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Gaming the Geithner plan?
Yes it can be done and here is how:
Let's say that I am a bank ("financial institution") with $100 billion in "toxic assets". I have them on my balance sheet at 80 cents on the dollar. The market has them marked at 30 cents. We do not know what the held-to-maturity performance will be, since that requires knowing the future, although for the moment let's assume that they are cash-flowing at the present time.
What I (the bank) do know, however, is that if I sell them at 30 cents I take a monstrous loss - perhaps enough to force me under Tier Capital limits and thus render me subject to an FDIC enforcement action. I therefore will not sell for 30 cents so long as I have any belief whatsoever that the cash flow - or any government subsidy - will exceed that value.
If I, as a "financial institution" can participate as a bidder in these auctions I can foist off my loss onto the taxpayer. Here is how I can rig the game so as to avoid an otherwise-inevitable loss:
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I become a "bidder" and "bid" on my own assets at 75 cents.
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I am providing 5 or 10% of the money. The rest is covered by Treasury, The Fed and the FDIC via guaranteed bond issuance.
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The loan, ex my contribution, is non-recourse. That is, I can lose 5 or 10% of the total portfolio purchased, but nothing more.
Now the "assets" (a passel of CDOs?) turn out to be worthless. I lose 5% of $75 billion, or $3.75 billion that I put up, plus the other nickel on the original mark, but that's all.
The taxpayer gets hosed for the remaining $71.25 billion dollars.
This can and will be done if the "sellers" of these assets are allowed to bid either directly or indirectly as it provides a means for banks to intentionally dump bad assets at a certain loss that is much smaller than their expected realized loss over time, shifting the rest of the loss to the taxpayer.
This program has the potential to shift literally $500 billion or more in losses onto the taxpayer, not through the operation of "bad luck" but rather through what amounts to a bid rigging operation.
Fortunately that example is a pure hypothetical. Is there a way to actually do this?
I thank DavidS, a loyal MR commentator, for the pointer.
Posted by Tyler Cowen on March 23, 2009 at 09:43 PM in Economics | Permalink
Comments
in other words, if the plan succeeds, it will unlease another wave of hatred against the banks. it's hard to imagine how nationalization could lead to more politicization of bank management and lending decisions than what we're going to get.
Posted by: anonymouse at Mar 23, 2009 10:05:06 PM
Yet one more method of tunneling. Expect it.
Posted by: Jim at Mar 23, 2009 10:11:54 PM
History provides all the evidence we need that folks will take advantage of the situation. By the time our regulators figure it out, the horse will be long gone out of the barn.
The example provided is very direct, so my belife is that the ultimate method of gaming will be much more oblique, but just as effective.
Posted by: ben at Mar 23, 2009 10:15:45 PM
The banks could also offer CDS protection to a 3rd party buyer, such that this buyer would make money if the deal fails via CDS payments. Or, if the banks want to be really clever, they could make a deal with another bank to provide CDS protection on each others sales, such that both banks survive and the taxpayer is unable to figure out they have been had.
Posted by: John Thomas at Mar 23, 2009 10:15:46 PM
Doesn't it all depend on the ability to ' "bid" on my own assets at 75 cents?"
So if we ensure that -- at the very least -- toxic banks etc can't bid on their own portfolios, doesn't that meliorate the issue? At least some?
Of course what interests me is how this all going to work since the very heart of the problem is that we don't know the value of these assets. ("We do not know what the held-to-maturity performance will be.)
Maybe the new PPIFs will be bidding on blind pools? What due diligence will they be allowed? If none then it really is gambling.
Posted by: David Sucher at Mar 23, 2009 10:29:19 PM
If you look under the "governance & management" sections of the summary of terms for both the legacy loans and legacy assets, you'll see a clause that states:
"Private Investors may not participate in any PPIF (Public Private Investment Program) that purchases assets from sellers that are affiliates or such investors or that represent 10% or more of the aggregate private capital in the PPIF"
So it seems like the folks at the Treasury did give some thought to possible gaming. There's also a separate clause:
"Private Invesotr groups must be approved by the FDIC"
While not giving full protection, the administration did show some pre-emption of possible gaming. All in all, I still don't like the plan cos it doesn't solve the economic issue of over-leverage and bad loans floating in the economy which makes people of making and taking new loans. However, this might give the banks some breathing space. Let's hope they don't abuse it.
Posted by: desmond at Mar 23, 2009 10:38:52 PM
Bill Siedman, former FDIC chairman and head of RTC, on CNBC's Fast Money show indicated that there is about $1 trillion of toxic assets, of which banks would like to sell about $500 billion worth.
