Tuesday, February 10, 2009

Reactions to BARF

The new and improved Bad Asset Relief Fund.

Krugman thinks it might be okay, mostly because nothing substantive was said. He calls it the Rorschach Plan, and I don't think he's referring to the Watchmen.

What is in it, in reverse order:

1. Super-TALF: a big expansion of the Fed's quantitative easing, with Treasury backing. I'm OK with that.

2. Private-public purchases of questionable assets; as I understand it, private investors would be the junior partners, so this is probably not a big giveaway (unless there's huge public financing, in which case it amounts to ring-fencing after all). I also suspect it wouldn't accomplish much, but no harm, no foul.

3. Stress test: everything depends on how this is actually implemented. What happens if, or more likely when, a major money center bank is stress-tested and found to have negative net worth? One possibility is that the auditors are told to come up with a different answer; that's a big concern. The other is that the bank is effectively nationalized; as I read the language that could be achieved as part of the public capital injection.

So what is the plan? I really don't know, at least based on what we've seen today. But maybe, maybe, it's a Trojan horse that smuggles the right policy into place.
Since when has Krugman become an optimist about the government? I think his Nobel prize money maybe enabled him to get a better dealer.

Wolf is totally unconvinced. He thinks that these guys still optimistically imagine that what the banks are telling them is true and that everyone is just panicked and the banks aren't insolvent.

... rational policymakers must assume the worst. If this proved pessimistic, they would end up with an over-capitalised financial system. If the optimistic choice turned out to be wrong, they would have zombie banks and a discredited government. This choice is surely a "no brainer".

The new plan seems to make sense if and only if the principal problem is illiquidity. Offering guarantees and buying some portion of the toxic assets, while limiting new capital injections to less than the $350bn left in the Tarp, cannot deal with the insolvency problem identified by informed observers. Indeed, any toxic asset purchase or guarantee programme must be an ineffective, inefficient and inequitable way to rescue inadequately capitalised financial institutions: ineffective, because the government must buy vast amounts of doubtful assets at excessive prices or provide over-generous guarantees, to render insolvent banks solvent; inefficient, because big capital injections or conversion of debt into equity are better ways to recapitalise banks; and inequitable, because big subsidies would go to failed institutions and private buyers of bad assets.

Why then is the administration making what appears to be a blunder? It may be that it is hoping for the best. But it also seems it has set itself the wrong question. It has not asked what needs to be done to be sure of a solution. It has asked itself, instead, what is the best it can do given three arbitrary, self-imposed constraints: no nationalisation; no losses for bondholders; and no more money from Congress. Yet why does a new administration, confronting a huge crisis, not try to change the terms of debate? This timidity is depressing.

The correct advice remains the one the US gave the Japanese and others during the 1990s: admit reality, restructure banks and, above all, slay zombie institutions at once. It is an important, but secondary, question whether the right answer is to create new "good banks", leaving old bad banks to perish, as my colleague, Willem Buiter, recommends, or new "bad banks", leaving cleansed old banks to survive. I also am inclined to the former, because the culture of the old banks seems so toxic.

Brad Sester strikes his characteristically measured tone. As always with this stuff, the question hinges around what price to pay for the assets, and how much of the losses the government is going to guarantee.

... the US Treasury will propose a fourth option: providing credit to private investors that are willing to buy the banks toxic assets.

Private investors then would have to figure out the right value of the banks existing toxic assets. In return, they would get all of the upside. They would also take some of the downside. But perhaps not all the downside.

If the government provided credit to private investors who put up cash to buy toxic asses, the private investors would take the first loss. That discourages overpayment. But with a non-recourse loan the government on the hook if the value of the toxic assets fell by too much. The private investors could extinguish its debt by handing the toxic assets it bought over to the government.

This seems like a transaction that requires the government take on additional risk. But that probably isn't totally accurate, as the government already in some sense has most of this risk.

So long as the government is committed to protecting the banking system's creditors – depositors, money market funds and bondholders – from losses, the government already has most of the downside risk on these toxic assets. There isn't much bank equity left. As a result the government is already on the hook it the banks' end up taking additional losses on their toxic assets. If the government provided financing to other actors willing to buy the banks bad assets, the government would have more exposure to those players' toxic assets, but less to the banks' toxic assets.

