Monday, March 23, 2009

Heads I Win, Tails You Lose

Due to the political infeasibility of the government buying toxic assets for above market prices, Secretary Geithner and the Obama administration have developed a convoluted public-private partnership arrangement which creates a distorted risk profile and encourages leveraged speculation. Under the plan, private investors will be able to obtain non-recourse loans from the FDIC to finance 85% of the purchase price and receive matching equity contributions from the treasury. The structure of this arrangement limits the downside risk to the private investor and encourages more aggressive bidding for assets. It is no wonder that the market skyrocketed by almost 7% with the banks and brokers rising 15-20%. This plan amounts to a taxpayer funded bonanza for the banks and investors that are allowed to participate.

Ultimately, private investors will contribute approximately 7.5% equity which will be matched by the Treasury. The first 15% of losses, therefore, will be jointly incurred by the private investor and the Treasury, but any subsequent losses will be entirely absorbed by the taxpayer. The government is essentially granting a free put that is 15% out of the money to anyone who can put up 7.5% equity and buy “toxic” assets. In addition, the financing cost of the non-recourse loan is subsidized through the manipulation of interest rates by the Federal Reserve such that the private investors are receiving below market rates enabled by the government. This seems distressingly similar to the fed induced credit bubble that resulted in the current crisis. The severity of the ultimate losses will not be realized for years as the underlying assets continue to deteriorate, but the greater fool of the Federal Government, ill equipped to evaluate these complex structured products, will be left holding the bag.

Even Paul Krugman, a liberal columnist for the New York Times and economist at Princeton University, despairs over the Obama administration’s view that there are no “bad assets” but only misunderstood assets who’s true value has been unrealized by the market. As he wrote in a March 21, 2009 opinion piece in the NYT:

"The Obama administration is now completely wedded to the idea that there’s nothing fundamentally wrong with the financial system — that what we’re facing is the equivalent of a run on an essentially sound bank. As Tim Duy put it, there are no bad assets, only misunderstood assets. And if we get investors to understand that toxic waste is really, truly worth much more than anyone is willing to pay for it, all our problems will be solved.

To this end the plan proposes to create funds in which private investors put in a small amount of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad — I mean misunderstood — assets. This is supposed to lead to fair prices because the funds will engage in competitive bidding.

But it’s immediately obvious, if you think about it, that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.

Or to put it another way, Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard.
This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized. And I fear that when the plan fails, as it almost surely will, the administration will have shot its bolt: it won’t be able to come back to Congress for a plan that might actually work.

What an awful mess."