Krugman vs. Sachs on PPIP Loopholes

Paul Krugman links to Jeff Sachs worrying about PPIP loopholes, and both have a good long handwring about all this. Sachs says:

Suppose, however, that [[Citibank]] itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.

Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank’s net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K. Since the total of toxic assets in the banking system exceeds $1 trillion, and perhaps reaches $2-3 trillion, the amount of potential rip-off in the Geithner-Summers plan is unconscionably large.

And Krugman adds:

As Jeff says, a bank can create an off-balance-sheet entity that buys bad assets for far more than they’re worth, using money borrowed from taxpayers, then defaults — in effect a straight transfer from taxpayers to stockholders.

If there’s a mechanism to police such deals, it isn’t clear. And the sense that the administration is just too close to Wall Street continues to grow.

Am I just being dense? Treasury’s FAQ on the PPIP plan contains these words:

A Fund Manager may not, directly or indirectly, acquire Eligible Assets from or sell Eligible Assets to its affiliates, any other Fund Manager or any private investor that has committed at least 10% of the aggregate private capital raised by such Fund Manager.

It sure looks to me like Sachs’ scenario is specifically disallowed; he’s postulating an example in which Citi contributes 100% of the private capital to a fund bidding on Citi assets. Did Sachs simply not read the Treasury documentation? What’s going on here?

Comments

[It Figures:]

If your facts are correct, this would not be the first time these two guys spoke before they thought things through. As you say, reading the docs might help too.

Apr 06 06:03 PM

[Ralphy:]

Ok - since the bank can't self-deal directly........Suppose that Citi and JPM decide to buy $100 billion of the other's junk under the same terms as in the article - but do it through an off-balance sheet entity. This accomplishes the same outcome.

Apr 06 06:24 PM

[Amateur?:]

Krugman and Sachs are just stating the obvious - there are a number of ways around this inconvenient 10% direct or indirect rule.

How about a little course in Financial Engineering 101?

Bank A and Bank B working together. Using the example above, Bank A puts in $75k and buys $1m of Bank B's toxic assets. Bank B, ever thankful, reciprocates and puts in a small $75k to buy $1m of Bank A toxic assets. Assume same defaults and both banks win, taxpayer loses. Easy.

Something more complex? Bank A lends $75k to the equity investor in the Fund on a limited recourse basis to the value of the equity in the Fund. If the equity in the Fund is worthless, the equity investor doesn't have to repay the loan to Bank A. Of course Bank A doesn't care since they've just stuffed the taxpayer with $925k of losses.

Something with less linkage? Bank A has a portfolio of subprime loans which it wants to sell (but not take losses). There are subprime indexes which may not have perfect correlation to Bank A's portfolio but will be very close. Investor puts in $75k equity into the Fund to buy the $1m subprime portfolio from Bank A. Investor acquires a credit derivative based on the subprime index (not based on the actual Bank A portfolio) from Bank A which economically shifts most of the risk on the $75k investment from the Equity investor to Bank A. If needed, Bank A and Bank B can play the same game as described above to mix it up a little. In general, if subprime tanks, both the index and the Bank A portfolio are likely to go down in value by a similar amount. The equity investor is flat, Bank A loses $75k and the taxpayer loses $925k.

I could give you some more clever ideas which which I'm sure the banks are working on right now, but hopefully you get the idea. In short, the system will be gamed unless very strict rules, penalties and oversight is put in place.

Apr 06 07:03 PM

[Speedspirit:]

You nailed it. LOOPHOLES. But we cant stand around and bitch we have to do something. These banks couldnt play these games if people cancelled thier credit cards, withdrew thier money, and found a honest banker to rewrite thier mortgages.

Apr 06 08:55 PM

[Master of t...:]

If you have been paying close attention you will notice that the Obama administration is dancing around loopholes already. Look at the executive pay restrictions. Look at the bailout money for AIG (which then funneled the money to Goldman Sachs, etc). Look at H-1B.

In each case the administration was careful to put a populist public face on but carefully write the rules to be broken.

Apr 06 09:13 PM

[huskerbob:]

If you think of this as a problem, you're missing the whole point of this plan. It's simply a fig leaf so the banks can foist their toxic or "legacy" debt onto the taxpayers. This has been the plan since the beginning of the bailout, only Geithner came up with a politically more palatable plan. Expect a lot of cheesy fake "outrage" from your appointed political representatives in Washington after the banks safely game the system. Maybe they can trot out AIG execs for another round of excoriation?

Apr 07 04:26 AM

[mediapro:]

If all of these gaming-the-system options are true, then why don't we just do away with the private banking system and run the Bank of the United States of America? If the balance sheets demonstrate under a stress test that the most egregeous of the lot are fundamentally insolvent, then receivership (and I would argue) without re-organization is the only viable option.

BTW, to the smart cookies who posted these various options: Don't you see how these thoughts are a good illustration of why private-capitalism is a failed model? What? Did most of you recently get laid off from the financial sector?

Apr 07 08:04 PM

[Jeeyum:]

Amateur?'s comment captures the essence of the PPIP loophole problem.


On Apr 06 07:03 PM Amateur? wrote:

> Krugman and Sachs are just stating the obvious - there are a number
> of ways around this inconvenient 10% direct or indirect rule. <br/>
>
> How about a little course in Financial Engineering 101?
>
> Bank A and Bank B working together. Using the example above, Bank
> A puts in $75k and buys $1m of Bank B's toxic assets. Bank B, ever
> thankful, reciprocates and puts in a small $75k to buy $1m of Bank
> A toxic assets. Assume same defaults and both banks win, taxpayer
> loses. Easy.
>
> Something more complex? Bank A lends $75k to the equity investor
> in the Fund on a limited recourse basis to the value of the equity
> in the Fund. If the equity in the Fund is worthless, the equity
> investor doesn't have to repay the loan to Bank A. Of course Bank
> A doesn't care since they've just stuffed the taxpayer with $925k
> of losses.
>
> Something with less linkage? Bank A has a portfolio of subprime
> loans which it wants to sell (but not take losses). There are subprime
> indexes which may not have perfect correlation to Bank A's portfolio
> but will be very close. Investor puts in $75k equity into the Fund
> to buy the $1m subprime portfolio from Bank A. Investor acquires
> a credit derivative based on the subprime index (not based on the
> actual Bank A portfolio) from Bank A which economically shifts most
> of the risk on the $75k investment from the Equity investor to Bank
> A. If needed, Bank A and Bank B can play the same game as described
> above to mix it up a little. In general, if subprime tanks, both
> the index and the Bank A portfolio are likely to go down in value
> by a similar amount. The equity investor is flat, Bank A loses $75k
> and the taxpayer loses $925k.
>
> I could give you some more clever ideas which which I'm sure the
> banks are working on right now, but hopefully you get the idea.
> In short, the system will be gamed unless very strict rules, penalties
> and oversight is put in place.

Apr 14 11:12 AM