Geithner's Doomed Bailout Plan

Finally, the bank bailout plan has been released. There are still details to be filled in, especially as regards its second leg, the expansion of TALF. But the big-picture takeaway is simple: the government needs at least $1 trillion, and probably much more, just to make a dent in the problem of the banks' toxic assets. (The term of art is now "legacy assets", actually.) But there's no way in hell that Congress would agree to spend even $100,000 on a bank bailout right now. So the government has to come up with some way of taking the $350 billion in already-approved TARP money and multiplying it.

This plan is the government's preferred solution. It decrees the TARP money to be "equity", and then goes off to the FDIC to provide "debt". Both of these sources of funds are US government risk capital which will be used to buy up toxic legacy assets. There's no economic reason to make the debt/equity distinction. But there is a political reason: Congress would have to approve any more equity spending, but FDIC guarantees can be issued to an unlimited degree without Congressional approval.

The problem with this approach is that it's needlessly expensive. What kind of yields will investors demand on FDIC-insured debt from a Public-Private Investment Fund? My guess is that they'll be at least 100bp and possibly much more than the yields on Treasury bonds. But because of all the political sillybuggery involved here, the government can't just issue debt to fund this program, and needs to come up with a way of pretending that it's in fact Public-Private Investment Fund debt being issued with no more than an FDIC guarantee. (I think that the FDIC will not charge any money for this guarantee, but that's unclear.)

Why is the FDIC being dragged into this? You might well ask: I always thought that the job of the FDIC was deposit insurance, not guaranteeing loans to Public-Private Investment Funds. But I suppose that the government can't be too picky right now about where it's getting the necessary billions.

What's more, there's no indication whatsoever that this whole scheme will, you know, actually work. Private-sector investors want to pay as little as possible for these "legacy assets", in order to maximize their returns. But the banks will not sell any of their legacy assets unless they can do so at a price close to the level to which they've already been marked down. Is there any reason to believe that there's a private-sector bid out there for legacy assets at their current marks? Not really. But if there isn't, the banks will simply refuse to sell, and there won't be any money or assets changing hands at all.

So color me highly disappointed in the whole thing. Here's Tim Geithner himself:

The depth of public anger and the gravity of this crisis require that every policy we take be held to the most serious test: whether it gets our financial system back to the business of providing credit to working families and viable businesses, and helps prevent future crises.

Does the plan as presented today pass this test? In a word, no. Sadly.

Comments

[CJJ:]

In the long run I wonder if they'll ever be able to tell how much money bloggers and economists end us costing the US Taxpayer and how much money they end up making for the private investors that are going to absolutely clean up with these "toxic assets".
Can't find a price, wah, blah, wah. You can't find a price when you keep telling everyone the price is 0. You can't find a price when there is no market to price them.
If anything this plan will price the assets and I don't really care if they are low or high. All this discussion about how you can't price them is like saying you don't want to even attempt to solve the problem because its too difficult.
I wish this plan allowed the ordinary person with some savings from getting in on this. I'd happily take the 10%+ returns this will be returning.
For the bloggers and the naysayers, keep editorializing, keep being slaves to the money, and keep on keeping on. You are helping make many many people rich, just probably not the people who particularly need it or who you think you are helping.

Mar 23 12:56 PM

[Boat52:]

The private investors can use this for their portion of the purchase

216.157.72.247/wp-cont...

Mar 23 01:00 PM

[William Cowie:]

The question nobody is answering: why don't we simply do another Resolution Trust Company? That worked. Just do it again. Push borrowers to default or get current. If they default, the RTC buys the property and sells it when the market picks up again. It's simple. Everyone understands it. And it has a track record of working - putting paid to all the debates and talk shows, fretting and wondering how much more this will cost.

I'm not given to conspiracy theories, but I'm beginning to get a sneaky suspicion that this bailout is for the bankers' benefit. Like Krugman said, they bet their banks on the health of the loans. They lost. Time-tested logic says there has to be a cost to them, or this will happen again. Why, the people who created this mess haven't even been fired. Is this because they gave billions of dollars in PAC ,money, or why are they being so coddled this time round?

Either the Obama administration is in over their heads or they have been bought. There is no other explanation for what's happening.

Mar 23 01:08 PM

[freeeee:]

Actually, depends on who is running it, you might see them pay VERY HIGH prices for the toxic assets.