It seems to me that FDIC, in the worst case scenario, would lose no more than $300 billion under the Geithner plan. I for one would settle for this loss to taxpayers if it can unclog the credit market.
Posted by: Sean at Mar 23, 2009 10:54:24 PM
Clever structurers (I imagine the banks still have a few left on the payroll) can easily get around the prohibition against buying their own assets. Bank A and Bank B can simply sell their more-or-less equivalent portfolios of toxic assets to each other.
Those with a long memory will recognize the similarity to the situation that arose with the Accelerated Cost Recovery System in 1981. Depreciation on acquired new or used equipment was (greatly) accelerated versus the previous ADR regime in order to stimulate the economy by increasing incentives for capital spending. But what if, say, two railroads sold their fleets to each other to increase their depreciation deductions without increasing their net rolling stock? The "anti-churning" depreciation rules were created, rules that still plague tax accountants whenever pre-1981 equipment is sold or exchanged. It happens more often that you probably imagine.
Gratuitous BSG reference: "All this has happened before, and all this will happen again."
Posted by: Steve Y. at Mar 23, 2009 11:02:37 PM
Isn't arbitrage what these guys think they know how to do? With half a trillion at stake, does anybody really believe cheating won't utterly dominate the situation?
Posted by: capitalistimperialistpig at Mar 23, 2009 11:25:12 PM
And if the terms allows the private entities to use purple lollipops instead of actual principal, their leverage will be nearly infinite (depending on the cost of purple lollipops). Except this isn't the case. Sheesh.
Posted by: Brian O at Mar 23, 2009 11:30:58 PM
Does anyone know of any case in which zombie banks have been induced "to start making loans again" with consequent good effects for economic growth by any sort of subsidy or assistance? Ever in the history of humankind?
Posted by: Eliezer Yudkowsky at Mar 23, 2009 11:31:25 PM
Consider a conversation between an optimist and a skeptic:
Optimist: "In the worst case of total scamming, banks get way more money than they deserve (a pure subsidy from government). But this is what they need to get back on their feet anyway. Thus, this plan is no worse than handing money to banks and possibly quite a bit better."
Skeptic: "In the worst case of total scamming, hedge funds get way more money than they deserve too. Thus, this plan could end up far worse than handing money to banks."
Opt: "Suppose hedge funds scam the gov't and make out with large profits, and the taxpayers suffer huge losses. The citizenry is pissed as all hell at the gov't, but they pretty much view the hedge fund as evil incarnate at this point. If you're Obama, with an angry citizenry yelling your ear off, threatening to deep-six you in 2011, how do you not lower the boom on the ransacking hedge funders? Thus if you're a hedge fund manager who thinks it through, why would you even want to think about scamming the government and risking your own survival?"
Skeptic: "Financiers are nothing if not reckless d*****bags. Unless the managers get thrown in jail, they'll just take their profits and walk."
Opt: "Will they take their profits and walk? Remember the House bill exorbitantly taxing upper-income AIG employees? Now pretend the citizenry is twice as angry. Now do you still think Obama doesn't know what he's doing? You think his people don't understand game theory? Good-cop, bad-cop? The House of Representatives is a ravenous, overgrown, caged animal. And Obama's got the key to the cage. That gives him a bit of negotiating... what's the word? Oh yes, 'leverage.' "
Posted by: mk at Mar 23, 2009 11:34:01 PM
As far as I can tell, the endless succession of plans offered up over the last six months has had one goal: come up with something complicated enough to provide political cover for foisting the huge losses of the banks off on taxpayers.
Even assuming no cheating/gaming, best-case scenario - isn't that the whole point of the plan?
As an antidote to this cynicism, here's some blind optimism:
While not giving full protection, the administration did show some pre-emption of possible gaming. All in all, I still don't like the plan cos it doesn't solve the economic issue of over-leverage and bad loans floating in the economy which makes people of making and taking new loans. However, this might give the banks some breathing space. Let's hope they don't abuse it.
Posted by: Bob Montgomery at Mar 24, 2009 12:09:07 AM
I ask you, what is the incentive to the people who would need commit fraud? And the schemes proposed are clearly fraud because the cash which must be lost to push further losses on FDIC would need to come from the bank by way of some conduit and multiple conspirators.
But I think the real message is the strong view that bankers and traders are inherently dishonest.
Posted by: mulp at Mar 24, 2009 12:35:01 AM
Cargo cult - that is all this is.
