Anatomy of a Giveaway, Or Why Stocks Soared Yesterday

The stock market’s positive reaction—best 10-day gain since 1938—should leave no doubt about Geithner’s bank rescue plan: it’s a mammoth taxpayer giveaway to investors. Or so the market believes it’s going to be. Forthwith, a tutorial for those not quite clear about the mechanics of the giveaway.

(At the bottom, there’s an extra credit question. And there’s a prize for being first to get it right!)

Having taxpayers absorb the banks’ bad assets means equity holders are no longer in line to eat those losses. Take Citigroup (C) stock for example. At $1 a share, C’s shareholders were essentially buying a call option on the possibility that the government would rescue them from their bank’s terrible mistakes. It’s a small bet with potentially huge upside.

On a stand-alone basis, the bank is insolvent. Its equity is worthless and much of its debt would be in line for a huge haircut. But if the government is going to absorb the bank’s toxic assets, then suddenly the balance sheet looks a heck of a lot better.

A busted bank balance sheet is very similar to an upside down mortgage. Understanding the mechanics of the rescue is to understand why equity is miraculously increased…

OA’s erstwhile example uses an imaginary condo buyer, who in 2006 plunked down $1 million for a phat pad that in 2009 is only worth $500k. His original equity investment was his $50k downpayment; the other $950k was financed with a mortgage. The condo buyer’s before and after balance sheet looks like this (recall assets = liabilities + equity):

Condo Buyer, 2006—$1m condo = $950k mortgage + $50k downpayment.

Condo Buyer, 2009—$500k condo = $950k mortgage - $450k equity

This is what it means to have “negative equity.” The value of the asset isn’t high enough to pay off the liability, so equity is negative. Someone has to eat the loss. It should be the bank. After foreclosing on the buyer (assuming he stops paying his mortgage), the bank has to sell the house at the $500k market value and write off the $450k portion of the mortgage it’s never going to collect.

So here is the bank’s balance sheet:

Bank, 2006—$950k mortgage loan = $400k consumer deposits + $400k debt + $150k shareholder equity.

Bank, 2009—$500k mortgage loan = $400k consumer deposits + $400k debt - $300k shareholder equity.

The bank’s stock is just a single share of its total equity. If equity is negative, then the stock is $0. In the example, there’s still $300k of losses to absorb after equity is wiped out. This puts the bank into bankruptcy, where creditors have to fight it out to determine how they’ll share the losses.

But the bank hasn’t been forced to write down the value of the mortgage just yet. It hasn’t foreclosed on the home just yet, so its day of reckoning is delayed. The market knows the writedown is coming, so the stock trades at a paltry sum, probably $1 or less. Why does it have any positive value? Because it’s possible the government will still rescue the bank.

To do so, the government has to do something about the toxic asset on the left side of the equation. This is how the Geithner plan miraculously repairs the bank’s equity. Using government money, he creates a brand new balance sheet to buy the $950k mortgage from the bank at close to that price.

The Fed prints money to buy Treasury bonds–>the Treasury uses proceeds of the bond sales to finance its public-private partnership vehicle–>the vehicle buys the toxic asset, the mortgage, for $850k let’s say.

Here is the vehicle’s balance sheet:

Vehicle, 2009—$850k mortgage = $720k FDIC debt + $65k Treasury equity + $65k private equity.

Having paid $850k cash for the bank’s mortgage, suddenly the bank’s balance sheet is rescued:

Bank, post Geithner plan—$850k cash = $400k deposits + $400k debt +$50k equity.

Suddenly the bank again has positive equity value. Shareholders are saved! The stock market skyrockets!

Ah, but like a good economist, you note that there’s no free lunch. The condo is still only worth $500k. Who eats the additional $350k loss? Well, you do.

Vehicle 2010—$500k mortgage = $720k FDIC debt - $220k Treasury equity + $0 private equity.

The money loaned to the vehicle is non-recourse, so the private partner stands to lose no more than his initial investment. It’s Treasury and FDIC, i.e. you and me, that ends up eating the loss.

And that’s how you use taxpayers’ money to rescue a bank.

———-

Extra Credit: As you can see in examples of the Vehicle’s balance sheet, private investors stand a good chance of being wiped out. Assume the asset will decline to $500k, and that the investor knows it will. Why might he be still be willing to lose money investing in the equity of the vehicle?

(Assume they have to hold the asset. They aren’t able to flip it to someone else.) Hint: all the information you need is in the balance sheet equations above.

There is a prize for the first person to answer correctly in the comments. The answer, and the winner, will be announced in tomorrow’s links.

Comments

[Dave Wrixon:]

Because they end with a massive cheap loan from FDIC which is discounted to market by more than the equity they put in the first place.

Mar 24 04:59 AM

[rven:]

What if the investor was the bank itself. They lose 65k and get back 350k.
Bank+investor: 850k(from vehicle) - 65k(to vehicle) = 785k

Mar 24 05:04 AM

[Dave Wrixon:]

Ah, well the old maxim there is no such thing as a free lunch obviously doesn't apply to Wall Street. I guess Goldman Sachs will be using their inside channel to line their own pockets.

