Editore"s Note
Tilting at Windmills

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March 22, 2009
By: Hilzoy

Some negative reactions to the Geithner plan: Krugman, more Krugman, Calculated Risk, Yves Smith, James K. Galbraith, Henry Blodget, Noam Scheiber. Brad DeLong, on the other hand, likes it, and whether you agree with him or not, he's made the strongest case I can think of for it, and it's absolutely worth reading, as is Krugman's response. All of these people actually know what they're talking about. I, on the other hand, do not: I'm just a reasonably informed non-economist like, I assume, most of you. Take what follows in that light, and if your time is short and you have to choose between reading me and reading, say, Krugman or DeLong, choose the latter. Also, if I get anything wrong, please let me know.

That said, several problems with this plan, and specifically with Geithner's proposal to create public/private partnerships which will bid against one another to buy various toxic assets, just leap out at me. For one thing, it might not work at all. From the NYT:

"Risk-taking institutional investors, like hedge funds and private equity funds, have refused to pay more than about 30 cents on the dollar for many bundles of mortgages, even if most of the borrowers are still current. But banks holding those mortgages, not wanting to book huge losses on their holdings, have often refused to sell for less than 60 cents on the dollar."

How, one might wonder, will holding an auction help here? If the banks are not willing to sell below 60 cents on the dollar, then absent nationalization or something similarly drastic, we can't force them to. If potential buyers are not willing to pay the price banks insist on, then the auction will simply fail, the assets will remain on the banks' books, and nothing will have been accomplished. And if the NYT is right about the gap between the price at which banks are willing to sell and what buyers are willing to pay, then the only way for an auction to work is if it somehow persuades one group to change its mind.

As it happens, some of the auctions Geithner plans to propose will do just that. From the WSJ:

"To target troubled securities, such as mortgage-backed securities, the government will create several investment funds. Treasury will act as a co-investor, in most cases contributing $1 for every $1 contributed by the private sector and sharing in the first-loss position.

To target troubled loans, the government will create a Disposition Finance Program with the FDIC. In that case, the government will be a co-investor, but could also agree in some cases to contribute 80% of the financing, with the government putting up $4 for every $1 in private financing. As part of that program, the FDIC would provide guarantees against losses on a pool of loans that a bank wants to sell. The program could guarantee as much as $500 billion in loan investments."

In the first sort of auction, we share the risk with private investors. In the second, however, we assume it all. Obviously, buyers will be willing to pay more for otherwise risky assets if the government guarantees any losses they might suffer. Why? Because any investment is worth more if you don't have to worry about losing money. As Ezra says:

"A private auction will not price the assets. It will price the potential upside of the assets given that taxpayers will assume the brunt of the losses. As illustration, imagine an art auction. Now imagine an art auction where Sotheby's loans money to the participants and promises to pay the losses if the paintings fall in value. Think the pricing will be the same?"

This means several things. First, one of the things you might think that an auction would do would be to help us to figure out what these assets are really worth. But while the auctions of troubled securities might do that, the auctions of troubled loans will not. They will, at best, help us to figure out what those loans would be worth if they had no downside risk. That's a different thing entirely. And it means that this auction will be useless for figuring out what those loans are actually worth.

Second, buyers will presumably pay more for these loans than they would have done had they had to assume their risks along with their potential gains. This might help overcome the gap between what buyers are willing to pay and what sellers are willing to accept. But it does so by artificially inflating the price of risky loans. Since we, along with the private investors, will be paying these artificially inflated prices, this is a subsidy to the banks, and should be recognized as such.

Third, it's worth reemphasizing this point: we, the taxpayers, assume a lot of the risks under this plan. This is one reason why, as Paul Krugman says, it's a huge gamble on the proposition that the assets in question are undervalued, and will regain their value as soon as the economy returns to normal. If that's true, then we will probably get our money back, though we won't do as well as we would have done had we paid market prices. But if it's not, then we will be left holding the bag. And it's a very, very big bag.

Hilzoy 1:00 PM Permalink | Trackbacks | Comments (30)

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Comments

I can't tell if it's good or bad.

