Geithner's Toxic Asset Plan Reborn

by: Linus Wilson

CNBC Reports that the TARP’s Public Private Investment Partnership’s (PPIP) asset managers are going to be announced on any day now. It will be a smaller affair with only $50 billion of assets to be bought not the $500 billion to $1 trillion originally planned.

The FDIC has largely abandoned the program after it unsuccessfully floated the really bad idea of banks buying their own assets. Further, smaller banks were rightly fearful that the FDIC's loan guarantees in the PPIP would raise deposit insurance premiums to help the mega banks. Thus, it is the Treasury alone that will be making the loans and putting up the equity alongside private investors that include Wilber Ross and Company.

My paper "The Put Problem with Buying Toxic Assets" shows that that zombie banks will be reluctant to sell their toxic assets, even if they are marked to market, because they don't want to give up the volatility. That volatility makes their shareholders richer and puts their bondholders and the FDIC, which insures deposits, at risk. If the bank is bigger than Lehman Brothers, then that volatility puts taxpayers also at risk of bailouts because regulators are almost sure to consider it "to big to fail" (TBTF). This paper shows that banks with too little common equity will be unwilling to sell their toxic assets at a price that any rational investor would accept.

If the bank is considered TBTF and Chapter 7 or Chapter 11 bankruptcy is not an option to restructure its liabilities, over leverage and volatile toxic assets will pervert its lending decisions. It will pass up safe but profitable loans and investments and pursue risky unprofitable ones. In that case, either having the bank sell common stock or toxic assets can improve the bank's lending decisions.

My paper’s tables 2 and 3 estimate that 68 of the largest banks in or exiting the TARP have raised a total of $60 billion in common equity capital since they received bailout funds. Most of this was raised in April, May, and June of 2009. Further, most of this was the result of the Fed's stress test. Since having banks raise common equity is a substitute for selling toxic assets, these capital raises have blunted the need for banks to sell toxic assets in order to have incentives to make new loans. (One dollar of common equity raised goes a lot further than one dollar of toxic assets sold due to leverage.)

Further, resolution authority if it passes is a much better mechanism to sell toxic waste than subsidized asset repurchases. Thus, I am happy that the PPIP is smaller than originally planned.

Moreover, any benefit from bank’s lending incentives will only occur if regulators can stop banks from reloading their balance sheets with toxic assets once they have dumped a bunch of them into the PPIP. Marketplace and Bloomberg report that many banks are loading up on assets that were once deemed toxic.

It is well known that the nonrecourse loans in the PPIP gives private investors incentives to overbid. Yet, many questions about the PPIP have not been previously addressed. My new paper, “A Binomial Model of Geithner’s Toxic Asset Plan” provides a guide to the PPIP toxic asset sales. It provides a formula to estimate the market value of toxic assets from the sham market prices of PPIP auctions. (As the Nobel Prize winner Joe Stiglitz points out, private investors are buying a call option on the toxic asset not the toxic asset itself. The PPIP auction price is the price of that call option.)

Moreover, my paper provides a guide to regulators in the Treasury at setting the interest rates in PPIP auctions to lead to trades and minimize expected taxpayers losses. Yet, getting the interest rate right is tricky, Anyone who has followed the warrants debacle should be very skeptical about the Treasury’s ability to do this in a way that does not sometimes lead to spectacular losses to U.S. taxpayers.

My paper predicts that it will be the healthiest banks that would be the most eager to sell. Yet, the stigma of participating in any TARP program is so great right now that many healthy banks will probably shy away from the PPIP. I will shed no tears.

It also predicts that private bidders will have to be encouraged by low interest rates and volatile assets to massively overbid before zombies will part with their trash assets. Zombies will be reluctant to sell even if the toxic assets are marked down to at or below fair market value. The private investors will rationally throw caution to the wind because they get the majority of the upside and taxpayers bear most of the downside. Ah, the magic of the government-subsidized market at work!

Disclosure: I only have long positions in broad based index funds.