Stiglitz Weighs in on the PPIP (And It's Not Pretty)

Another Nobel Prize winner has joined Paul Krugman in taking a position critical of the Geithner Public Private Partnership Investment Program (PPIP). Columbia University professor Joseph Stiglitz had a strongly worded op-ed in yesterday’s New York Times (April 1).

Prof. Stiglitz does not pull any punches in expressing his opinion. He begins with:

“THE Obama administration’s $500 billion or more proposal to deal with America’s ailing banks has been described by some in the financial markets as a win-win-win proposal. Actually, it is a win-win-lose proposal: the banks win, investors win — and taxpayers lose.”

Stiglitz criticizes the plan as an extension of the high leverage philosophy of the financial sector of the past 30 years, which went parabolic in the most recent years. He uses an analogy to the options market to explain the leverage of the PPIP:

“In theory, the administration’s plan is based on letting the market determine the prices of the banks’ “toxic assets” — including outstanding house loans and securities based on those loans. The reality, though, is that the market will not be pricing the toxic assets themselves, but options on those assets.”

Prof. Stiglitz uses a comparison to call options to illustrate. In essence, his description is based on the view that, although not explicitly stated in the PPIP, the FDIC “loan” is really a purchase of assets (by the FDIC) and the partnership is essentially buying a call option (with no explicit expiration). In a comment to a Steve Waldman article I had proposed the term “Geithner Put”. This was from the view that the PPIP wrote a put (with no premium received and no explicit expiration) to guarantee the loan to the partnership. However you look at it, the leverage of options is the essence of the Geithner plan.

In a previous article I discussed the win/loss potential of the PPIP. Stiglitz uses a much simpler example (than I did) to illustrate:

“Consider an asset that has a 50-50 chance of being worth either zero or $200 in a year’s time. The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.” Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses. Some partnership!

Assume that one of the public-private partnerships the Treasury has promised to create is willing to pay $150 for the asset. That’s 50 percent more than its true value, and the bank is more than happy to sell. So the private partner puts up $12, and the government supplies the rest — $12 in “equity” plus $126 in the form of a guaranteed loan.

If, in a year’s time, it turns out that the true value of the asset is zero, the private partner loses the $12, and the government loses $138. If the true value is $200, the government and the private partner split the $74 that’s left over after paying back the $126 loan. In that rosy scenario, the private partner more than triples his $12 investment. But the taxpayer, having risked $138, gains a mere $37.”

Stiglitz argues that the problem is being addressed with the wrong assumptions. The emphasis is too much on liquidity and not sufficiently about insolvency.

“The main problem is not a lack of liquidity. If it were, then a far simpler program would work: just provide the funds without loan guarantees. The real issue is that the banks made bad loans in a bubble and were highly leveraged. They have lost their capital, and this capital has to be replaced.

Paying fair market values for the assets will not work. Only by overpaying for the assets will the banks be adequately recapitalized. But overpaying for the assets simply shifts the losses to the government. In other words, the Geithner plan works only if and when the taxpayer loses big time.”

I think that Prof. Stiglitz may have a correct argument, but there is a scenario possible (one can argue about likelihood) that he is wrong in assuming that the banks can only be rescued by the partnership overpaying for the “toxic” assets. A major problem with these distressed instruments is that their eventual value is not known. In the event that the banks are rescued by “overpayment” by today’s mark-to-market standards, it is still possible that the current marks are significantly below the true present value that will only be known when looking back from future years. Prof. Stiglitz’s argument implicitly excludes this possibility, which would be a win-win-win scenario.

Prof. Stiglitz’s position is the only one possible if The Efficient Market Hypothesis is accepted. If there are inefficiencies in these markets, there are win-win-win possibilities.

The arguments for nationalization by an FDIC model is described as preferred:

“Some Americans are afraid that the government might temporarily “nationalize” the banks, but that option would be preferable to the Geithner plan. After all, the F.D.I.C. has taken control of failing banks before, and done it well. It has even nationalized large institutions like Continental Illinois (taken over in 1984, back in private hands a few years later), and Washington Mutual (seized last September, and immediately resold).

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.”

If Prof. Stiglitz’s assumptions and analysis are correct, nationalization of one or more super banks may be where we end up anyway, after the PPIP has run its course. If that happens, the cost of nationalization has been increased at least by the net of all the transaction costs of PPIP and the continued operational costs of failed institutions. However, the real cost of failure of PPIP could be much greater: the opportunity cost associated with the time wasted before resolution.

Comments

[djo:]

Notice ... your words ... "Another Nobel Prize winner has joined Paul Krugman in taking a position critical of the Geithner Public Private Partnership Investment Program (PPIP)."

you and almost all the Financial media and Media never assign criticism to Obama.