If this is a way to force banks to sell the junk at 30 cents on the dollar, using the hedge funds as cover against political pressure to pay higher, it's great.

If this is a way to launder 75 cents on the dollar through the hedge funds, it's terrible.

All depends on how much arm-twisting Treasury is doing behind the scenes. Given their track record so far, I'm not holding my breat.

Posted by: slaney black on March 22, 2009 at 1:47 PM | PERMALINK

It's not literally true that the private parties have no downside risk, the smallish amount of capital they put in is at risk. But, their risk is limited, essentially the taxpayers are giving them implicit Credit Default Insurance.

The plan is also frought with political and social justice issues, that I think are pretty serious. We already have a significant chunk of the population who believes our government is controlled by the masters of the universe, and handing hedge fund managers an opportunity exploit the asymmetric exposure to risk implied by the non-recourse loans will only add to their ranks. Cynicism about our government is corrosive to the proper functioning of the political process, and this will simply fuel it further.

Posted by: Omega Centauri on March 22, 2009 at 1:49 PM | PERMALINK

In my book, it's worth fifty demerits when someone justifies an investment on its putative value "when the economy returns to normal".

Posted by: joel hanes on March 22, 2009 at 1:50 PM | PERMALINK

DeLong has liked every bail out plan so far, including the original TARP.

Posted by: devildog on March 22, 2009 at 1:55 PM | PERMALINK

Omega C: As I read the coverage, private parties would be at risk, along with us, in the auctions of securities. But we would be guaranteeing against risk in the auctions of mortgages.

Posted by: hilzoy on March 22, 2009 at 2:07 PM | PERMALINK

So, it's all a gimmick for the government to assume the entirety of the debt?

Posted by: alan on March 22, 2009 at 2:09 PM | PERMALINK

Being wedded to growth is the problem. It's time, past time, for a better idea. I suggest it's time to listen to people like Herman Daly.

http://www.adbusters.org/magazine/81/the_crisis.html

Posted by: E.R. Beardsley on March 22, 2009 at 2:15 PM | PERMALINK

Alan: there are several bits. In the auctions for loans, I think we do take the whole downside risk. In the auctions for securities, we only take part of it.

Posted by: hilzoy on March 22, 2009 at 2:18 PM | PERMALINK

Aren't we left holding the bag under either Geithner's plan or a nationalization plan?

Posted by: Aaron on March 22, 2009 at 2:27 PM | PERMALINK

To the extent I understand the plan (which is not great) it seems to me that it suffers from the "play money" problem on a poker web site. Any of the real money poker sites will also allow you to play with fake money just to get the hang of it.

But you couldn't begin to model most features of a real poker game based on what people do in the play money games. The bottom line is people are far more willing to take risks than they are when they actually have their own money at stake. You'll see people going all-in with marginal hands or just because they get bored.

Sure Geithener makes them ante up a little dough, but they would only seem to slightly mitigate the problem not eliminate it.

Posted by: The Fool on March 22, 2009 at 2:28 PM | PERMALINK

Holding three quarters of a lead anchor while we jump off the boat hoping there's something besides water beneath us hardly sounds better.

Posted by: alan on March 22, 2009 at 2:29 PM | PERMALINK

Geithner and Summers are unwilling to bite the bullet and admit that the reason the market price for these assets is so low is that they are crap. If we are committed to a policy based on that denial, let's just buy them at the banks' imaginary price, and cut out the middle man. The new plan is just a gimmick.

Posted by: biggerbox on March 22, 2009 at 2:37 PM | PERMALINK

At ground level in the ordinary Universe, a loan is a contract between two parties, the borrower and the lender. The lender takes the risk, which he uses various instruments to minimize, that the borrower, willfully or unavoidably, will be unable to meet his side of the contract. The borrower takes the risk that he will be unable to repay the loan and interest, and so face the legal and pecuniary consequences. In the ordinary Universe these arrangements are entered into with care and honest intention, and hence generally work out as intended.

