Why Should Geithner’s Auctions Work?

According to the New York Times, pools of distressed mortgage-related assets of US banks have been 30 cents bid, 60 cents offered, in recent weeks. The bidders are hedge funds, the potential sellers under-capitalised, but State-guaranteed, US banks.

The Geithner plan appears to include a new type of investment vehicle with capital structure 3% private equity, 12% taxpayer equity, and 85% debt, also provided by the taxpayers. The holders of the 3% private equity would provide management and would bid for the distressed assets at auction. The expectation is that they would bid more than 30 cents on the dollar, thus improving banks’ balance sheets.

If the State equity is fully participating, it changes nothing from the standpoint of the fund manager. Only if the 85% debt is available at terms better than debt currently available to the hedgies (who will bid no more than 30 cents) can the plan work. The NY Times says that the 85% debt will be non-recourse, which certainly helps, and that it will be ‘cheap’, details to follow!. If it is provided at anything close to T-bill rates or short Treasury note rates, it’s a steal, and the Geithner hedge funds will of course bid more than 30 cents. I suspect that 85% non-recourse lending to distressed-asset hedge funds is not available at non-stratospheric prices right now. This is not a certainty-equivalent game since nobody knows the true value of the distressed assets, but cheap, non-recourse leverage will improve the bid price for any plausible distribution of returns.

The government could achieve the same objective by lending cheap non-recourse money to existing hedgies, unless I am missing something. But this would lack opacity. The critical economic component in all of these plans (including bad banks and insurance schemes) is the distribution of gains and losses. The critical political components appear to be fig-leaf involvement of private equity, the avoidance of overt nationalisation, and non-transparency.

12 replies on “Why Should Geithner’s Auctions Work?”

What i find bizarre and ironic is that this is essentially leveraged structured finance investments, designed and backed by the government but involving the private sector, being set up to solve a crisis born out of misfiring structured finance investments, designed and backed by the private sector, but involving the government (Fannie/Freddie)!! That old phrase that says “if you don’t learn from your mistakes, you’re bound to repeat them again” seems quite apt right now.

I agree that the the private equity stake seems to be very low. FDIC guaranteeing 6 to 1 leverage with the treasury and the PE splitting the initial investment.

Example from the plan announced today:

“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.”

Ok, 84c might seem a little ambitious, but the question for me from this plan is who is going to buy in?

The inflationary risks in the US are high in the medium term, so why would any investor want to become more exposed to them?

Voxeu has an alternative solution published today, which is probably better from a medium term perspective: http://www.voxeu.org/index.php?q=node/3327

It is clear that there is a subsidy element of the Geithner scheme. To be sure, competition between bidders in the Geithner auction should eliminate pure profit from this dimension of the scheme. But it will not prevent the government overpaying for the legacy loans. As Colm has observed, the subsidy comes through the underpriced non-recourse debt-financing offered by the FDIC.

Here’s how it works

As Colm says, we know that there is a large gap between bid and offer prices for many of these toxic assets. The inference is that the “true” market price S is unknown – probably lying somewhere between the bid and offer prices. Such trading as is occurring is, according to the Treasury “trading at prices below where they would be in normally functioning markets.” The suggestion (“private sector price discovery” is being made that the auction process will determine a fair market price. (“Private sector investors competing with one another will establish the price of the loans and securities purchased under the program.”) But will it?

After all, what is being auctioned is a call option on the toxic assets with an option price of 0.143X, where X is to be the strike price. When the auction establishes X, the government will then pay the bank X for the assets.

In contrast to a normal option market, where the strike price is fixed, and the option price determined be supply and demand, this is a very distinctive type of market-clearing process. Here, a change in the option price automatically changes the strike price.

We know from option price theory that the price which the market will pay for this option will depend on the relation between the strike price X and the current asset value S, and on the uncertainty/variance surrounding this price. Only for a particular value of this variance will S=X. If the variance is higher, the auction price X will be higher, and therefore the Government will overpay.

But the uncertainty surrounding the future value of these toxic assets is very great. Hence the likelihood that the Government will overpay is also high.

There is a real danger that we could get lost in the technical details of the “new” Geithner plan. Krugman cuts through the mist of the finance to highlight the key issue:
“The Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets. . . No amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.”

Maybe the benefit of it is that it helps avoid the ‘moral hazard’; i.e., it makes it more likely that if the loans are collectable, they will be collected upon. If the loans were simply taken over by the government, there would be a higher probability that they wouldn’t get collected on at all.

The S&P Financial index closed up 17% this evening. So Wall St. (or what’s left of it) seems happy with the plan, insofar as they have worked out what the plan is..

But it does, as Brendan points out, point to general opinion that this is a much better deal for the Troubled Institutions (formerly known as Banks) than for the taxpayer.

Thanks Colm. Your point — “I suspect that 85% non-recourse lending to distressed-asset hedge funds is not available at non-stratospheric prices right now” — is indeed crucial here and one that I should have emphasised in my post on this. I was focused on the mechanics of how the non-recourse leveraging element of the Geithner plan boosts expected returns for private equity and so I only briefly mentioned the low-interest loans. Of course, perhaps the hardcore believers in these plans might argue that private investors unwilling to offer low interest rates on 85% non-recourse lending to buy toxic assets are just “mis-pricing risk” but I think we know that’s not true.

The Feds are conducting an unneccessary experiment: if you give Wall St. lots of cheap leverage, we know might they pay over-the-odds prices for dodgy assets. The Paulson version of this wheeze had the virtue of disintermediating Wall St. and buying the stuff directly. The only solid point against temporary nationalisation (or a Paulson State vehicle) is Antoin’s: which structure maximises collection of the bad debts?

All inflation is a way of transferring money’s worth from one or more classes to one or more other inflation wiser classes. As more and more become wise to this we can expect the “miraculous” benefits of inflation to appeal less and less often. Re-inflating may succeed but for a generation or so, (definition of that is interesting) expect the suckers to be unenthusiastic.
As re-inflation is inflation in action and on cocaine, of course the details are fudged and the claque of pundits will bay ever louder, it is necessary as otherwise the fleeced might object to the outright theft.
Some of the pundits above belong to this claque as they find inflation necessary, they may justify it intellectually, but they and theirs benefit by inflation. Go ahead, poke with a stick and stand well back!

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