You’re a large U.S. bank. Crappy (er, “legacy”) assets are weighing you down. You feel like you're driving a Ferrari hauling an open flatbed piled with all the backroom junk from Uncle Clem’s double-wide trailer. Secretly, you know that you’ve marked the value of these assets too high on your books, but you also know the federal government (a big-money guy, not terribly bright -- the perfect mark) is hanging around, riffling a big wad of cash.
How could this not end happily for you?
Then some government guy, a bigshot named Tim Geithner, unveils a plan to buy your sort-of-blemished-but-cute-under-the-right-light assets. A public-private partnership will purchase them. Private investors (such as hedge funds) will bid against each other to set a price, then the government will stroll in with matching funds and generous financing.
The plan is announced to some fanfare. You should be elated right? But a couple of days later, you realize something.
You’re screwed now. Really, really screwed.
Why you’re terrified of the Geithner plan:
1. It reveals this sort of, well, lie, you’ve been telling that the assets can’t be sold at a fair price simply because of a liquidity crisis.
The Geithner plan is swimming with leverage and liquidity. Private investors will have to put up less than 10 percent of the purchase price (some estimates have been as low as 3 percent). Public money is waiting to flood in to support transactions.
But that won't be good if you have an asset on your books for $80 (when face value is $100), and the “fire sale” price that you rejected a month ago was $37, and the bid (under the Geithner plan) comes in at $41. In this case, you can hardly blame a liquidity shortage for the low offer. So that means, um, the main problem with getting $80 for your asset isn’t a broad, out-of-your-control systemic issue (liquidity and those damn credit markets) but a specific, you-screwed-up issue (you’re holding a piece of junk).
2. Your game of vastly over-marking assets grinds to a halt.
Once your impaired bank assets are put in pools for private investors to bid upon, and real market bids result, you will be under enormous pressure to revalue huge swaths of your holdings. You can maintain that fictive price of $80 only if you keep the assets cloistered away, locked in a high tower away from judgmental eyes. Once you invite bids, you invite price discovery that, even if you reject the sale, will force you into what could be a crippling re-evaluation of how financially sound you are.
3. You’re being screwed by the “big overpaying” fallacy making its rounds on the Net.
As if things couldn't get worse: there is a simple mathematical model of how these bids will work, showing that (with the public ponying up most of the money) private investors will have an incentive to overbid by 30 or 40 percent because of the extensive government support. The model turns out to be wrong (see my preceding two entries), but it's spreading like a brush fire and was started by Mr. Nobel, Paul Krugman himself. (The real overpayment incentive will be much smaller ... perhaps a few percent?)
So here's how you're screwed: You list the asset for $80. Let’s say the bid comes in for $41. You can't accept that price; it's too low. Meanwhile bloggers worldwide begin to mutter, “Okay, that asset’s true value was about $30 because of the overpaying -- holy criminy, these banks really are clinging to a bunch of crap.” So your asset book looks even worse to the public at large than it really is. Great.
4. Private investors will use “adverse selection” against you.
There's been a lot of talk about how the public may get screwed because, when looking for assets to contribute to the pool, banks will select stinky investments that look better than they are and try to pretty them up for a sale. This is known as “adverse selection.” While the government may be dumb enough to fall for this little trick, you can bet that private investors won’t.
If anything, private investors will compensate for the likelihood of “adverse selection” by bidding LOWER for the assets. So this factor will, if anything, nudge the offered price downward even further.
5. You're doing this under the klieg lights, and it may not be pretty.
This is the Obama Administration Experiment to Save the U.S. Banking Industry. A lot of red-meat business journalists will pounce on the first published auction results, scrutinizing them to see what they tell us about the state of banks and their books. So far, you have been able to hide behind uncertainty and obfuscation. You say the asset is worth $80. Someone else says $37. Who can tell really, in these troubled times?
Of course you don't want to exist in a state of uncertainty forever. But if the state of certainty is that the asset is worth $40 -- or $41 -- or something on the low end, you may long for the good ol' days. Back then you could pretend your assets weren’t perfect but pretty good, and when the sun rose again over the land of lollipop trees and marmalade skies, everything would be just fine.