Wednesday, March 25, 2009

Geithner Plan Matrix.

Now that at least the basic mechanics of the bank bailout plan are known, it's time to try and reduce the still enormous uncertainty surrounding its effect to as few questions as possible.  First, if you haven't seen this stuff already, you need to understand exactly how the structure works.  Start with this simple math based on the original white paper the Treasury put out.  If you want to follow up on that there has been a tremendous amount of good stuff written for and against.  I can recommend Mark Thoma, Brad DeLong, Jeff Sachs, and Paul Krugman.  But you can read till your blue in the face on this one without getting a definitive take on whether it's a good idea or not. 

What is not in dispute is that no matter how you look at it, the plan constitutes the possibility of a subsidy for both the banking industry and the private investors who will be buying these assets with government assistance.  This possibility is created by the fact that the plan allows private investors to borrow against each asset they buy individually, which essentially gives them a cheap put option on the ones that go bad.  So there's no longer any question that the plan is structured to afford, at least the possibility of a back-door subsidy to the banking industry.  This is in and of itself a bit sneaky I think, because officialdom keeps insisting that there is no subsidy, which is just a big fat lie.

How big is this subsidy, who gets it, and what effect will all this have on the economy relative to our other options for dealing with this?  These are tough questions.  The answers really depend on how the program is administered, what prices banks are willing to accept for these assets, and whether the assets . 

Because you see, the whole process begins with banks identifying what assets they want to sell.  This should already raise your hackles.  These insolvent fucks are going to tell me what toxic crap they want to unload?  But that's how it works.  The banks are carrying most of these assets on their books at better than 90 cents on the dollar, insisting that they are unimpaired.  The assets that have actually traded in the market have gone for around 25 cents on the dollar.  That's one hell of a bid-ask spread.  A recent Goldman report does some plausible back of the envelope math that suggest that the plan's leverage and embedded put could raise this bid to 66 cents on the dollar, and the buyer would still make the same return.  The assets are probably worth something like 40 cents if a unlevered investor held them to maturity and made a decent but not spectacular return for taking this risk (note that what an asset is "worth" is not a straightforward question -- these loans are certainly not "worth" their face value, both because some have defaulted, but also because they were risky to begin with, and so anyone making them should have asked for a much better return.  One thing that has been mostly missing from this debate is that we really don't want these assets to go back to being worth face value, because they damn things really shouldn't have existed in the first place.  Sometimes it's hard to see that we're not looking to go back to status quo here, even if that were possible).

So, will the plan work?  Well, if the banks are willing to sell all the toxic crap that's really worth 40 for 66, and stomach the writedown from 95, and the taxpayer is willing to pick up the tab of this subsidy, and then the additional tab that comes from the fact that at least Citibank will be insolvent and require further government capital -- then ... umm ... yeah, the plan will "work".  Work in the sense of transfer billions to the banking and private equity industry to ensure that they are solvent so that we can go back to business as usual. 

This assesment is actually probably a little harsh.  Some of the banks probably are solvent even as it stands, and have simply been cuaght up in the panic.  Others are just mildy insolvent (depending on what you mean by insolvent) and this subsidy combined with a period of low short term rates would probably enable them to earn their way out of it.  For those banks, this plan could legitamately be said to work.  It's not fair.  It involves a big taxpayer subsidy to folks who made loans they shouldn't have.  But of course, it also bails out all the creditors to the banks -- especially the depositors.  If this were the whole story, I guess I would go along with the plan, even though it means higher taxes for me, because for me there really is some value in having the financial system around at least long enough for me to finance by bunker.

Unfortunately, I don't think that the plan will work. 

First, just from a practical perspective, it doesn't look like even this subsidy will be enough to bridge the gap between bid and ask, which suggests that the banks may simply collectively stone-wall the process.  If I were the CEO of Citibank, I'd be carefully preparing a smallish list of slightly dinged assets to sell, without in any way hinting that these are close to the best ones I have on my books.  I offer these up, get a bit of subsidy for them, and insist that all the rest are fine.  See, everything nice and marked to market.  The investors aren't going to quite believe me, and the stock will spend the next three years alternately soaring and tanking, soaring and tanking, but so what.  I'll gradually earn my way out of it, or, better yet, make a bunch of risky new loans and dig the hole even deeper.  After all, at that point my stock options are either worth zero, or a lot if I get lucky, hit the jackpot, and make a bunch of big loans just before the economy recovers.  Once you're effectively bankrupt, there's nowhere to go but up.

I'm exaggerating (a little) but my basic point here is that unless the government is serious about stress testing the banks after this new plan allows us to get an idea of what their assets are really worth, serious about forcing them to take new equity dilutions form the government if they are short of capital, then there really no stick for the bank to offer up any assets for sale at prices that don't hit their current bids.  What does Citibank have to gain from marking these assets down if it will be insolvent afterwards?  They will not commit hari-kari all on their own.

The second problem is related to the first.  Let's assume that we somehow convince the deeply insolvent banks to mark things to (already subsidized) market, and they are now well and truly insolvent.  Are the monkeys that run our congress going to have the political will to nationalize a big chunk of the banking industry?  Or are they going to avoid this isssue just like Citibank would like to?  Instead of forcing the banks into receivership, or FDIC restructuring, or nationalization, or whatever you want to call it, they are more likely than not to keep kicking the can down the road by dribbling out another $100b here and there to keep them afloat for a while longer.  Look how they are treating GM.  Why would it be any different with a perpetually bankrupt Citi?  In fact, it would be worse, given that the price of letting Citi fail would be larger, and given that you can garner a lot more in the way of campaign contributions from CEOs by perpetually putting them on congressional life support. 

If you want to look at the bright side, you can imagine that the Geithner plan is step one -- a very generous price discovery mechanism -- of a multi-part plan to deal with the whole banking system.  Step two would be serious stress-testing or the remaining assets, and step three recapitalizaiton, if necessary. 

If you prefer dark meat, you can see this big up front subsidy as just a prelude to larger lootings in the future. 

I hardly think you need to ask where I stand.  And the worst part about the whole thing is that fianancial history contains clear lessons about how kicking the can down the road costs much more over the long-term than dealing with the problem in a straightforward way.  So the difference between the good and bad interpretation of the plan is not simply one of fairness, but also one of total cost to the overall economy.  I guess I hope I am wrong.


adam said...

Sorry you feel that way!

I'm buying Interfluidity's take on this. Obama has already shown he is happy to use the failed corps like AIG as pass-throughs to the unsecured creditors. They would probably claim they are staving off systemic collapse, but in reality its just about protecting the creditors from a haircut and maybe protecting Obama from accusations of socialism.

Clark said...

Yeah, I feel sorry for all of us if the looting continues. I'm not sure I go all the way to Interfluidity's dark views, but I'm definitely with you in leaning in that direction. I get the impression that they are trying to balance what they know is the right thing to do, with the favors necessary to build a new political machine on the back of an old corrupt congress. It occurred to me this morning that if Hillary were president (shudder) there might be more chance of dealing with this stuff in the short term because she has a more established network of long-term backscratching. Obama has to build everything from scratch in the middle of a crisis.

adam said...

The Hillary 'what if' has crossed my mind, but then Obama has all the Clintons' financial team anyway.

Ironically, if he & Geithner wanted to nationalize, I think Congress would be quite happy to go along and give him genuine bipartisan support. Even Lindsey Graham (!) and other Republicans are calling for it.

My friendliness to the evilness theory from the "economic hitman" stuff. This kind of looting is old news in places like Argentina. The looters might not even see things in those terms, they are just following the path of least resistance.