Apr 02 08:40 AM

[jse17:]

Alas as employees of well endowed universities, neither Joe nor Paul has ever missed a meal! In fact, their salary checks are directly deposited faithfully bi-weekly, their health care is fully paid, they are provided a nicely funded defined pension benefit plan, and their progeny receive gratis educational benefits.

Paraphrasing, they exist in a risk free atmosphere with tenure and write about economic hazards that we mortals engage in daily. Perhaps their analysis is correct but if so, the foundation will be anything other than personal, down and dirty EXPERIENCE. Moreover, an old adage states that if one cannot do “it,” do not become dismayed, just write about or speak out on the issue that both do in abundance!

Apr 02 09:14 AM

[CautiousInv...:]

For the reasons mentioned by the author and those identified by professor Stiglitz, I do not warmly embrace the plan put forward by Treasury to rid bank balance sheets of legacy assets.

It is flawed and the preponderance of risk is assumed by the taxpayer, whose upside potential is not commensurate with risk. Under the present circumstances, though, I suspect any plan to motivate the private sector to acquire toxic assets will have glaring weaknesses of varying degrees.

The extreme course of nationalization mentioned by Roubini, Krugman and Stiglitz has its own set of problems including the direct and indirect costs of wiping out shareholders and, perhaps, subjecting bond holders to a haircut. And the international market turmoil would be incalculable.

Also, I'm not sure what regulatory authority would be used as the FDIC currently has authority and power to seize depository banks, but does not have similar authority for bank holding companies such as Citigroup. The Federal Reserve has authority to make non binding suggestions to bank holding companies.

Apr 02 09:35 AM

[j_remington:]

PPIP is the biggest financial fraud committed on Americans.

Obama and Geithner make Madoff look like an altar boy.

Apr 02 09:57 AM

[Leftfield:]

Since we are at the edge of the cliff at best, these attempts to keep the perpetrators afloat seem to guarantee they will do even worse if they become recapitalized. Wall St. has been at the center of the 3rd world loan mess of the 80's, the thrift mess, early 90's, LTCM, dotcom bubble/bust, now, real estate. Even if this is cleared up by throwing out the last of our common sense and propriety as well as the last vestige of our balance sheet, how can this come out well?

Apr 02 10:34 AM

[ur2smrt4me:]

What is extreme about asking shareholders and bondholders to take their losses? The international markets can calculate "zero" pretty well I think. It's called facing reality.


On Apr 02 09:35 AM CautiousInvestor wrote:

> For the reasons mentioned by the author and those identified by professor
> Stiglitz, I do not warmly embrace the plan put forward by Treasury
> to rid bank balance sheets of legacy assets.
>
> It is flawed and the preponderance of risk is assumed by the taxpayer,
> whose upside potential is not commensurate with risk. Under the present
> circumstances, though, I suspect any plan to motivate the private
> sector to acquire toxic assets will have glaring weaknesses of varying
> degrees.
>
> The extreme course of nationalization mentioned by Roubini, Krugman
> and Stiglitz has its own set of problems including the direct and
> indirect costs of wiping out shareholders and, perhaps, subjecting
> bond holders to a haircut. And the international market turmoil would
> be incalculable.
>
> Also, I'm not sure what regulatory authority would be used as the
> FDIC currently has authority and power to seize depository banks,
> but does not have similar authority for bank holding companies such
> as Citigroup. The Federal Reserve has authority to make non binding
> suggestions to bank holding companies.
>

Apr 02 10:35 AM

[MDR:]

He's a professor at Columbia, not NYU:

"Joseph E. Stiglitz, a professor of economics at Columbia who was chairman of the Council of Economic Advisers from 1995 to 1997, was awarded the Nobel prize in economics in 2001."

Apr 02 12:18 PM

[John Lounsbury:]

Thank-you MDR. I'll ask the editors to accept a correction.

Apr 02 02:16 PM

[John Lounsbury:]

MDR - - -

The embarassment of my error is compounded by the fact that I earned a Master's degree from Columbia many years ago.

Thanks again for pointing out my mistake.

Apr 02 02:33 PM

[The Sim:]

On Apr 02 09:35 AM CautiousInvestor wrote:

> Also, I'm not sure what regulatory authority would be used as the
> FDIC currently has authority and power to seize depository banks,
> but does not have similar authority for bank holding companies such
> as Citigroup. The Federal Reserve has authority to make non binding
> suggestions to bank holding companies.
>

they did it with WaMu

Apr 02 02:46 PM

[Jason Rines...:]

JSE. The pen is mightier then the sword. I would reserve judgement on anyone prior to know what it took to get them to where they are today. These men whom are writing the truth now will become marginalized and there careers destroyed to silence them. And if this country becomes a dictatorship for a short time it will be these men the men in black from for first. I and all here feel your pain. Some of these men that write are willing to do more but are also awaiting concepts from the Patriotic entrepenuar class to invest alongside them. Your not alone against this tyranny.