If they have it on their balance sheet over marked, they can save themselves by ponying up a few bucks so they can control 12x that and overpay for assets (again) but this time with (new) taxpayer's money. And if they're really smart the money they put into the equity bucket will also have come from taxpayers via tarp in the first place.

It's sort of like Geithner's logic of solving AIG's bonus problem by reducing the $30 billion by $165m. What kind of logic is that?

Mar 23 01:17 PM

[Paul H. M.:]

Looks like the markets all around the world liked this plan.

Mar 23 01:25 PM

[bartpr:]

this is going to be a competitive bid process. banks have to dump these assets to be going concerns. if they dont like the price let them eat crow. those who are willing to cooperate will be successful. remember that the values of the underlying real estate are 60% good. this will be discounted for individual risk of likely maturity. the securities with too high risk will not be transacted. just saying a program will not work is not enough. give your thought on a beeter approach.

tired of the critics with nothing but hot air to offer.

Mar 23 01:29 PM

[Mad Hedge F...:]

I’m sorry I’m late getting my comments out today, but I had to get my application in to manage the Treasury’s latest $1 trillion bailout program. They’re due April 10, and I wanted to get mine in ahead of Black Rock’s and PIMCO's. I only have to show $10 billion in assets under management and the ability to raise $500 million. For this, the FDIC will effectively lend me interest free long term loans to buy all of the toxic assets I want at deep discount prices with 6:1 leverage. I’m sorry, but I can’t resist those “heads I win tails, you lose” trades the Feds are offering, hence the rush. This certainly takes nationalization of the banks off of the table, and makes those buyers of Bank of America (BAC) two weeks ago at $2.50 look pretty smart. The government has now shot its wad, and there is really nothing else they can do now but sit back and pray until the $3 trillion in stimulus/bailout/reliq... they have committed to starts to work.

Mar 23 01:30 PM

[abeoman:]

How else is government going to yield a say in financial regulatory reform if it does not entice Wall Street to the table and have a stake in it directly? This is not what we want on Wall Street - we enjoy our independence from Uncle Sam, but the risky carrot is out to bring the cash from under the mattress to be matched by government ( in part) and make "toxic assets" disappear.

The question now becomes what will the next problem be that Wall Street will fuss about...if toxic assets are temporarily relieved.

The govt. is essentially following the money here.... Get the funds, retirement plans and hedge funds involved and then weaken the dollar to attract foreign investment. Show me a business commitment to match this anywhere in the world........

Mar 23 01:54 PM

[Tesa:]

Its good to know that "ironic" itself would be matter of future speculation of market full of speculators!.

On Mar 23 10:57 AM Kevin Walmsley wrote:
> The irony is that it won't work anyhow

Mar 23 02:06 PM

[Tesa:]

Why not.. The street's game is to seek maximum gain but pass maximum losses to counter parties. They don't care about the health of the overall markets. That's why they can not save the system.

On Mar 23 12:05 PM User 143167 wrote:

> Why can't a bank just set up a fund to bid its own toxic assets at
> a high price and let the taxpayers (FDIC in this case) pay for it
> eventually? There is clearly an arbitrage opportunity.

Mar 23 02:11 PM

[Mr. Big:]

To me, the whole situation is simple.

These toxic assets represent massive exposure. The banks are holding them at above market value and therefore there are hidden (and potentially massive) losses associated with these assets. So....let's cut to the chase here..... the real question is: WHO WANTS TO TAKE THE HIT?

1) Private Investors
2) Tax Payers
3) Banks

Private investors will never voluntarily enter into a transaction knowing they will be absorbing losses on a present value basis. In fact, they would not enter into a transaction even if they expect to break even. They will only enter if there was potential for profit on a risk-adjusted basis. By introducing the concept of the private investor into the bailout equation, Geithner has just made the cost of the bailout a lot more expensive, because now he has to worry about generating a return for the private investor.

That's why I am surprised that Geithner even conceived of this idea. Did he expect private investors to be charitable? Did he expect private investors to take a hit so that banks don't have to?

Where's the logic in the whole plan?

Mar 23 02:12 PM

[Chris B:]

The reason banks are refusing to dispose of these so-called "toxic" assets is because they know that the assets, particularly mortgages, will return more than the thirty cents on the dollar that the market is currently offering. Even if mortgage default rates double and hit 15% and the resulting forclosure sales yield 100% losses, that's still a 0.85 on the dollar return of capital over time. The banks know this, and are fighting to hold onto these assets rather than being forced to dispose of them (and recognize losses) for 0.30 on the dollar. One way of looking at the credit crunch is that banks are hoarding cash and avoiding new lending so that they can recognize gains on the MBS later.

