Geithner's Plan: A Look at the Options

Last September I had a conversation with someone knowledgeable about buying toxic assets. I figured if Morgan Stanley sold those assets at 22 cents on the dollar, well, there had to be bargains. He told me to forget about it. First, that 22 cents was for a CDO and the price that I had in my head was miles short of what the US Government "might" pay.

In December I saw him again and I asked, "So how come the few transactions that happened with AIG under the Maiden Lane program looked to be for about the price I was thinking about?"

I was told, "Well that was a forced sale, there was no option for AIG, and in any case that was just one government department buying something from another government department. Sure, if you could buy at that price, it would be a steal. But you can't."

So what's going on?

Transactions happen in markets when buyers and sellers agree on the value of things. The "problem" right now is that the owners of "toxic assets" think that these assets are worth more than their auditors, the bank regulators, and potential buyers think they are worth.

Another (linked but separate) problem is that until buyers and sellers reach an agreement on what is the right price, the economy will continue to suffer, because credit will not be available, and all economies need credit to work.

Of course that's not the only reason that the economy is suffering, the other reason is that in the not too distant past, a good proportion of Americans (and others) bought assets at twice the price they are worth today (or thereabouts). Many are now broke; many more are feeling sorry for themselves, ditto anyone who was foolish enough to lend money collateralized by those assets with the "L" in the LTV (then) worth more than the "V" (today) [LTV= Loan to Value]. But that's another story.

Mexican Standoff

For expediency, I call "the government" the whole infrastructure including the regulators and the auditors who work under the direction of "the government".

The state of play right now is that the "sellers" have been forced to write the assets down to a price that the government thinks is "fair".

This may or may not have been a good thing, but the result is that under the government's rules the sellers are now severely constrained in how much lending they can do, or in the case of companies with long obligations like AIG, how many assets they could snap up at bargain basement prices, which is what they would normally be doing now, if they weren't broke.

So whether it was "right" or not, on the surface that was counter-productive in that it moved the government further from it's goal rather than closer.

The important thing is that the "sellers" haven't got anything more to lose; some are bankrupt, some are partially (or effectively wholly), owned by the government, some are "technically" insolvent and hanging on by a thread. But the government has implicitly or explicitly guaranteed that so long as they pass a "stress test" they will be supported (and if they don't well they will be toast - game over).

So the sellers have as much time on their hands as a death row inmate - secure in the knowledge that you can't execute someone twice.

The government is not proposing to make the "sellers" write down their assets any more than they have already; and they (the sellers) are pretty sure than in a year or two, the assets in question will be worth more than the government has forced them to write them down to. (They may of course be wrong - they have been known to be wrong in the past).

The government does not have time however, at least if it wants the economy to recover any time this century.

So that's a Mexican Standoff, the sellers know that the potential buyers are running out of time, so they wait. That's normal.

What are the options?

OPTION 1: The government can put together a scheme where they pay too much.

That was the original idea behind TARP, which didn't work because there wasn't anything like enough money. The difference between that scheme and the new plan is that by bringing in the private sector and providing a structure where the private sector are guaranteed to make profits, and the government will effectively guarantee (a) any losses, plus (b) a healthy profit to the private investors, so there ought to be enough money, regardless of the price that is paid.

That makes some sort of sense, and there is a consistency in that approach. After all, governments always pay too much, from $30,000 screwdrivers; to $700 billion to find out that there were not any WMD in Iraq; to the settling up of AIG counter-parties where they paid 100 cents on the dollar when the counter-parties would have settled for 50.

And sure the politicians stand up and make a nuisance of themselves grandstanding about pennies, but once the money is out of the window, well, it's hard to get it back.

Whether it is a good idea to mortgage the future of the grandchildren of ordinary Americans to achieve this objective, is of course politics.

One argument for that idea is that the plan will be profitable to the government in the end, although sadly history does tend to show that if you pay too much for something you generally lose money in the end, and if you borrow to pay too much for something, you lose even more. But chance is a fine thing, and as they say, history doesn't always repeat.

A possible opportunity therefore is to "join" with the government and go shopping. So long as they are taking a good part of the risk, that's as big or a bigger opportunity as signing a cost-plus contract to provide military hardware.

The problem of course is that this great plan won't in fact achieve anything (for the government), although if they are handing out "get-rich-quick" passes, who cares?

The reason it won't work is because instead of the "ex-sellers" holding on to the assets and refusing to sell until someone pays too much, private investors will be holding on to them and refusing to sell until someone pays too much, plus of course a margin.

