Geithner's Toxic Asset Plan

[Trom]

I’m trying to understand the new “toxic asset” plan Geithner revealed today. As I understand it, the Feds are going to attempt to solicit bids for these assets from institutions (banks, pension funds, mutual funds, hedge funds, etc). In order to encourage bidding, the government is only requiring the bidders to put up 7% of the asset purchase price. The TARP funds then match that amount. The other 86% is loaned to the bidding institution from the FDIC and Fed.

Is this basically correct?

Assuming it is…

What is to prevent the potential bidders from bidding artificially high for these toxic assets?

Imagine Citigroup having a portfolio of assets in an SIV or other off balance sheet vehicle.The original purchase price was $1 billion. The last trade in that particular market was at 20 cents on the dollar. The market has now completely dried up and there is no accurate known price. What is there to prevent Citigroup from bidding 80 cents? Can banks enter bids for in markets for assets in which they have an interest?

If Citi were to “buy” these assets the financing would be as follows:

$800 million total

-$56 million from Citigroup (7%)
-$56 million from TARP (7% match)
-$688 million from FDIC and Fed (non-recourse loan for 86%)

What if the portfolio turns out to actually be a non-performing bunch of junk and is worth essentially nothing? The taxpayer is now on the hook for $744 million, whereas Citigroup takes a loss of $256 million.

The same institutions that are holding the toxic assets are going to be doing the bidding. This is an obvious conflict of interest. Call me cynical, but this seems to be nothing more than a plan to socialize losses - with a confusing little step in the middle.

[MOIDALIZE]

I don’t know if they’ll bar the investors from bidding on their own assets, but what’s to stop the banks from just buying each other’s crummy assets? It will basically be a way for them to offload their garbage onto the taxpayer but with a bunch of smoke and mirrors obfuscating everything.

The only way this plan makes sense is if you believe these assets are actually valuable but the market disruptions are driving down their value. I don’t think that’s the case at all.

[Trom]

@MOIDALIZE

I don’t know if they’ll bar the investors from bidding on their own assets, but what’s to stop the banks from just buying each other’s crummy assets? It will basically be a way for them to offload their garbage onto the taxpayer but with a bunch of smoke and mirrors obfuscating everything.

The only way this plan makes sense is if you believe these assets are actually valuable but the market disruptions are driving down their value. I don’t think that’s the case at all.

I had thought of that, as well.

In the example above, Citigroup could just get on the phone with SAC Capital, Citadel, Bank of America, or whoever and trade a swap (Remember these completely unregulated things?) Citadel bids the 80 cents, takes a loss, then collects on the swap from Citigroup. Citadel would essentially be serving as a proxy in the toxic bidding market for Citigroup.

[Paranoid_Randroid]

Economiost Brad DeLong (who worked for the Clinton administration) is optimistic.

Q: What is the Geithner Plan?

A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world’s largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off–in either case at an immense profit.

Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn’t make back its money?

A: Then we have worse things to worry about than government losses on TARP-program money–for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

[elucidator]

Rebutted by a chipmonk with a Ph.D. here…

http://krugman.blogs.nytimes.com/2009/03/22/brad-delongs-defense-of-geithner/

[elucidator]

The possible forms of dark conspiracy referenced above are plausible enough, but have a couple of weaknesses. First off, is trust: these guys would have to run a variation of the Prisoner’s Dillemma, with a bit of Lucy holding the football. Mammon Group decides to accidentally shaft MolochCo for a couple billion, MolochCo can’t cry “Foul! They ripped us off while we were ripping you off!”

They would need contracts, stuff written down by lawyers. So not only do they have to trust each other, but each other’s lawyers.

[Leaper]

This guy says it won’t work.

However, I don’t know enough to judge his points or expertise. I’m trying not to hold the fact that blogs like this are linking to it approvingly.

[RogueAOV]

I have to assume that the government will be watching sales, and authorising sales in this plan. Also, isnt it in the best interests of the banks to make this work?, if anything the possible problem would be the seller, claiming the potential sale is worth more, then it really is/or could be worth.

Anyone have any knowledge about that idea? (assuming i have it correctly to start with!)

[Sam_Stone]

I’m with Krugman on this one. The whole point to the public/private partnership is to use the market to price these assets. A good idea in concept, because government is utterly incapable of doing it.

But this particular plan has such a large built-in distortionary subsidy that prices can’t possibly work. The market is broken before it even opens. All of these assets are going to wind up being overpriced by the market. But even worse, because the subsidy is on the risk side the price distortions will not be consistent across every asset. Assets that are relatively safe but which have lower potential returns will be underpriced in favor of assets of higher risk but with high upside - a bias favoring the most dangerous assets.