That said, government budget hawks should be arguing that the banks should be forced to sell these assets to the government in order to restore their capital ratios (at 0.30 or so on the dollar!). The 50-100% gains that could be realized by the government a few years later would go a long way towards paying down the national debt, which has recently been refinanced at basically zero real interest rates. Plus, the banks would be out of their current zombie state, and back to lending, which would raise more tax revenue.

Doing this AND... repeat AND balancing the budget in the future would be our best hope of knocking down the national debt AND enjoying economic growth. I'm not sure we have the political courage to do it.

Mar 23 02:20 PM

[DougM:]

jr007 you forgot a few more losers - younger potential buyers for those homes, renters, etc. All to bail out the bond holders of failed financial institutions, letting them keep the higher yields they reaped over the past 10+ years and the big bonuses they paid themselves for outperforming the artificially-low (Greenspan) "market" interest rate.

Mar 23 02:27 PM

[PROXIMO:]

Hot Richard---I am not certain that bigger government is the goal. Although I do believe it is the inevitable outcome.


On Mar 23 11:47 AM Hot Richard wrote:

> Before you claim the plan to be doomed, shouldn't we know the real
> goal of the plan. I am suspicious that it is NOT to stimulate the
> economy. In this much, it will be a success. The end result will
> be a weakened dollar (great for a nation with massive debt valued
> in dollars) and much, much, much larger government payrolls and regulation
> authority. In this much, it will be a success.
>
> I support none of this, but let's be clear about what the real goal
> is here.

Mar 23 02:43 PM

[mr clark:]

thank u hot richard, people often overlook the obvious for much more complicated scenarios

Mar 23 02:48 PM

[David Braun...:]

Although detail are to be forthcoming, I expect the "legacy assets" will be pooled into securities and sold to investors via a prospectus cheat sheet. In order for this plan to succeed, the Government must guarantee a minimum return to investors. For example, they could give investors a minimum guarantee of 85% of the purchase price of the pool. Investors then take 6% of their own equity and borrow the rest with a government backed loan to purchase the pool.

What's not to like. The banks will lend because they are taking no risk. Investors will buy the "legacy assets" because their only risk is making 2% over 10% before leverage. The deal will likely be sold as some type of closed or dutch auction. That way these troubled assets are sold for the highest price. The price sold will likely be more than the bank's written down value. The banks win because then they not only get the bad stuff off their books, but they also get a write-up in capital from the sale.

The government wins as it does not have to put up much capital initally. It will address problems in the future as they happen. Some of these loans are in excess of 20 years. There will not likely be an active secondary market and if there is one, it will be razor thin. Investors will have to hold their pool to maturity to prove up a loss to the government as the Fed's are not likely to pay up for a loss in the secondary market.

More problematic will the covenents on the loans defining default to the banks. When and how does the bank collect on the bad loan? Does the bank also have to wait until the security is completely worthless (in some cases more than 20 years) to get the government guarantee?

Eventually the tax payer takes the hit, but it will likely be our children who suffer. Also there is a moral delima. The government is using leverage to get us out of the same situation that too much leverage put us in. The government is talking about 10 times leverage. Is that a good thing?

Mar 23 03:48 PM

[freeeee:]

Just because they think it's worth more than 30c doesn't make it so. If they really believed that they should dispose of every other asset out there and buy everything up at 30c.


On Mar 23 02:20 PM Chris B wrote:

> The reason banks are refusing to dispose of these so-called "toxic"
> assets is because they know that the assets, particularly mortgages,
> will return more than the thirty cents on the dollar that the market
> is currently offering. Even if mortgage default rates double and
> hit 15% and the resulting forclosure sales yield 100% losses, that's
> still a 0.85 on the dollar return of capital over time. The banks
> know this, and are fighting to hold onto these assets rather than
> being forced to dispose of them (and recognize losses) for 0.30 on
> the dollar. One way of looking at the credit crunch is that banks
> are hoarding cash and avoiding new lending so that they can recognize
> gains on the MBS later.
>
> That said, government budget hawks should be arguing that the banks
> should be forced to sell these assets to the government in order
> to restore their capital ratios (at 0.30 or so on the dollar!).
> The 50-100% gains that could be realized by the government a few
> years later would go a long way towards paying down the national
> debt, which has recently been refinanced at basically zero real interest
> rates. Plus, the banks would be out of their current zombie state,
> and back to lending, which would raise more tax revenue.
>
> Doing this AND... repeat AND balancing the budget in the future would
> be our best hope of knocking down the national debt AND enjoying
> economic growth. I'm not sure we have the political courage to do
> it.