The current situation is very far removed from the ordinary Universe. The lending formula has been distorted and corrupted out of all recognition. It is dysfunctional and derelict. Until we recognize and accept the complete collapse of the contractual lending ethos, we will be fruitlessly chasing a rabbit with horns, which does not exist.

Normal business practice deals with anomalous, unretreivable loss through the write-off account. Frankly, all the symptoms of unrecoverable loss are evident in this situation. My recurrent question is : Why not just write-off the whole bang shoot?

I'm sure there is an answer, however bamboozling, but I would like to have it.

Posted by: Goldilocks on March 22, 2009 at 2:39 PM | PERMALINK

I'm going to side with DeLong on this one, if for no other reason than all of the naysayers bandying about the phrase "toxic asset" without seeming to understand why the asset is toxic in the first place.

If, for example, we want to label a great big batch of mortgage-backed securities as "toxic," then pray tell---what, specifically, makes it toxic? Identify the exact sub-component or sub-components of the package that are poisoning the entire package, please. Don't just strawman the whole sordid mess by saying "some of the components are bad." Let's see some factual, empirical evidence of asset toxicity, before we unilaterally declare "Geithner's Plan" to be unsound....

Posted by: Steve W. on March 22, 2009 at 3:08 PM | PERMALINK

I wish you could still trust Krugman, but after he went through his whole Hillary-worship phase, you have to check everything he says that touches on the administration.

Posted by: sean on March 22, 2009 at 3:15 PM | PERMALINK

The toxic assets are not the whole problem. I will have to refresh these numbers but the last time I saw estimates it broke down about as follows:

Toxic Assets (Bad subprime loans) $ 1.7 Trillion
Total Default Value if Toxic Assets Default $55 Trillion

So this leads to one fundamental question that need answering in detail. Why is the default value so much higher than the actual value of bad loans? And this leads back to what happened in the last two years before the final crash last year, and back to the nature of shadow banking. Once it became obvious to those "in the know" on Wall St that this whole house of cards was flying apart, many hedge funds placed open shorts or just outright gambles that the subprime loans were worthless, that companies were going to fail, etc. It was pretty much equivalent to you going to Vegas and betting for the end of the world as we know it. This was only possible because anything goes on the shadow market assuming somebody is dumb enough to take your bet.

So what happens when we bailed out AIG? The US taypayers are paying off these gamblers, and we may very well be paying out to the gamblers about five dollars for every dollar that goes to buying toxic assets. It's why there has been an appalling lack of transparency to this process. From the day that they proposed these insane schemes, they knew the level of the public's outrage would be immense so it was best to keep the public in the dark.

Why would Summers, Geithner, etc. want to do this? Because they want to preserve the shadow banking system as much as possible, and they are afraid that allowing a more normal bankruptcy process will bring in the contract experts and bankrutpcy experts and will allow a court to rule that the SIVs, CDOs, and CDSs are practically worthless (especially the outright gambles) in in the eyes of a US Court at which point tremendous world-wide turmoil could result. Remember that the estimated value of the shadow banking system is $550 trillion.

Posted by: Glen on March 22, 2009 at 3:35 PM | PERMALINK

Steve W: I have actually thought for a while that the phrase "toxic asset" is misleading since it suggests that this asset is poisoning everything. Making a contract with unlimited downside risk would be toxic in this sense (poisoning an otherwise healthy balance sheet), but most of the things that are called 'toxic assets' don't do that.

What they are are assets that have by pretty much any account taken real losses, but that are hard to value, so that it's hard to figure out just how great the loss is. There is an obvious incentive for their owner (say, a bank) to keep from admitting the extent of the loss: admitting the loss means having it show up on your balance sheet, needing to come up with new capital, etc. But if you suspect that the loss is more than you've admitted, you might be wary of making loans, since you know you might need that capital. And if others suspect that you have unacknowledged losses, they might worry about your financial soundness, and not want to deal with you.

As Paul Krugman has said on several occasions, there's an easy way to deal with toxic assets: write them down to zero. (This would not be true of my first example, the one with unlimited downside risk.) The problem is that if you write these assets down to zero, you might find that you're insolvent.