Mar 24 05:05 AM

[Dave Wrixon:]

Yep, that has to be it. So really it is just the dime and three egg cups trick all over again.


On Mar 24 05:04 AM rven wrote:

> What if the investor was the bank itself. They lose 65k and get back
> 350k.
> Bank+investor: 850k(from vehicle) - 65k(to vehicle) = 785k

Mar 24 05:13 AM

[BidEd:]

Not sure if this is what you are looking for but here is what I see.

The private investor knows his max loss will be 65k using your example. The Treasury (ie tax payer) will suck up all the rest of the losses beyond that initial investment. However, the underlying asset that the investor still owns (50%) would have to decline basically 85% form original value for his share to be worth what he originally put up. That assumes that the Treasury and FDIC will eat all the losses beyond the private guys original investment upon liquidation of the underlying asset and the proceeds would be split 50-50.

So the investor has minimal downside risk considering that the majority of the risk is laid off to other side, Treasury (ie taxpayer)after the initial investment. So if the asset is sold for 500k and the proceeds are split 50-50, the private guy just made nearly 3x his original investment even with it selling it at a 41% loss. The taxpayer isn't as fortunate.

Hope that is what you are looking for. The private guy puts up 7.6% and the Treasury/FDIC takes the bulk of the risk. If the proceeds from disposal are split 50-50, I would put up 7% knowing that the underlying asset would have to drop 85% for me to breakeven.

Heck, as the Treasury is hoping, I would even overpay for that opportunity if the system is indeed set up that way.

Mar 24 05:22 AM

[Jeff Buckley:]

The assets that will be purchased represent homes that have to be sold, or homes that are already owned?

Mar 24 05:23 AM

[Moon Kil Woong:]

You left out the part where all the other banks then get to claim their $500k investment is now worth $850k due to the twisted logic of a manipulated mark to market. Now aren't we all feeling rich?

This process is a method for fraudulently altering banks balance sheets through asset pricing manipulations. It's shoddy and quite obvious.

Mar 24 05:34 AM

[Dave Wrixon:]

> This process is a method for fraudulently altering banks balance
> sheets through asset pricing manipulations. It's shoddy and quite
> obvious.

Now I am reassured. Finally we are back in familiar territory.

Mar 24 05:43 AM

[KSengineer:]

The only way for everyone to come out a winner is if the asset value eventually returns to it's full price. Since the government probably can not cause another credit bubble to push prices back up, the tool they have control over is inflation. Just hold the asset for a few years while Ben inflates the currency. The private investor wins big. The government escapes it's debt. The big problem is dealing with our foreign investors. Maybe that's why the Chinese are currently buying up California real estate by the bucket load.

Mar 24 07:08 AM

[APM:]

As indicated by the last equation of Vehicle 2010 ...

Vehicle 2010 — $500k mortgage = $720k FDIC debt - $220k Treasury equity + $0 private equity.

The loss of the private and public equity will have be instantly recognized if the vehicle needs to mark-to-market of their investment. But why would they do that? As long as the creditor (FDIC) is not in a hurry to liquidate the vehicle and recover its loan, the vehicle will just live on.

So although in reality, the private and public equity is wiped out on day one, but on paper, the vehicle will still survive. As a result, instead of zombie banks, we have zombie vehicles.

Without the pressure of being forced into bankrupt, the zombie vehicle will be collecting the interest payment of the mortgage. Given the amortization structure of a mortgage, the private/public equity will enjoy some handsome returns on their investment in the first couple of years. After the initial investment is paid back, the equity portion of the vehicle will enjoy net-gain interest income in the years to come.

Due to inflation, or even high inflation, the collateral (the house) will eventually worth its claimed 850K in the market. That's when the mortgage will be dumped back to the private market, and everybody (FDIC, Treasury, private investor) gets their money back.

The (unlikely, but possible) risk here is what if the deflation continues in many years to come and the house never gets back to its 850K paper value again? Well, the vehicle will just hold the mortgage until maturity. The private equity, once made its 65K investment back from the interest income, all the future cash flow will be positive. The treasury, as an equal partner, will show the same cash flow to the public, and claim the tax payers are making a profit on the deal also.

But nobody will talk about the opportunity cost of the FDIC loans, which at the end of the day, coming from the pockets of tax payers also. The FDIC is losing money since day one, in the form of offering a extreme low cost loan in a inflationary environment.

So back to the Extra Credit question ...
Assume the asset will decline to $500k, and that the investor knows it will. Why might he be still be willing to lose money investing in the equity of the vehicle?

Answer: They won't lost money, because the vehicle will not be forced to liquidate. They will most likely get their money back and make more in short time, by collecting the interest payment collected from their investment in the 14-times leveraged vehicle sponsored by the federal government.