It's easy to forget that the objective was to re-start the market for those types of securities, but after the private investors have bought all those assets for too much, well who will they sell them too?

And there is another problem.

The reason that "toxic assets" were so popular in the first place was that they were worth much more for the calculation of capital adequacy or solvency under the government "rules" than a simple loan. The reason for that was that they were considered "liquid".

All you had to do the get the "stamp of liquidity" was to list the things on an exchange, and in that regard (a) that was a sham, the assets were hardly ever traded on the exchange, and in fact they were hardly ever traded at all (one reason for that is that they were all slightly different), (b) more important, now everyone knows that was a sham.

So the "value" of those instruments for padding up your capital adequacy is much less than it was. That brings you back to supply and demand - who actually wants to own a toxic asset unless the government pays you to own one?

So OK it could be an opportunity, if you are not too concerned about your exit, but whether it will re-start the secondary credit market is extremely debatable.

OPTION 2: The "government" (plus it's new-found partners) pays too little.

That's a good idea, except there is just one small problem, which is how do you get the people who own the assets to sell them too cheap?

It's one thing getting them to mark those assets down to some arbitrary number based on the assumption that the market is working when obviously it's not, the government has the power to do that.

But to force them to sell too cheap, the government will have to become the owners (like it did with AIG). Of course if that happens, then there is a clear opportunity to join in the game and basically asset-strip.

But it's hard to see how asset-stripping will make more credit available, although there again if that's the deal, who cares?

OPTION 3: The "government" holds on to its money (well actually it isn't its money, but that's just detail).

That would open up an opportunity for the private sector to buy toxic assets, without the sellers saying "Buzz Off - the US Government will pay twice that (one fine day)", which is basically what they have been saying for six months.

The opportunity there would be to be able to buy toxic assets with the knowledge that there might be a chance to sell them to someone else in the future. That's how markets start.

But doing nothing is the hardest thing to do.

Of course if the government was desperate to "do something", it could actually think about doing what it was set up to do, which was not actually to become the marketplace of last resort, it was to set up rules so that the economy works efficiently.

For example it could mandate that the toxic assets are valued by an independent valuation firm using International Valuation Standards to determine their "Other-than-market-value", and allow capital adequacy and solvency to be calculated based on that not mark-to-market.

And on that basis, guarantee to be the lender of last resort, which is what it is doing anyway, so its exposure wouldn't change.

The advantage of that approach is that the market would start up, credit would become available and the time before the market-value reflected the other-than-market-value, would be minimized. Also it wouldn't cost anything more than the government has already committed.

Which option will they chose?

Well there is no talk about doing nothing or mandating that assets be valued according to the only valuation standard that is approved by every valuation institute of any consequence in the world.

So I guess it will be (1) or (2). Which means that anyone with the right "connections" can get rich ripping off the government; which is nothing new.

Comments

[Between The...:]

It was getting too politically risky to enrich only the banks, bank equity shares, and bond holders. We had to make sure the class of hedge fund managers and other private equity would be enriched as well by channeling the bailout money through them so that if there is a chance of a profit, it doesn't foolishly end up being earned by the government. I mean, what is a giveaway if you have a chance of getting some back?

Mar 24 06:29 PM

[Mad Hedge F...:]

“I said a few months ago that Washington was all in. We are now all in squared. The FDIC, Fed, and the Treasury are making a concerted effort to turn deflationary swamp water in inflationary wine.” Ah, Paul McCulley, man of Virginia, you have such a way with words. PIMCO must love you. I agree.

Mar 24 07:56 PM

[Steven Hansen:]

as a trial balloon, why doesn't the banks with the help of a pimco try to market these toxic assets inside of some etf bond fund. if done slowly (not flooding the market), they could establish a market price and the m2m problem would go away.

Mar 24 09:19 PM

[Tai Daboiku:]

You seem to have the answer to this crisis, what are you doing on the side line? Join Tim Geithner group and help us solve this problem.

Mar 24 10:47 PM

[Blackeyebart:]

CDO's were created to achieve a higher average value for a block of assets than they would have achieved separately. It worked for a while, as investors took the ratings at face value. . But now CDO's probably are worth LESS than the value of the composite parts because there is no way to prove their true value.
The obvious answer is to unwind them - but how? One way is for the Courts to force the CDO owners to sell in their holdings and to bid out for the component parts. It would be rational to allow others to bid also. The more buyers the better the price.
The key problem with this is that Institutional Owners would have to face up to the real value of their assets and this might not be popular. For the ordinary punter the liquidity benefit is probably worth the value risk. In most cases they would be better off.