Posted by: hilzoy on March 22, 2009 at 3:38 PM | PERMALINK

Thanks, hilzoy,

You have, inadvertently perhaps, addressed my question (above). You mention : As Paul Krugman has said on several occasions, there's an easy way to deal with toxic assets: write them down to zero. (This would not be true of my first example, the one with unlimited downside risk.) The problem is that if you write these assets down to zero, you might find that you're insolvent.

I guess I have probably read this several times since I try to keep abreast of Krugman's observations, but somehow it didn't register. With your reference you have now taken it to the next level: "The problem is ... you might find that you're insolvent."

My question now is : In what way is that a problem? In the context of all the expertise here and around, you may think I'm just being perverse. What I'm actually doing is trying to see the forest rather than the trees - and strike at the root (of the forest?!).

You see, to my naive eye, the whole thing is a like a mirage. We're looking for drinkable water where there is none. My instinct keeps telling: cut our losses and start again. I seriously believe that the whole shambles is beyond repair. Step back, get to the root of it, find the solid ground, mercilessly clear all the rubbish, and start again.

It's hard being a heretic!

Posted by: Goldilocks on March 22, 2009 at 4:06 PM | PERMALINK

you might find that you're insolvent

There are rules already in place about what the government does to insolvent banks. The FDIC is suppose to seize these banks because experience has shown that banks start taking MORE RISK as they go down assuming that if they win big , they are made whole, and if they lose, it didn't really matter.

This behavior ends up costing the FDIC more money, so after the banks reach a predefined point, the FDIC is supposed to act.

Unfortunately there are many banks now "zombie" meaning we are allowing them to value the toxic assets at higher value than mark to market would. Without these accounting allowances the shear size off the bank (these would overwhelm the FDIC), we should have acted against these banks by now.

Posted by: Glen on March 22, 2009 at 4:14 PM | PERMALINK

Haven't you folks heard of inflation? Obviously, the nominal value of the assets is going to go way up.

Posted by: Bob M on March 22, 2009 at 4:56 PM | PERMALINK

Good point, Glen. The FDIC has done an excellent job with many insolvent banks, such as IndyMac.

Hilzoy, good answer Steve W's question. To better understand what happened and why these assets are bad and difficult to mark to market, it's necessary to explain collateral debt obligations (CDOs) and some of the other securitized investment vehicles (SIVs) that make up the so-called toxic assets. The most recent issue of Rolling Stone (of all places) has about as good an explanation for the lay person as I've seen in an article by Matt Taibbi.

Posted by: DevilDog on March 22, 2009 at 5:16 PM | PERMALINK

It's all one super-high-tech gigantic casino. Isn't it? Casinos seem to do OK. Is there anything to learn from their methods?

Posted by: Goldilocks on March 22, 2009 at 5:29 PM | PERMALINK

It cost us $10 B to take care of IndyMac, so it's easy to see why the FDIC has avoided the zombie banks - these could potential cost trillions.

But the question remains - what are we going to do about the shadow banking system? If we, the taxpayers, are asked to pay it off in-full, we have just put the US in-hock for a long, long time.

Posted by: Glen on March 22, 2009 at 5:35 PM | PERMALINK

And, it should be noted that the guy that bought IndyMac, bet against them in the shadow banking system (i.e. profited handsomely from their very failure.)

Posted by: Glen on March 22, 2009 at 5:42 PM | PERMALINK

Goldilocks: I favor nationalizing insolvent banks, myself.

Posted by: hilzoy on March 22, 2009 at 6:03 PM | PERMALINK

I'm going to side with DeLong on this one ... Let's see some factual, empirical evidence of asset toxicity, before we unilaterally declare "Geithner's Plan" to be unsound....

Reread DeLong and then read Krugman's response. Factual evidence? There is NO fucking market for them. NO FUCKING MARKET. That's the best empirical evidence we have in a market-based economy.

And Geithner would "create" a market by fucking taxpayers. This all is SO ridiculous.