Mar 24 08:26 AM

[kotika98:]

this analysis is right only in spirit, even though it offers up a long winded numerical example. Of course it is the taxpayer who is stuck with the losses, we knew that all along, since October at least. But the particulars are not correct. I think the assets are going to be sold for cents on the dollar, meaning less than the 500K in your condo example. Why would the bank agree, you ask? It gets a clean balance sheet, and sudddenly their equity is worth something. Most importantly, from the management point of view, they get to keep their job and to go back to normal. Thats what they call a "win-win-win" situation, except of course it is paid for with taxpayer money, though not precisely in the way Rolfe described it.

Mar 24 09:28 AM

[kotika98:]

by the way, it is this "back-to-normal" scenario that Krugman so much hates... he would like to see the government to run the banks directly for many years to come, and thats just not going to happen with the new Geithner plan.

Mar 24 09:30 AM

[User 357469:]

Dave Wrixon,

I'm sure I speak for a lot of people here when I say that I am getting rather tired of looking through an article's comments and seeing such a large percentage of them coming from you which have no real content. So far this article alone has only 17 comments from SA members yet 9 of those comments are from you with 3 or 4 of them actually duplicates. Have you nothing better to do with your time?

Mar 24 10:40 AM

[User 357469:]

In order for asset values to return to even close to their previous highs there would have to be a significant increase in demand for those assets. With increasing unemployment, a general lack of liquidity and a tightening up of credit facilities, that is not likely to happen for many years to come. In fact the asset market has not yet fallen to even close to what it will within the next several months. This current rise in the markets is only a small teaser to sucker a few more people into believing that it is back to business as usual so that those with hard assets can sell them. They know it is not business as usual. Smart companies and individuals are preserving cash not spending it because they know that the worst is yet to come.

On Mar 24 07:08 AM KSengineer wrote:

> The only way for everyone to come out a winner is if the asset value
> eventually returns to it's full price. Since the government probably
> can not cause another credit bubble to push prices back up, the tool
> they have control over is inflation. Just hold the asset for a few
> years while Ben inflates the currency. The private investor wins
> big. The government escapes it's debt. The big problem is dealing
> with our foreign investors. Maybe that's why the Chinese are currently
> buying up California real estate by the bucket load.

Mar 24 11:53 AM

[Kup:]

The payments made to the equity investor on the assets held, which go to them in their entirety, will far outweigh the loss/chance of an equity loss.

Mar 24 01:53 PM

[streamforty...:]

The investor is buying NOLs (Net Operating Losses) which are tax losses for (effectively) pennies (or fractions of pennies) on the dollar. NOLs can be used to directly reduce gross income, so if I buy $1 million of NOLs for (say) $1000, I can take $1 million of gross income, subtract the NOLs of $1 million which I bought for $1000, end up with no gross income, and no tax liability. It's kind of like paying $1000 tax on $1 million of income...

Mar 24 09:18 PM

[monday1929:]

"Shoddy and Quite Obvious"- A good description of our Age ?


On Mar 24 05:34 AM Moon Kil Woong wrote:

> You left out the part where all the other banks then get to claim
> their $500k investment is now worth $850k due to the twisted logic
> of a manipulated mark to market. Now aren't we all feeling rich?
>
>
> This process is a method for fraudulently altering banks balance
> sheets through asset pricing manipulations. It's shoddy and quite
> obvious.

Mar 25 07:59 AM

[Between The...:]

I think Rven was closest so far, but let me take it a step farther:
One does not even have to be the bank itself for this to work, just a bank equity shareholder! As per the equations above, the 65K investment yields a change of +350K for the equity holders, a ratio of 5.4:1. I'd even be willing to pay the full 950K, as every marginal $1 paid for an asset flows directly to shareholders while the vehicle equity holder need only put up 7.6 cents. More losses (complete loss) in the equity tranche are *good* for me, as that means the bank was overpaid by that much more and my bank equity holding goes up by that much.

I could also be a bank debt-holder looking at a 75% haircut (and now made whole), or even an issuer of CDS on the bank debt staring a $0.25 settlement value situation ($0.75 liability)!

Mar 25 09:52 PM

[Between The...:]

Also, it seems the other comments may be missing the point of this giveaway. Yes, it is a sweet deal for an investor to get levered, non-recourse financing, and there exists a chance to make a killing on the right assets. However, as Reggie pointed out:
seekingalpha.com/artic...
It isn't as great an upside as one would think, and the banks will be unwilling (unable) to sell at the prices that would leave lots of upside for investors because it would force them to take immediate large losses. Banks that sell even a small piece of their assets book-valued at $0.75 for, say, $0.40, face an immediate book loss of $0.35 on all of the other assets if marked-to-market.

No, this plan is primarily about figuring out a way to overpay for weak assets and have that non-recourse loan kick in as a back-door re-capitalization giveaway to banks. Maybe Timmy G. isn't the fool we are making him out to be, as this is actually a quite subtle and creative plan to move 220k from the Treasury to the bank without fomenting the lynch-mob that would form were he to just give the cash directly.

Mar 25 10:02 PM