This plan really amounts to the government simply subsidizing the purchase of these assets to the level required to get banks to buy them at firesale prices. It’s going to cost a fortune.

[threemae]

@Sam_Stone

This plan really amounts to the government simply subsidizing the purchase of these assets to the level required to get banks to buy them at firesale prices. It’s going to cost a fortune.

In what world or through what mechanism can we carry out re-capitalizing the banks where it won’t cost a lot of money?

Alternatively, and I’m asking in all seriousness here because I respect your economic views, what do you propose we do?

This is better than Paulson’s original plans from October and November of last year because it involves some market pricing mechanism (and I agree with you that the government can’t be trusted to try to value these toxic assets on its own), but beyond making the Treasury Department the preferred shareholder in the new PPIF’s where the Treasury gets a larger chunk of the profits as the risk increases or there’s a larger overall profit, what other mechanisms have serious economists proposed to get these things off of bank’s balance sheets?

[Sam_Stone]

One option would have been to let the banks go into receivership and restructure. Some economists argue that the problem today is that government action is preventing these assets from being priced - the government won’t let them find the floor. It’s like setting a price control above the market clearing price - you wind up with no purchasers. And as long as that is the case, the assets won’t move and the credit market will remain frozen.

The government’s plan now, it seems to me, is to maintain the prices high, but offer enough of a subsidy to entice buyers of the debt, who will then make out like bandits once the system becomes unclogged. The problem is that by doing this, they make it harder to price these assets and slow down the process of getting the price system working again so capital starts to flow.

Other economists, like Krugman, thinks the answer is to temporarily nationalize the industry, then have government wade in and sort it all out. That seems to me to be problematic. It sounds too much like, “1. Government takes over. 2. … 3. Profit!” I’m not sure how government is supposed to price these assets if the market can’t do it.

My opinion is mixed. I don’t know if simply letting these assets find their bottom will crater the entire financial system or not. But I think government is currently making the problem worse by injecting uncertainty in the market - with government throwing out new plans on a seemingly weekly basis, it makes it that much harder to figure out what assets to buy. Will there be a mortgage bailout? If so, some mortgage assets are bargains. But wait, maybe there won’t be. Don’t buy them. What about auto stocks? Will Detroit get bailed out again? Who knows? This uncertainty is contributing to the problem.

I think ultimately, the government should act as a social agent, and not a manipulator of markets. Let the banks go into receivership. Let auto companies fail. Spend the bailout money on unemployment insurance and job retraining. If necessary, provide interim financing under chapter 11 for companies who can’t get it out of the credit markets. Let the markets find their bottoms, clear out the mess, and start rebuilding. It would probably be a sharper recession, but it would be shorter and the U.S. would come out of it without having added trillions of dollars of debt.

I also think this is not a recession you can or should try to spend your way out of. It’s not a matter of the business cycle temporarily lowering demand. This is a recession caused by the collapse of a major economic bubble, which caused a real decline in wealth. Or rather, the wealth that people thought they had turned out to be a mirage, and now the country’s collective debt to asset ratios are way out of whack. The natural, healthy response to this IS a cut in demand. People need to stop spending so much, need to rebuild savings and pay off debt, and in general adjust to the reality that they aren’t as rich as they thought.

The government’s response is instead to try to re-inflate the bubble, and this huge subsidized bailout is part of that.

In the end though, no one really knows what is going to happen. Everyone’s working in uncharted territory now. That includes Obama’s team.

[Lantern]

Assets that are relatively safe but which have lower potential returns will be underpriced in favor of assets of higher risk but with high upside - a bias favoring the most dangerous assets.

This is probably a feature not a bug. Remember there has been a huge flight away from risk and assets like these are probably seriously undervalued right now. Creating a bunch of investors who are relatively open to risk is not a bad idea under the current circumstances.

The hedge funds will have 30 billion dollars in the game which should ensure some discipline; given the state of the hedge fund industry today 30 billion is not a sum that they can easily afford to lose. At the same time the leverage will encourage some amount of risk-taking which is not a bad thing.

As for the OP are banks going to be allowed to invest under this plan; I had though it was mainly hedge funds. Even if they are I would imagine there are some strict rules to prevent the kind of self-dealing mentioned.

[Sam_Stone]

@Lantern

This is probably a feature not a bug. Remember there has been a huge flight away from risk and assets like these are probably seriously undervalued right now. Creating a bunch of investors who are relatively open to risk is not a bad idea under the current circumstances.

