Comments on: Either/Or

By: Michael Drake

Michael Drake — Tue, 31 Mar 2009 00:42:46 +0000

“Oh dear, too many hands. Economists are contagious.”

That’s why they started using invisible hands.

By: Henri Vieuxtemps

Henri Vieuxtemps — Mon, 30 Mar 2009 13:47:18 +0000

Well, in 3 the banks at least “squeak through”; that’s something. In 5 the bailout money is (for all intents and purposes) stolen and you are back to square one. You gave a trillion dollars to some (relatively few) individuals without affecting anything in the financial apparatus.

In fact, if I am a bondholder, I will volunteer to be Geithner’s investor and gladly lose my 7% of the bailout – as long as I expect close to 100% of my bonds to be paid back. Because right now my bonds are worth nothing.

By: Zamfir

Zamfir — Mon, 30 Mar 2009 12:05:09 +0000

henri, that’s 3 again or not?

By: Henri Vieuxtemps

Henri Vieuxtemps — Mon, 30 Mar 2009 09:29:29 +0000

5) The auction is an apparent success, but the buyers end up losing their shirts. All the toxic assets are actually toxic and the Fed is on the hook for those loan guarantees, which are now revealed to have amounted to a huge giveaway to the banks. The banks get the money, channel it to the bondholders, preferred shareholders, and CEOs ‘deferred compensation’ from years ago. As all the bailout loot disappears the banks cheerfully declare bankruptcy.

By: Zamfir

Zamfir — Mon, 30 Mar 2009 09:08:51 +0000

Hey, I read that book. But in translation it is called very different, so I didn’t recognize it from the title. What does that title mean anyway?

By: John Quiggin

John Quiggin — Mon, 30 Mar 2009 08:58:21 +0000

There’s a great scene in The Chrysalids where the protagonist is given a hiding by his father for wishing for a third hand.

By: Zamfir

Zamfir — Mon, 30 Mar 2009 08:51:50 +0000

Oh dear, too many hands. Economists are contagious.

By: Zamfir

Zamfir — Mon, 30 Mar 2009 08:51:10 +0000

I was saying that, if markets were efficient as required for the plan to work, we wouldn’t be in this mess in the first place.

On the other hand, people did have 18 months to read up on their subprime-risk knowledge, and to re-estimate the usefulness of their models. There must by now be people out there who can make a reasonable (and better than before) guess at the worth of stuff.

On the other hand, is there a any reason to believe that the nationalization squads are at the ready in case this plans doesn’t work? If not, option 3 seems the only option worth considering, and it is not the good option.

By: John Quiggin

John Quiggin — Mon, 30 Mar 2009 06:37:29 +0000

“But isn’t that the opposite of what you said before? Before you were saying that for the plan to work, one has to assume that the markets are not efficient. Now you seem to be saying that the plan to work, one has so assume that the markets are efficient.)”

Apologies for writing confusingly. I was saying that, if markets were efficient as required for the plan to work, we wouldn’t be in this mess in the first place.

Undoubtedly, some of these problems will arise under nationalisation/receivership. But at least then the government will have access to the book, control over the reward structure of the employees, and hence a much better idea of what is and isn’t worthless than it can gain from external scrutiny.

Plus, on my first point, we get to do triage properly, instead of (probably) wasting a lot of money making good the bad bets of those banks that aren’t going to fail. The insistence on handing out money to everybody has been one of the most disastrous features of the Geithner-Summers-Paulson approach, and it rests on the idea that no one must be allowed to fail (in the sense of going into receivership/nationalisation).

By: David Wright

David Wright — Mon, 30 Mar 2009 06:29:16 +0000

John Holbo @ 26: I think I can clear up the confusion. To clarify that the subsidy comes from the implicit put (aka non-recourse loan), my example scenario included only it, not the more complex mix of implicit put plus matching investment that the real plan includes. Since JQ was responding to my example, it was fair of him to also ignore the matching investment.

In an imperfect market, the matching investment component may weaken the effect of cheating buyers on the government’s finances somewhat. (That may be why the smarter-than-me game theorists as Treasury included it. Or maybe it was just a political demand that the government “see some of the upside”.) But given a sufficently imperfect market, JQ is certainly right that the buyers can extract some money. But I think that I am also right that these problems are also going to occur if the government, having nationalized the banks, is trying to sell the toxic assets directly.

By: David Wright

David Wright — Mon, 30 Mar 2009 06:16:38 +0000

Yes, JQ, colluding buyers, or buyers with inside knowledge of which assets will definitely pay out or not, can most certainly fleece the government and/or the selling bank. (But isn’t that the opposite of what you said before? Before you were saying that for the plan to work, one has to assume that the markets are not efficient. Now you seem to be saying that the plan to work, one has so assume that the markets are efficient.)