Mar 24 10:56 PM

[random walking:]

Look up the symbol AGNC. Seems like there IS a market for something fairly equivalent.

Mar 25 02:54 AM

[Econ 101:]

Of course the government will pay too much. congress has to repay all those political contributions to wall street. This "crisis" was created to pay off the rich, dissove the middle class and enslave everyone else.

Government needs to shrink. Repeal the 16th ammendment, abolish the FED and the Patriot Act.

Enforce that part of the Constitution that says "The powers not delegated to the United States by the Constitution, nor prohibited by it to the States, are reserved to the States respectively, or to the people". Sometimes known as the tenth ammendment to the Constitution.

Mar 25 11:01 AM

[CaptainJJack:]

I have a number of problems with this analysis.

First, it is not at all clear to me that the banking system, in total, is lending significantly less. They HAVE tightened lending standards, but I do not think ANY program to deal with their bad loans will change this much.

I have seen no data to support the idea that banks have significantly cut back on "good" loans. This is especially true at the 1800 smaller banks.

What HAS changed is the securitization market. Further, bond spreads are very high --- but this is not part of Geithner's new program.

Second, the banking system has been in worse shape than this. After the Latin American default in the early 1980s, ALL of the major banks would have been insolvent. The things that "saved" them was forbearance by the Fed, there were no mark to market rules, and the fact that their regular business was very profitable.

Third, banks are making boatloads of money on their regular business right now. I have seen estimates that the top four banks will make something on the order of $250 billion, operating pretax. This is compared to estimated losses of $250 billion to $500 billion.

Finally, you are suggesting that banks won't sell, but I believe that the whole purpose of the stress tests is to deal with this. If the bank does not pass, it will get more capital AND there will be a discussion about the carrying values of their assets.

I believe the banks will be forced to reflect the true value (write down) of at least their marketable assets, and if I am right, I expect they will be much more amenable to an attractive bid.

Mar 25 11:10 AM

[Andrew E Bu...:]

1: You could well be right about banks lending - I don't do banks I do valuation, but there is a lot of noise about lending getting restricted although, still if that's just bad lending that's a good thing.

2: But when Nouriel Roubini says all banks are insolvent mark-to-market and pushes for mass nationalization - I'm thinking err OK but.....?

3: Yes the securitization market is stalled, as far as I ever understood this was the main driver of credit anyway, it was also the driver of capital adequacy because once loans were securitized they could be treated as liquid. I think it is quite possible it will take a long time for this to re-start as the rules about what you can do with them will change.

4: I agree with you, the banks don't look like Zombies to me

5: Sure if the government forces them to sell they will sell, but that is a terrible idea, open to corruption and is completely Stalinist.

6: I disagree that "write" down is true value - true value is what you can sell them for in two years time less the cost of carrying them.

Thanks for the comments


On Mar 25 11:10 AM CaptainJJack wrote:

> I have a number of problems with this analysis.
>
> First, it is not at all clear to me that the banking system, in total,
> is lending significantly less. They HAVE tightened lending standards,
> but I do not think ANY program to deal with their bad loans will
> change this much.
>
> I have seen no data to support the idea that banks have significantly
> cut back on "good" loans. This is especially true at the 1800 smaller
> banks.
>
> What HAS changed is the securitization market. Further, bond spreads
> are very high --- but this is not part of Geithner's new program.
>
>
> Second, the banking system has been in worse shape than this. After
> the Latin American default in the early 1980s, ALL of the major banks
> would have been insolvent. The things that "saved" them was forbearance
> by the Fed, there were no mark to market rules, and the fact that
> their regular business was very profitable.
>
> Third, banks are making boatloads of money on their regular business
> right now. I have seen estimates that the top four banks will make
> something on the order of $250 billion, operating pretax. This is
> compared to estimated losses of $250 billion to $500 billion.
>
> Finally, you are suggesting that banks won't sell, but I believe
> that the whole purpose of the stress tests is to deal with this.
> If the bank does not pass, it will get more capital AND there will
> be a discussion about the carrying values of their assets.
>
> I believe the banks will be forced to reflect the true value (write
> down) of at least their marketable assets, and if I am right, I
> expect they will be much more amenable to an attractive bid.

Mar 25 01:38 PM

[Walking:]

It was getting too politically risky to enrich only the banks...

Mar 30 02:56 PM