
Hopefully, you won’t mind unpacking why you think this is spurious on Krugman’s part (or at least where y’all disagree)?
March 24th, 2009 at 12:39 am
I suspect we disagree as to the definition of systemic risk. I accept that correlation is an indicator of systemic risk and that higher implied correlations generally indicate expectations of greater systemic risks (did I misstate that relationship elsewhere?). But I reject that systemic risk is defined solely by asset correlation.
I understand that the Gaussian Copula model treats asset spreads and correlation as separate inputs–that the levels of asset spreads are independent of the correlation between asset spreads. I reject this assumption on common sense grounds. There is feedback both ways. For some entities that are particularly interconnected to the financial system, their credit risks are high precisely because they are especially susceptible to correlation. From a macro view, if a large number of interconnected entities were to suddenly default simultaneously, the conditional expected recovery would be tiny.
My statement “Assume it’s worthless and bid $0?” was hyperbole. You lost me at “the level of credit spreads can be ignored…”