This is a very good point. However, it does rest on the assumption that the risky assets are undervalued. I don’t think we know that. No one knows where the bottom of this recession is. No one knows what the recovery is going to look like. No one knows if the fed will be able to unwind the trillions it has injected into the economy, or whether there is high inflation coming. So the risk premium is bound to be really high.

Still, you make a good point. This program does have the feature of making the most difficult-to-price assets more attractive.

The hedge funds will have 30 billion dollars in the game which should ensure some discipline; given the state of the hedge fund industry today 30 billion is not a sum that they can easily afford to lose. At the same time the leverage will encourage some amount of risk-taking which is not a bad thing.

Unless the risk is under-priced, in which case there could be another bailout coming of the companies that gambled on this bailout…

[Lantern]

Well, yes there is a lot of uncertainty about the markets and the right policy. But you can’t let that cripple decision making. You have to make an educated guess about the state of things and craft a policy on that basis.

The Obama administration is guessing that right now financial markets are simply not functioning properly because of a massive flight away from risk as well as a lack of liquidity and a general atmosphere of panic. Therefore it doesn’t makes sense to let markets find their bottom not least because this will probably trigger a fresh round of bankruptcies in the financial sector and beyond.

According to them the problem is concentrated in the market for risky securitized assets where prices are now too low because of the flight from risk. Therefore if they can increase the amount of risk-taking in these markets, prices will move closer to their correct value which will also repair the balance sheets in the financial sector and stimulate lending to the rest of the economy. That is what this plan seeks to do.

So they have identified a fairly specific market failure and identified a solution closely tailored to solving it. They would prefer not to have the government directly purchasing these assets nor to have the government directly running nationalized banks. It’s analogous to the carbon tax for global warming where instead of the government micromanaging a lot of industries you set a single tax and let markets respond to the changed incentives.

Overall I share their assumptions about the nature of the problem and also their reluctance to micromanage financial markets so I think the plan is on the right track. They havealso been pretty brilliant in marketing the plan and wooing Wall Street which is a good example of their pragmatism and their ability to learn quickly from mistakes. Their will be a time later to turn the regulatory screws and prevent a repeat of the shenanigans of the last few years. Right now though Obama needs to work with Wall Street to fix the financial system.

[China_Guy]

I’m largely with Sam on this one. This plan stinks. This repeats the meme of the assets are temporarily undervalued but will reach their true value over time. This is just another ATM funded by US taxpayers.

Fixing this problem is not rocket science. Take a lesson from the Japanese bubble, from which the japanese economy has not recovered in nearly 2 decades.

1. You can’t warehouse this toxic crap. The government is setting an artificially high price, which is effectively warehousing (and praying the price will eventually go up).
2. Take the pain NOW and get it out of the way. Reach a clearing level, even if it’s 20 cents on the dollar, where private funds with no guarantee will take this stuff on
3. Keep the banking system capitalized and reduce moral hazard.
4. Deficit spending is needed but let’s not go hog wild. Let’s not try to debase the currency and introduce massive inflation when this is done.

[spazattak]

@Sam_Stone

One option would have been to let the banks go into receivership and restructure. Some economists argue that the problem today is that government action is preventing these assets from being priced - the government won’t let them find the floor. It’s like setting a price control above the market clearing price - you wind up with no purchasers. And as long as that is the case, the assets won’t move and the credit market will remain frozen.

It seems to me part of the problem is that they legally can’t go into receivership. They don’t really have the authority to take control of these ibank hybrids, correct? On top of that, taking these large institutions into receivership would require massive funding (magnitudes more than what’s already been committed), which would in turn require an act of congress (and I think most of us can agree that the political capital to pull off a massive nationalization of this sort is nonexistent).

The government’s plan now, it seems to me, is to maintain the prices high, but offer enough of a subsidy to entice buyers of the debt, who will then make out like bandits once the system becomes unclogged. The problem is that by doing this, they make it harder to price these assets and slow down the process of getting the price system working again so capital starts to flow.

Other economists, like Krugman, thinks the answer is to temporarily nationalize the industry, then have government wade in and sort it all out. That seems to me to be problematic. It sounds too much like, “1. Government takes over. 2. … 3. Profit!” I’m not sure how government is supposed to price these assets if the market can’t do it.

When Krugman talks about nationalization, it’s in reference to your receivership. Basically taking over the bank, sorting through the books and selling off the profitable entities. IE the same thing the FDIC has always done with failing banks.

My opinion is mixed. I don’t know if simply letting these assets find their bottom will crater the entire financial system or not. But I think government is currently making the problem worse by injecting uncertainty in the market - with government throwing out new plans on a seemingly weekly basis, it makes it that much harder to figure out what assets to buy. Will there be a mortgage bailout? If so, some mortgage assets are bargains. But wait, maybe there won’t be. Don’t buy them. What about auto stocks? Will Detroit get bailed out again? Who knows? This uncertainty is contributing to the problem.

