Details of Tim Geithner’s plans for dealing with toxic assets at US banks have been leaked: The New York Times article is here. From an Irish point of view, these plans are of interest not only as an example of how another country is dealing with its banking problems (the Minister for Finance has explicitly stated that he intends to learn from the approaches taken elsewhere before launching an Irish plan) but also because a successful resolution of the US banking problems seems like an essential ingredient in getting a world economic recovery going.
The toxic asset element of the scheme appears to be a bit complicated but here’s how I think it will work. The plan is to purchase about $1 trillion in mortgage-backed assets by setting up a number of different special purpose vehicles. The major source of financing will be $820 billion in nonrecourse loans to these vehicles (so that the mortgage-backed assets are the only collateral) from the taxpayer in the form of the FDIC or perhaps the Fed (I don’t think the FDIC has $820 billion in its fund). The equity for these vehicles will come in the form of $150 billion in TARP funds from the US Treasury, with the remaining $30 billion coming from private investment managers.
This structure means that the private equity investors will be providing only 3% of the total investment but will own one-sixth of the equity and thus will obtain one-sixth of any profits earned. The private equity investors will manage the funds, choosing which assets to buy and (crucially) will also decide the prices by bidding against each other for these assets in an auction. They will also choose when to subsequently sell these assets. The US government, despite putting up 97% of the money, will merely act as a passive investor.
In one sense, this program can be viewed as similar to the proposals being floated in Ireland for a state-owned asset-management company to pay over the odds for the banks’ bad assets. After all, the US government is going to put up 97% of the funds. The interesting wrinkle is the role played by the 3% put up by private investors. Up to now, banks have not been able to sell this stuff to private investors at “acceptable” prices, i.e. if they accepted the prices the market would offer, they would be insolvent. How would this scheme change this so that the private investors that have invested in, and control, these SPVs would be willing to buy this stuff at prices the banks would accept?
The answer appears to be the tails-you-lose\heads-you-win-big structure of the vehicles. Suppose the banks were willing to sell at prices such that, at those prices, the assets purchased by the SPVs could rise by 36% in the coming years or else fall by 36% with equal probability. In normal circumstances, that’s an expected return of zero, which isn’t great. Now consider the return for the private investors in the Geithner plan. With total equity totalling only 18% of the value of the loans, in the bad scenario, all the equity capital is lost. But in the good case, the 36% gain represents a doubling of money for the private investors and the US Treasury (the FDIC just gets its low-interest loan repayed, so the total return to the US taxpayer is much smaller). In the bad case, the private investors lose their $30 billion; in the good case, they gain $60 billion. So the government-supplied leveraging up with non-recourse debt combines to give an expected return of 100%.
These calculations explain why, for any given price paid, the role played by government funds in the Geithner plan helps to juice up the expected return. And if the private investors go into this program with a specific expected return in mind, then the juicing up will imply higher prices for these assets at the auctions. (In other words, they will be willing to pay more for these assets at auction with all the Geithner goodies in place than they would have otherwise).
A cynical (but probably correct) interpretation of this plan is that it is simply a way of over-paying for assets that is so complicated and opaque, the bailout-fatigued US public won’t figure out what’s going on. An early sign that points in this direction is Council of Economic Advisers chair Christy Romer’s statement that “We are trying to help the taxpayer by using the expertise of the market by trying to set the price for these toxic assets”.
- This statement roles out the popular myth that there aren’t prices for mortgage-backed securities. This is not true: Click here for a set of prices. The problem is the prices are so low that, if the banks sold at these prices, they’d be insolvent.
- Talk about “using the expertise of the market” sounds good and even has a grain of truth—the private investors will not buy at prices such that they are certain to make a loss, so the prices set will reflect some possibility of upside and some possibility. But remember that the scheme has still altered normal market incentives to get the private equity investors to pay more for these assets. And every extra dollar paid is effectively a dollar cost to the taxpayer. On this issue, note that the New York Times got fooled by the role of the auction. They wrote “To help protect taxpayers, who would pay for the bulk of the purchases, the plan calls for auctioning assets to the highest bidders.” In fact, the point is to help bankers, not the taxpayers.
- Is this market expertise so hard for the US government to find that it needs to give them 17% of any gains in return for putting up only 3% of the capital?
So there’s plenty to not like in this plan. And indeed, Mark Thoma has a very useful round-up of blog expertise on this (Krugman, Yves Smith, Calculated Risk) and apart from Brad DeLong, nobody seems to like this plan. Brad’s argument appears to be that the Federal government could only lose money on these investments in a disaster scenario and then we’d have other things to worry about. Brad’s assumption that subprime mortgage-backed assets are under-priced is not very convincing when you consider the evidence on default rates on sub-prime mortagages (look at page 7 of the this).
My final concern about this scheme is that the financial chicanery may still not have been clever enough. In general, I’m not sure we could say how much the “Geithner put” will do to raise the value of these assets but I doubt if it’s enough to leave the banks well-capitalised. And, of course, the scheme can do nothing to raise the price of an asset that is completely worthless—the private investors just won’t buy that stuff.
So, for all its ingenuity, I don’t think this is a model that the Irish government should follow.