Posted by: Econobuzz on March 22, 2009 at 8:22 PM | PERMALINK

Tiny Tim Geithner and Helicopter Ben Bernanke are going to ruin this country. They both need to GO!

http://fargoneworld.blogspot.com

Posted by: TalithaTwoBlade on March 22, 2009 at 9:09 PM | PERMALINK

Econobuzz---Why is their no market? Because Krugman et al says they're toxic. Why are they toxic? Because Krugman et al says there is no market.

Sorry, but I'm not buying into the Blazing Saddles gig of circling one lonely Conestoga. We've just spent 8 wretched years building a false economy with the exact same economic program.

Hilzoy, I have to disagree with the notion that the assets are toxic to the point that they need to be written down to zero. Every single one of those bad loans is backed by a physical piece of hardware: a boat; a plane; an art collection; a house; in some cases, an office building or a neighborhood-sized apartment complex or a herd of condominiums or even a shopping mall.

The investment banks want the money, but they don't want the part of Geithner's plan whereby our dear Uncle Sammie becomes creditor of first claim when those "toxic assets" are unwound. They just want the cash to offset a zeroing-out of the debt---and then you just watch how fast those debts get untangled. We pay off someone's mortgage, and then the bank gets to keep the collateral as well? THAT is what Wall Street, the banks, and the GOPers are angling for, my friend---and if "Geithner's Plan" is the only alternative, then as they say at the poker table: I'm all in for it.

That's why I can't figure Krugman out on this one; he's a damned sight smarter than he's coming across as with his proposal. Also, neither he nor anyone else of economic substance is stepping up to the plate on these subprimes, and why the vast majority of them went south in the first place.

Let's say you buy in at a teaser rate of 2%, with a projected reset of 8% in 24 months, and a promise to qualify for a fixed-rate after 36 months. You run the numbers, and say, "I can do that. No sweat." During the 24, your mortgage gets repackaged a couple times, and when you hit the 36, the multiple groups who've bought into your note decide that you can't get a fixed---and they arbitrarily reset you at 12%, with an annual review on the APR. At 48, your credit score gets bumped down a few notches, and you now qualify for a floating APR of 15 or 16. You miss a payment, and inherit a 2% penalty spike in your APR.

The assets are toxic, all right---but not because there's no market for the damned house---it's because there's no market of a three-bedroom on a postage-stamp lot that's wearing a highballed APR of 18 percent or more.

You need to remember that what was once a $200,000 house that was calculated to be worth another $400,000 or so in raw interest profit, finally would up---after all the repackagings and APR resets, penalties, late fees, and daytrader-driven speculation---to be worth somewhere in the neighborhood of at least a cool million, maybe more.

It's like putting a defective tire (the subprime loan) on a good solid tire rim (the house), and then pumping too much air (the constant resets on the APR) into the tire. Your going to blow out the tire, which is now worth zero and for which there's no market whatsoever for---but that good solid rim is still there.

It's simple arithmetic---and everyone's trying to go all pre-Calc on it. Geez, people....

Posted by: Steve W. on March 22, 2009 at 9:21 PM | PERMALINK

Kruggman misses one thing in his reply to DeLong, and that is, what if Geithner (Summers) NEVER, last-ditch never, is going to do the Sweden plan?

Posted by: SocraticGadfly on March 22, 2009 at 10:06 PM | PERMALINK

Isn't the likely outcome here that the banks offer their assets at, say, 60 cents on the dollar and then no one is willing to buy them at that price?

In other words, unless the banks move their ask, who's going to buy the assets? Or do people think that the public/private organization would be likely to buy them at an inflated price?

If very few are willing to participate in the forming the partnership and then they aren't able to buy assets at a price that they like, is the whole thing likely to be a bust?

I think the bottom line here is that nationalization is likely the only path - and that path is hard and may be unworkable itself. But right now nationalization is politically untenable. Can anyone imagine the outcries of socialism if Obama/Geitner put that forward? I think we have to try a bunch of plans that don't work to generate the political will for what might be the only path (as bad as it is). Bad choices all around.

Posted by: inthewoods on March 23, 2009 at 9:41 AM | PERMALINK




 

 

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