US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.
The plans proved controversial, with critics charging that the government’s public-private partnership - which provide generous loans to investors - are intended to help banks sell, rather than acquire, troubled securities and loans.
I brought this up when the plan was first released, via a marginalrevolutions’ post in that link, but the idea seemed so absurd that I didn’t mention it in any subsequent posts. It is apparently staying, and we need to consider what this will do to the process.
I was out at “Debaser Night”, a 90s-music dance party in San Francisco, with some friends. A riot grrl rock cover band opened, followed by lots of great singles. I was getting a bit nostalgic. A friend of mine, who used to be on an energy trading desk back in the early 2000s, was listening to me talk about the government plan. He couldn’t believe what I was telling him about letting the banks that are selling auctions also bid on them. In the middle of my explanation, he had his own wave of nostalgia: “Man does that bring back memories….”
Before we go there, what will happen with these banks when they can bid on each other’s assets? Let’s do a thought exercise. Let’s say you are a bidder for Bank A. You know your banking asset is worth $50, and you also know the asset Bank B has is worth $50. You call your buddy up, the trader at B, and make a deal. Happens all the time. You go to bid, and you bid $80 for B’s asset. Then you wait. If B doesn’t come through, you are screwed out of a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your asset - $80 from B. You have each bid up each other's assets and traded them. And now the government is screwed. Let’s chart out that payment (click to enlarge):
Yup. Bad news. Bank A pays $6.50 for its new asset because of the leverage, and it loses all of that. It also loses the $50 from not having the asset anymore. However it gains $80, net profit - same as Bank B. The government has paid $73.50 for a $50 asset, twice. (See previous for how the levered non-recourse loan turns into a put option.) We tend to call this collusion if you and I did it. No price discovery, no movement of the assets from the banks balance sheet to private investors.
So why did my energy trading friend get all nostalgic? “Because what you are telling me brings back some great memories from what Enron was up to back in the day. All of us energy traders back then watched with our jaws on the floor. 2000 was a hell of a year.”
It is August, 2000. Let’s say you are a trader for Enron. You know your energy in California is worth $50, and you also know the energy that Reliant Energy (RRI) has is worth $50. You call your buddy up, the trader at Reliant, and make a deal. Happens all the time - you even have a nickname for it, The Daisy Chain Swap.
You go to bid, and you bid $80 for Reliant’s energy. Then you wait. If Reliant doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your energy - $80 from Reliant. You have each bid up each other's assets and traded them. And now the government is screwed, because it has to pay you $80. Let’s chart out that payment (click to enlarge):
You can go ahead and replace an Enron subsidiary for Reliant in that example, as I did in the chart. Enron did, and the banks are probably going to now. My friend was very excited telling me all the strategies Enron deployed - “Forney Perpetual Loop”, “Ricochet”, “Ping Pong”, “Black Widow”, “Red Congo”, “Get Shorty”, the whole works - and how all of them will be reliable guides for gaming the legacy asset market here. Buy assets high, write them down, then pay back with “fees.” Got it. Create SIV to bid up the profits. Brilliant.
What is really exciting, from the evil point of view, is the idea that we are going to get to see one giant, massive, Enron Death Star put into play:
That's no moon.
The Death Star strategy (yes, they called it that) was where Enron would take a fee for relieving a congested market of its excess supply by moving it elsewhere. Just like our legacy assets! There are too many of them, it is clogging up trade, let’s get them to someone else who wants them. However, Enron would just move the energy in a circle, collecting a fee for not doing what it was supposed to. As their memo famously said, they are paid “for moving energy to relieve congestion, without actually moving any energy or relieving any congestion.”
And, it appears that the large banks are gearing up to do just that -- with the Geithner Death Star, they’ll just be collecting a large fee to run assets in a circle, without actually moving any of them off their collective books. For old time’s sake, I hope they route their loan bids through Oregon and then Utah before putting them back right where they started.
Mind you that was the electrical grid of California - this appears to be at the scale of the entire financial market. In case you are wondering, traders out there are licking their lips to try and find ways to game this even better than Enron. It appears the public will get to invest in these vehicles too. Direct Democracy in the 21st century means that all of us get to take part in collusion and ripping off taxpayers - we are the ones we’ve been waiting for!
I’m not the biggest Enron junkie - else I would have seen this connection sooner. If any people who know their playbook of strategies want to leave a comment with a move that could be made by the PPIP bidders, I’d be much obliged. And please, tell your representatives to keep the selling banks and their subsidiaries from bidding. I’m still hoping this part is a bad dream…