Mar 23 04:12 PM

[Azoth:]

I wish to cite a highly probably scenario under the plan described by Geitner:

Consider two banks A and B. Each with 50 Billion dollars of Toxic Waste(TW) (aka stupid bets placed by their bookie (CDS dept.) or MBSs bought by their real estate broker) and 5 Billion of TARP money.

On Monday, Bank A either directly as an investment or indirectly through a ETF, hedge fund or other vehicle pays 100 Billion dollars for bank "B"s TW . They pay 100 Billion because they believe that they are undervalued and it is a fair price and hence they don't want too lose this opportunity. As luck would have it, bank thinks the the same about "A"s TW. Hence it pays 100 Billion dollars for bank "B"s TW .

Buy the middle of the week, both bank A and B figure out what they just bought was garbage and really only worth $0 . Since 95 Billion in each case was borrowed according to Geitner wonderful plan, both banks only need to record a loss of 5 Billion dollars along with a gain of 100 Billion for the TW that they each just sold.

On Friday, both banks now have recorded net profits of 95 Billion dollars, which they promptly decide to invest in something safe like Chinese MBS. On the other hand, I and my family now can look forward to an additional 190 Billion dollars of debt so that the finance division banks A and B can party like their is no tomorrow (for America).

Please tell me why something like the above cannot happen. If it can happen, please tell me why I as a citizen have any interest in supporting this.

Would it not be better to let bank A and B go bankrupt. Move their current deposit accounts to smaller banks that acted prudently during good times, and stuff half of the above amount ( at 0% interest rates) into their coffers to grease the wheels of the transition.



azothstone.blogspot.com/

Mar 24 04:55 PM

[Azoth:]

I wish to cite a highly probably scenario under the plan described by Geitner:

Consider two banks A and B. Each with 50 Billion dollars of Toxic Waste(TW) (aka stupid bets placed by their bookie (CDS dept.) or MBSs bought by their real estate broker) and 5 Billion of TARP money.

On Monday, Bank A either directly as an investment or indirectly through a ETF, hedge fund or other vehicle pays 100 Billion dollars for bank "B"s TW . They pay 100 Billion because they believe that they are undervalued and it is a fair price and hence they don't want too lose this opportunity. As luck would have it, bank thinks the the same about "A"s TW. Hence it pays 100 Billion dollars for bank "B"s TW .

Buy the middle of the week, both bank A and B figure out what they just bought was garbage and really only worth $0 . Since 95 Billion in each case was borrowed according to Geitner wonderful plan, both banks only need to record a loss of 5 Billion dollars along with a gain of 100 Billion for the TW that they each just sold.

On Friday, both banks now have recorded net profits of 95 Billion dollars, which they promptly decide to invest in something safe like Chinese MBS. On the other hand, I and my family now can look forward to an additional 190 Billion dollars of debt so that the finance division banks A and B can party like their is no tomorrow (for America).

Please tell me why something like the above cannot happen. If it can happen, please tell me why I as a citizen have any interest in supporting this.

Would it not be better to let bank A and B go bankrupt. Move their current deposit accounts to smaller banks that acted prudently during good times, and stuff half of the above amount ( at 0% interest rates) into their coffers to grease the wheels of the transition.



azothstone.blogspot.com/

Mar 24 04:55 PM

[monday1929:]

Thank you, Mr. Bernanke.


On Mar 23 11:08 AM jr007 wrote:

> The point that most wealthy and anti-Obama folks a seem to be missing
> is that the Real estate in question has intrinsic value. When the
> "inflation effect" of all this money being printed, hits the street...real
> estate will be one of the beneficiaries..along with equities, commodities
> and metals etc. The upside down homers will have their perserverance
> rewarded.
> The losers will be bonds, fixed income and cash just to name a few..along
> with those who have financed the debt. I for one would rather deal
> with inflation ...than recession or depression.

Mar 25 08:15 AM