Posted by: Clark at Mar 24, 2009 2:51:39 AM
I cannot agree more, actually I wrote a similar post weeks ago
Edward
Frontier Blog - No one ahead, no one behind
http://www.hwswworld.com/wp
Posted by: frontierblog at Mar 24, 2009 3:11:28 AM
You ripped this from Karl Denniger's Ticker today - word for word:
http://market-ticker.org/archives/894-Open-Letter-To-The-FDIC-Ombudsman.html
He doesn't mind his Tickers being reproduced/printed elsewhere, but at least give the courtesy of stating the source instead of making it look like you wrote this, Tyler.
Posted by: Logicaloutlaw at Mar 24, 2009 4:06:38 AM
Logicaloutlaw - Tyler linked to that URL in the first line of his post (and indented the entire quote). This is common practice on this (and most other) blogs; I don't think most readers will mistake it for Tyler claiming the article as his own.
Posted by: Leigh Caldwell at Mar 24, 2009 4:35:19 AM
As Krugman pointed out, there is actually in implicit taxpayer subsidy even without self-dealing.
What's odd is that Krugman seems to think of his pointing this out as some sort of "gotcha" moment, whereas in fact this implicit subsidy is the core of the program. This is how treasury is going to get the market to pay the banks a higher price than its view of the payout probabilities of these assets would imply. It's really a rather creative way to simultaneously create a market price and pay the banks more than that price.
On NPR, Krugman was giving an interview in which he claimed (1) selling the toxic assets wouldn't help the banks, because the market's view of their worth isn't high enough to make the banks solvent and (2) this program subsidizes the buyers at taxpayer expense. Connect the dots, please Paul -- you might not like it, but if the subsidy is high enough, (2) fixes (1)!
Posted by: David Wright at Mar 24, 2009 6:19:04 AM
Firstly, any wording whatsoever they might in the plan trying to prevent arbs can be got around by two or more parties who both want to participate executing total return swaps on the pools of assets they are going to bid on. So party A does a TRS paying the total return on x million notional of its assets to party B and another TRS receiving the total return on x million notional of B's assets. Now it bids through the ppip on B's assets and just imagine its huge surprise when B bids through the ppip on A's assets.
This swap arrangement can be structured in a myriad of ways which prevent any oversight the Fed or the Treasury might hope to exercise to prevent arbitrage of this kind.
Posted by: Sean at Mar 24, 2009 7:15:19 AM
As has been mentioned, if firms that put up assets for sale are not allowed to buy assets in the plan this scenario is not an issue. I do not know what the rules are on this.
Posted by: dk at Mar 24, 2009 8:01:25 AM
Why would the assets turn out to be worthless? Hadn't the market valued them at $30 billion? So the taxpayer would lose 90%-95% of $45 billion *if* the bank immediately sells after its leveraged purchase.
Also, why would the bank sell immediately when it is only liable for 5%-10% of the $75b purchase price. Without the deal, they'd book a loss of $50b if they chose to sell. With the deal, they book an initial loss of $5b plus, in the *worst* case, they lose another $7.5b if they sell. And if the assets increase in value on the market by a mere $10b, they lose at most a measly $3.5b if they sell. Assuming they could also easily buy out the govt's debt and get full equity down the line, it seems like a low risk way of keeping their fingers in a few pies.
(OTOH, if this is really a problem scenario, shouldn't someone at the FDIC, etc. get suspicious when there is a sole bid that is 2.5 times the market price?)
Then again, I don't know what I'm talking about!
Posted by: voracity at Mar 24, 2009 8:10:23 AM
Could you provide a single example of a 'cash-flowing' MBS that is priced $0.30 per dollar face? I'm assuming you mean 'cash-flowing' as flowing as contracted because you could be paying pennies of interest when dollars are expected and still be maintaining some 'cash-flow'.
Many normally cash-flowing mortgages would actually be priced above $1.00 per $1-face because they are at higher rates than newly originated mortgages. My mortgage is at 6%, but I plan on moving within a year, so refi doesn't make sense, so wouldn't $100 @ 6% trade much higher than $100 @ 4.5%? Not that there are many of these, but some pricing analysis would be helpful.
The idea that these securities are so intractable is lazy. What is actually happening to the underlying assets is important, and also discoverable. Why isn't more attention going into that?
Posted by: winstongator at Mar 24, 2009 9:17:28 AM
Fortunately, this one is pretty easy to fix. No purchases of assets from affiliates; no resales (or other transfers of economic interests, to account for swaps) for one year or so (to prevent fronting or pass-through entities).
Posted by: Norman Pfyster at Mar 24, 2009 9:57:16 AM
It's going to take a massive, spectacular failure to get us over the notion that the government is some entity separate from all of us, capable of omniscient and omnipotent actions. This might be just the thing. The government will be on the hook for mountains and mountains of bad debt.
Posted by: K T Cat at Mar 24, 2009 10:02:41 AM