Geitner does seem to be taking some pains to avoid this danger. He isn’t just asking Goldman to bid against Morgan-Stanley. He has asked a bunch of pension and mutual funds to bid, too. I believe even some closed-end funds for retail investors are forming specificly to buy toxics under this plan.

Of course, there is no guarantee that this attempt to ensure competetive bidding will succeed. But there is no guarantee that it would succeed if the government, having acquired the assets via nationalization, were the direct seller, whether or not it were offering the implicit put. Creating a market isn’t easy, but we are going to have to do so either way.

(Or are you suggesting that the government, or a “bad bank”, should simply hold the assets until maturity? For anyone who knows that the market has undervalued the assets, that is of course a smart thing for it to do. But I presume you are willing to grant that the government doesn’t know more about the payoff probabilities than other market participants. In fact, I could make a decent argument that it probably knows less.)

By: john c. halasz

john c. halasz — Mon, 30 Mar 2009 05:59:08 +0000

All this fine liberal talk about forming correct market prices for financial assets misses the possibly myriad ways that the whole proposal might be gamed through circuitous set-ups amounting to collusion between banks/sellers and hedgies/buyers, in which case the government is not paying out a premium to effect “correct” market pricing, even vaguely, but paying out a premium to forestall that eventuality and increase the eventual economic costs/losses, while recapitalizing bank managements/shareholders privately at public expense. As a too simple example, which nonetheless could probably be effected through a much more complex and effectively untraceable scheme:

“Say I am SAC Capital. I get to be one of the bidders on bank assets covered by the program

Citi holds $100mm of face-value securities, carried at $80mm.

The market bid on these securities is $30mm. Say with perfect foresight the value of all cash flows is $50mm.

I bid Citi $75mm. I put up $2.25mm or 3%, Treasury funds the rest.

I then buy $10mm in CDS directly from Citi [or another participant (BOA, GS, etc)] on the bonds for a premium of $1mm.

In the fullness of time, we get the final outcome, the bonds are worth $50mm

SAC loses $2.25mm of principal, but gets $9mm net in CDS proceeds, so recovers $6.75mm on a $2.25mm investment. Profit is $4.5mm

Citi writes down $5mm from the initial sale of the securities, and a $9mm CDS loss. Total loss, $14mm (against a potential $30mm loss without the program)

U.S. Treasury loses $22.75mm

Great program.

It’s just a scheme to transfer losses from the bank to the taxpayer with an egregious payout to a middleman (SAC) to effectively money launder the transaction.

You’ve also transmuted a $30mm economic loss into a $36.75mm economic loss because of the laundering. So its incredibly inefficient.

How did fraud and money laundering become the national economic policy of the US?

One would have to be a criminal to participate in this.”

http://www.nakedcapitalism.com/2009/03/investor-on-public-private-partnership.html

By: John Holbo

John Holbo — Mon, 30 Mar 2009 05:54:26 +0000

One detail that doesn’t really affect your overall point, John Q: as I understand it, the final split might go more like this. The auction settles on $80 (let’s just say). The investor puts up $6 (or whatever the small amount is.) The government matches that (another $6.) And the rest, $68, is loan guarantees. So half the profit actually accrues to the government, if things go well. So maybe the amount that goes to enrich the investor should be halved, in your case? Or is it the case that the government’s $6 stake, plus loan guarantees, doesn’t actually buy it a 50% overall stake in the potential upside? Maybe it only gets paid potential profits proportional to its $6, not according to the $74 that is really, effectively, fronting?

I’m so confused.

By: John Quiggin

John Quiggin — Mon, 30 Mar 2009 05:31:26 +0000

Coming back to my point, that’s great if the market is perfectly competitive. But suppose that it isn’t and that assets like this go for $50. The government puts up $45 and loses it 70 per cent of the time for an expected loss of around $30, of which the bank gets $20 and the buyer an expected profit $10 (some of which might be spent on things like getting bank insiders to point out the relatively good deals).

So, instead of having $30 with which to finance the bank’s receivership, the government has used $20 to do a recapitalization and $10 to enrich the investor.

By: John Holbo

John Holbo — Mon, 30 Mar 2009 05:02:42 +0000

“A little math reveals that the market, with the exact same beliefs, will end up paying $81 for the exact same asset under these circumstances.”

That’s rather eye-opening, David. But it seems to make sense. The gap between $30 and $80 is rather significant, as price-discovery goes.