You can already see how this is shaping up to be a slight of hand that people outside the financial industry are unable to follow. First you set up a structure with a sliver of government equity. You let a bunch of big hedge funds put up more equity and become both limited partners and part owner of the general partner. That is, they put capital at risk, but they also get to charge fees for managing the capital. Next, you use a government backing on this structure to leverage the shit out of it. The hedge funds being invited to the dance will lobby for as much leverage as they can get, because the government is going to back the structure and limit the losses. Now you hold your nose and you go out and buy up toxic waste. There's no reason to be overly careful about the price you pay, no reason to build in any margin of safety, because the deal is structured as an option anyhow. Let's say you buy the assets for 50 cents on the dollar and they turn out to be worth 50 in 5 years. In the meantime you collect the high yield and pay interest at the rate the government (your partner and guarantor) can borrow at, and you make a fortune because you get to take home the fees and your share of the spread, all of this leveraged out the wazoo. If you are lucky and buy the assets below their eventual value, you really hit the ball out of the park. And if you "goof" and overpay for them you still get to milk the spread and fees for a few years while you wait for these things to default. By then, you've gotten back a lot of your capital. So maybe your downside is losing 50% on the investment -- no matter what you pay for the assets -- and your upside is enormous because of the leverage. You bought an option, and the taxpayer is the lucky counterparty.

So, what are the variables in this structure. The price for the assets, the amount of losses the government is going to guarantee, and the leverage. As Krugman points out, if the guaranteed losses are high, this is "ring-fencing" by another name, and just loots the taxpayer. However, if you don't guarantee enough, then the private capital that comes in will drive a hard bargain, and you will low-ball the banks into insolvency, given that current estimates put the forthcoming losses at $1T plus . If the government were willing to buy a lot of bank equity, this would be fine, but this is going to take a whole lot more than the $350 billion of remaining TARP money, even assuming that this time you don't blow nearly a third of it bailing out your buddies.

This brings us the part of the plan where the government kicks the big banks' tires to decide whether they need more equity. Krugman is right here again -- the devil is in the details. If you get the first part of this delicate structure right and guarantee just the right amount of toxicity to attract private capital without encouraging them to simply overpay and recoup everything from milking the fees, you still have the other side of the coin, which is convincing the banks to sell at these prices, which are still below their marks, and could throw them into bankruptcy.

Sester puts it this way:

So long as a bank can rely on the government to prevent a run (thanks to the government's guarantee that creditors of large banks won't take losses; i.e. "no more Lehman's") the banks current owners may prefer to sit on its toxic assets and hope the market recovers.

Finding private buyers doesn't solve this problem. No bank has much incentive to sell its toxic assets at a price that would leave the bank bankrupt. Not selling is one way of gambling for redemption.

Breaking this logjam presumably is the purpose of another reported component of the reported Financial Stability Plan: a review of the balance sheets of large banks and, if needed, additional injections of equity capital into troubled banks.

The fact that you can simply take over the equity of most of the US financial system for around $400 billion (the stocks have gotten crushed) and so avoid dealing with valuing anything at all, suggests that all of these gyrations, as Wolf correctly points out, are due to nothing more than our deathly deathly fear of the N-word. This in turn suggests that the Treasury really, really doesn't want to own and control these banks, which, if the loss estimates are correct and the system is in aggregate insolvent, means either that they are going to fake the solvency of the banks by overpaying for the assets via this hedge fund rope-a-dope structure (a marketing breakthrough that simply makes it look like private capital is on the line thus surmounting the initial resistance to the TARP I overpay) or via some tweaking of the accounting rules so that after the Bad Assets are removed we can pretend the newly zombified banks are not walking corpses.

Anyhow, in sum, while it's not inconceivable, I think you have to be pretty generous to see this as anything but a politically expedient way of bailing out the banking system at taxpayer expense. It is meant to balance not hurting the bondholders, not completely giving away money to the equity holders, and not offending the precious goal of bipartisanship by nationalizing the banking system. Unfortunately, while I might support those goals in theory, I think the combination of forces at work here essentially guarantees a multi-year Japanese style deflationary slump. The only other option would be to devalue the dollar relative to gold and every other currency via inflation, and I've come to believe that this is a much longer term outcome.

UPDATE: Jim Hamilton also has some comments on the plan. The synopsis:
Oh, dear. We obviously don't have clear details of the plan, only the concept, but it sounds to me like the wrong concept. As I've argued before, there basically are five parties who might be asked to absorb the losses on existing assets, namely, stockholders, creditors, managers, employees, and the taxpayers. My favored concept is, we use player 5 to get as much leverage as possible out of the first 4. It appears that the Treasury's concept is instead a continuation of Plan A, namely, hope that if we hold on tight and keep the ship from sinking long enough, everything will turn out OK.

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