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.