On Apr 02 09:14 AM jse17 wrote:

> Alas as employees of well endowed universities, neither Joe nor Paul
> has ever missed a meal! In fact, their salary checks are directly
> deposited faithfully bi-weekly, their health care is fully paid,
> they are provided a nicely funded defined pension benefit plan, and
> their progeny receive gratis educational benefits.
>
> Paraphrasing, they exist in a risk free atmosphere with tenure and
> write about economic hazards that we mortals engage in daily. Perhaps
> their analysis is correct but if so, the foundation will be anything
> other than personal, down and dirty EXPERIENCE. Moreover, an old
> adage states that if one cannot do “it,” do not become dismayed,
> just write about or speak out on the issue that both do in abundance!
>

Apr 02 06:07 PM

[carey_jim:]

Stiglitz is simply asserting common sense and economic wisdom over Washington's 'the fire hose as usual' policy.

While it is obvious that the Obama presidency itself is a real improvement over the Bush presidency, it isn't clear at this point that the Obama administration is better than the Bush administration.

Obama will assert his superiority over time but, as Stiglitz points out, his economic advisers will cause valuable time to be lost with their 'fire hose as usual' policy. At some point, Obama will come to understand the meaning of the 'loneliness of executive power' but not before damage has been done.

The 'fire hose' policy comes out of a long period of careerism and self promotion that rests on the axiom: 'Save your friends and benefactors before all else.' But careerism wont save the economy.

It's pretty sad when a man has to have a Nobel Prize in economics for his voice to be heard over the din of 'every man for himself' that the American economy (and culture) has become.

It's a long way from Jack Kennedy's 'Ask not what your country can do for you ...." www.youtube.com/watch?...

Apr 03 01:56 PM

[Steven Hansen:]

My concern is the clouding of FDIC books. i can understand this if the banks were taken over by FDIC, but this is not the case. This is a perversion of their charter.

i agree with the author about his concerns of PPIP. and carey_jim took the words out of my mouth. i would like to add that economically, obama is a continuation of the Bush administration. you gotta believe the smoke filled room conspiracy theories about who really runs this country.

Apr 03 07:49 PM

[Stephen Yu:]

I agree that there can be a win-win-win situation in which the banks can unload their bad debts at price above current market price, the investors can buy these debts below fair value, and the taxpayers make a profit. However, given that the large amount of leverage that the gov't is guaranteeing, even a tiny loss in these bad debts will wipe out the taxpayers' chance for profit. So I think the odd of taxpayers making out unimpaired is low. And if I cannot benefit as a taxpayer, and since I am not a bank, I would like to be the investor in this equation. In other words, I would want to be the gov't's partner in buying these debts. With the gov't taking most of the risks, and most debt unlikely to lose more than 80 cents on the dollar, I believe the investor is well-protected. As an investor in the PPIP program, at least I can reap some profits to offset the loss that the gov't has placed on me as a taxpayer!

Apr 03 08:27 PM

[ron_paulite:]

One does not need to be a Nobel prize winner to know that the PPIP is unfair to the tax payer. Even a 10 year old can see this.

Those who say this is a win-win-win are lying through their teeth -- because they cannot possibly be so stupid to really think it is win-win-win. Sure it can be win-win-win but with the tax payer bearing most of the risk. How can this be win-win-win? Also, if everybody becomes wealthier, the person whose wealth increased the least actually becomes poorer.

Nationalize the banks, please.

Apr 05 04:05 AM

[William Cowie:]

The question is: WILL his voice be heard? As ron_paulite points out, nobody needs a rocket science degree to see the U.S. taxpayer is being screwed by the very people who caused the mess.

I guess we are seeing by their actions who Geithner and Obama care about the most: their voters or the Wall Street bunglers...



On Apr 03 01:56 PM carey_jim wrote:

> Stiglitz is simply asserting common sense and economic wisdom over
> Washington's 'the fire hose as usual' policy.
> ...
> It's pretty sad when a man has to have a Nobel Prize in economics
> for his voice to be heard over the din of 'every man for himself'
> that the American economy (and culture) has become.
>

Apr 05 07:04 AM

[firecat:]

It ain't about just hoping things all work out in the end. Signing a deal where the possible outcomes are win, win, lose or win, win, and win is only a good deal if the party who might lose in the first scenario will be commensurately rewarded in the second scenario. There is no reasonable alternative view.
The private parties being in on the deal to help with the auction and keep the government from overpaying, that's fine. They don't have to split the profits equally.
Regardless of the eventual payout, these assets are not underpriced. They went for good money, back in the day, because they were backed by the good names and integrity of JP Morgan, Goldman Sachs, Citigroup, AIG, etc., and by the good names of the rating agencies.
Turns out there wasn't any integrity. Those loans were all underwritten by freaking pirates. We should trust these people now? These banks should choke on this stuff. The last thing we need is to get these ships afloat again.

Apr 06 08:06 PM