Which is worse? Uncertainty in a sector? or the complete elimination of it? If the autos are far enough in debt, they’ll be liquidated. An orderly bankruptcy with restructuring won’t be possible. That in turn will have ripple effects through the supply chain (this has all been hashed out in other threads). So which do you go with here? The uncertainty or the potential for millions more in lost jobs? There’s no real good answer here IMO.

I think ultimately, the government should act as a social agent, and not a manipulator of markets. Let the banks go into receivership. Let auto companies fail. Spend the bailout money on unemployment insurance and job retraining. If necessary, provide interim financing under chapter 11 for companies who can’t get it out of the credit markets. Let the markets find their bottoms, clear out the mess, and start rebuilding. It would probably be a sharper recession, but it would be shorter and the U.S. would come out of it without having added trillions of dollars of debt.

I also think this is not a recession you can or should try to spend your way out of. It’s not a matter of the business cycle temporarily lowering demand. This is a recession caused by the collapse of a major economic bubble, which caused a real decline in wealth. Or rather, the wealth that people thought they had turned out to be a mirage, and now the country’s collective debt to asset ratios are way out of whack. The natural, healthy response to this IS a cut in demand. People need to stop spending so much, need to rebuild savings and pay off debt, and in general adjust to the reality that they aren’t as rich as they thought.

The government’s response is instead to try to re-inflate the bubble, and this huge subsidized bailout is part of that.

In the end though, no one really knows what is going to happen. Everyone’s working in uncharted territory now. That includes Obama’s team.

I agree with your premises but not your conclusions. Yes, people and banks are overextended and we’re going to need time to come back into a responsible savings/debt balance. This process is creating financial gridlock though. I don’t think the government is attempting to re-inflate the bubble but rather rationalize the market instead of letting it be run by human emotions. Right now fear and group-think appear to be the major driving force instead of long-term planning and value.

[Trom]

@spazattak

It seems to me part of the problem is that they legally can’t go into receivership. They don’t really have the authority to take control of these ibank hybrids, correct? On top of that, taking these large institutions into receivership would require massive funding (magnitudes more than what’s already been committed), which would in turn require an act of congress (and I think most of us can agree that the political capital to pull off a massive nationalization of this sort is nonexistent).

…

It appears they are seeking to expand their power to do so.

@WP

The Obama administration is considering asking Congress to give the Treasury secretary unprecedented powers to initiate the seizure of non-bank financial companies, such as large insurers, investment firms and hedge funds, whose collapse would damage the broader economy, according to an administration document.

U.S. Seeks Expanded Power to Seize Firms

[Sam_Stone]

@spazattak

It seems to me part of the problem is that they legally can’t go into receivership. They don’t really have the authority to take control of these ibank hybrids, correct?

Banks have failed before. So have insurance companies. What happens to them? I assume they go into bankruptcy, and are then allowed to create a restructuring plan that allows them to pay off creditors at some rate and renegotiate some of their contracts. Why couldn’t that be done in this case?

I’m not talking about a government takeover - I’m talking about regular old Chapter 11 bankruptcy. Is that not applicable in this case?

[XT]

It’s funny…people went absolutely nuts over a measly $165 million dollars in bonuses to AIG executives. This is one TRILLION dollars and it’s going to allow all these bad assets to be essentially chocked up on the governments dime. We are, basically, re-inflating the economic bubble that burst and put us here in the first place.

While I’m unsure of what is the best thing to do at this point (I’m unsure there is a ‘best’ thing…just various levels of bad), it’s ironic to me that while folks were literally going nuts over the AIG bonus lash up, this is sailing by those same folks with nary a ripple. And from what I’ve read, the potential for abuse inherent in this is…high.

Well, it looks like this ship is going to sail. I guess we’ll see what happens. I think we are going to be in the same boat the Japanese were in for a few decades, but I guess we’ll see.

-XT

[spazattak]

@Sam_Stone

Banks have failed before. So have insurance companies. What happens to them? I assume they go into bankruptcy, and are then allowed to create a restructuring plan that allows them to pay off creditors at some rate and renegotiate some of their contracts. Why couldn’t that be done in this case?

I’m not talking about a government takeover - I’m talking about regular old Chapter 11 bankruptcy. Is that not applicable in this case?

How many banks do you know of that have ever gone into chapter 11? How many insurance companies? How many hybrid banks/insurance companies? It’s not the creditors that we need to worry about so much as the depositors. We’re talking about people’s life savings here between bank accounts, annuities and other insurance products.