Will the Geithner plan work?

The internets are abuzz with speculation, and this roundup at the NYT is a useful gathering of views. As a cautious optimist, DeLong's is the most persuasive to me at this juncture.

A post at NRO's Corner is fairly sane by NRO standards, but its argument that the Obama administration's approach has not been intellectually serious enough is pretty humorous coming from one of the Bush administration's top budget officials. That's a pot calling a foggy mist black, at best.

Noam and Andrew liked this post, which I'll quote since the site is slow:

The details of the “Geithner Put” have been released. It has two parts: One to deal specifically with bad loans, the other to deal with other legacy assets (securitized yadda yadda). In this post I will discuss the first part, dubbed the “Legacy Loans Program”.

The Treasury helpfully provides an example, which I reproduce here:

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.

Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.

Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.

Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.

Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.

Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

Let’s flesh this out by repeating it 100 times. So say a bank has 100 of these $100 loan pools. And just by way of example, suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. (These numbers are made up but the principle is sound. Nobody knows what the assets are really worth because it depends on future events, like who actually defaults on their mortgages.)

Thus, on average the pools are worth $50 each and the true value of all 100 pools is $5000.

The FDIC provides 6:1 leverage to purchase each pool, and some investor (e.g., a private equity firm) takes them up on it, bidding $84 apiece. Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools but only puts in $600 of its own money.

Half of the pools wind up worthless, so the investor loses $300 total on those. But the other half wind up worth $100 each for a $16 profit. $16 times 50 pools equals $800 total profit which is split 1:1 with the Treasury. So the investor gains $400 on these winning pools. A $400 gain plus a $300 loss equals a $100 net gain, so the investor risked $600 to make $100, a tidy 16.7% return.

The bank unloaded assets worth $5000 for $8400. So the private investor gained $100, the Treasury gained $100, and the bank gained $3400. Somebody must therefore have lost $3600…

…and that would be the FDIC, who was so foolish as to offer 6:1 leverage to purchase assets with a 50% chance of being worthless. But no worries. As long as the FDIC has more expertise in evaluating the risk of toxic assets than the entire private equity and banking worlds combined, there is no way they could be taken to the cleaners like this. What could possibly go wrong?

Update 19:30

Wow, my site got Felixdotted (SlashSalmoned?). In response to some of the comments there and elsewhere:

Yes, with the auction process, the assets will get bid up to the point where private equity (and Treasury alongside them) do not make such massive profits. But in the process, the outcome becomes even sweeter for the bank and worse for the FDIC. This appears to be the entire point of the exercise.

And yes, the FDIC is funded by the banking industry itself. Or has been so far.

Since the day-to-day mission of the folks at FDIC is concered with defending the integrity of their insurance fund — that is why they seize banks in the first place — this proposal is likely anathema to the culture of the organization. And I did read somewhere about rumors that some people at FDIC were objecting to this plan. (Sorry, I lost the reference.) This rings true to me.

I have more to say in Part 2.

Another update, next morning

Yes, yes, my model where half the pools are worth zero and half are worth $100 is totally unrealistic. It was not meant to be realistic; it was meant to be illustrative. I am of the opinion that most people, even intelligent laypeople, do not know that non-recourse high-leverage loans are equivalent to a put option. I suspect many of them do not even know or care what a put option is.

Yes, a binomial distribution is oversimplified and also worst case, since it maximizes the variance and therefore the value of the “embedded put”. But it also yields to a two-paragraph analysis that requires no ability to understand what my previous sentence even means. My intention was to explain the principle in simple terms and to do a little exploration of who exactly will be left holding the bag.

Also:

In Part 1, I gave an example of how a private investor could buy some loans for $8400, ultimately realize $5000 on them, and still earn a 16.7% profit. Milo Minderbinder would be proud. The loser would be the FDIC, which is interesting because the FDIC is financed not by the taxpayer but by the banking industry — or at least, it has been so far. So even if the FDIC needs to tap their new $500 billion credit line to make good on tons of bad loans, in theory they will eventually repay the Treasury by exacting higher insurance premia from the banking industry.

Thus Part 1 could be read as a transfer of wealth from good banks to bad banks and private equity. Assuming Treasury actually demands repayment on the credit line and does not just write it off…

Part 2 of the Geithner Put is called the Legacy Securities Program. Here again, the Treasury provides an example:

Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.

Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.

Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.

Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.

Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.

Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

This may sound similar to Part 1, with the Treasury providing the leverage instead of the FDIC… But it is actually completely different. The key concept is the non-recourse loan. If Treasury wants to hire a handful of money managers, ask them to raise private capital, match the capital raised, and then let them lever up 3:2 or 2:1, that is not a subsidy in the same way as Part 1. In this case, the loans are full recourse with respect to all of the assets run by that manager. So it is not trivial to construct an offensive example, and this structure by itself is not so bad.

No, the bad part is this bit which appears a few paragraphs earlier:

Expanding TALF to Legacy Securities to Bring Private Investors Back into the Market

… stuff elided …

• Funding Purchase of Legacy Securities: Through this new program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency residential mortgage backed securities (RMBS) that were originally rated AAA and outstanding commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that are rated AAA.

Whoops, there are those “non-recourse loans” again. The TALF is the Fed’s new $1 trillion program to provide non-recourse loans against new asset-backed securities. Part 2 of the Geithner Put extends this program to existing securities. (Note the phrasing “originally rated AAA”. We are definitely talking about toxic assets here.)

So the Treasury provides equity investment and loans for fund managers to purchase assets, and then the Fed provides the subsidy via non-recourse loans against those assets. The degree of leverage here is determined by the “haircut” applied to the assets; a 10% haircut corresponds to 9:1 leverage, for instance. Search for “collateral haircuts” in the TALF FAQ to get an idea of the numbers. Although bear in mind those are for the current TALF, and we will have to wait to see the haircuts for the Geithner Put extension.

Apparently, we are left with private equity firms and bankers being able to fleece the FDIC and the Fed via abusing the non-recourse loans, with the Treasury/taxpayer participating in the upside of the fleecing. Which is fine, I guess, if you believe the FDIC and Fed are themselves good for the losses; i.e., that the losses will not ultimately be placed on the taxpayer. Color me skeptical, especially with regard to the Fed.

But I do give them points for creativity.

I think I'm dizzy. Megan is a bit more helpful.