Warning: This is LOOOONG and a bit GEEKY.
It's been almost a week since Treasury Secretary Geithner took the wraps off his plan to rescue the U.S. banking industry from an onerous backlog of toxic assets. Geithner sketched out a scheme (PPIP, for short) wherein public and private investors would buy assets jointly, with the FDIC kicking in a large non-recourse loan. That fat FDIC loan sweetens the deal for private investors (such as hedge funds) because (1) the FDIC loan is very low-interest (2) The FDIC eats all the deep losses (the public and private investors take the “first loss”).
Immediately the financial engineering-minded types started to sort through the problem of how much overpaying would result. It’s been a wacky week in blogland. Estimates are coming in all over the place, based on differing approaches, differing assumptions. I like the work done by Rortybomb, and Nemo (after recovering from following Krugman off a cliff with a badly oversimplified model) has produced some good stuff too (his comment section is worth the trip -- some really zingy and smart chatter on the sidelines).
Anyway Rortybomb’s latest estimate: there will be overpaying in the low teens, say about 12 percent. This may be correct, but I’m reaching the “throw up my hands” point. That’s what today’s entry is all about: broadly, why it’s so damn hard to get a grip on the magnitude of the overpaying. Let's go, point by point.
1. These assets are hard to value in the first place, even in a good economy.
The so-called legacy securities are complex, currently illiquid and basically unique. (I read once there are 100,000 different types out there clogging up bank balance sheets. Incidentally, for this reason the reverse auction idea was abandoned -- that approach works great to sell commodities like road salt, but not well at all for collections of complicated, unique products.)
2. In a bad economy, with high market volatility and a very uncertain future for growth and unemployment, placing a value on the assets becomes even trickier.
3. Once you value the security, you have to make adjustments for the “FDIC effect.” In other words, you're buying it through the Geithner special program where the FDIC shields you from deep losses and provides low-cost money. This effectively enables you to bid higher. But how much? Part I: calculating the value of the “embedded put.”
There’s been a lot of talk about the “put” in this plan. In this context, “put” refers to a kind of option commonly used in financial markets. It’s basically a bet that a price will fall. It gives the owner the right to sell a security for a certain amount, within a certain time frame. Confusing to novices, I know, so let’s look at a real world example using shares (“puts” are common on the stock markets).
Let's say I think Microsoft stock is going to plunge, so I buy a $3 put that expires November 30. It allows me to sell 100 shares for $30. (Say they currently trade at $35.) Summer comes, the new Xbox Millennium Plus is a stinkeroo, and the shares sink to $25. I exercise my put (I buy 100 shares at $25 each, then resell them to the writer of my option for $30). My profit: $5 a share (the difference between $30 and $25). I pocket a cool $500.
Now how does the Geithner plan contain a put? The plan works like this, according to one example provided by the Treasury Department: if the bid on an asset is $84 (out of a face value of $100), the private investor chips in $6, the Treasury throws in $6, and the remaining $72 takes the form of an FDIC non-recourse loan. The private investor won't lose more than what he contributes: $6. So he is protected from the worst ravages of downside risk.
It's like having a put option on $72 ($72 not $78 because he shares losses on the way down equally with his public partner, so his six dollars don’t evaporate completely until the price hits $72). More accurately, it’s a put embedded in the security (and so is a little less valuable -- in a perfect world, you could strip out the put and trade the pieces separately. For instance you could sell the riskier, high-leverage put to a hedge fund, and the asset itself to a more conservative investor, say a pension fund).
So the point is: you also have to figure out how much this put is worth for the particular asset you’re bidding on.
4. Part II: Calculating the value of the low-interest loan.
The FDIC supplies a low-interest loan. That loan, especially over a multi-year asset, could be worth quite a lot.
Let’s say the private investor, a hedge fund, demands a 12 percent return on its investments. Also right now, in these tight credit markets, it must pay 15 percent to borrow large quantities of money (here lies the liquidity problem). So how much would it pay for a five-year asset predicted to churn out yearly revenue of $27 million, then return a lump-sum principal of $100 million at the end?
This is an easy one: $100 million (for simplicity, I disregard inflation). Every year it pulls in $27 million ($15 million a year covers its borrowing costs, leaving $12 million for profit). At the end of five years, it gets back the $100 million.
Now what happens if you substitute a 2 percent cost of borrowing (let’s pretend for the sake of simplicity that the FDIC loan is about 1 percent and the hedge fund’s own costs bump the average up to 2 percent)? How much would the hedge fund pay for the asset now? Almost $145 million, or 45 percent more!!!!
(For those who want to double-check my math: it doesn't simplify all that easily and I initially got it wrong -- whoops! -- so I'll refer you to the comment section, where a poster straightens it out for me. If anyone out there wants me to revisit this calculation in a later blog entry, just drop in a comment and I will. Else, my hunch is 99 percent of you don't care that much, though the underlying point is quite critical: being able to obtain money much more cheaply than at market rates can really boost the value of a long-term asset.)
Ah, but hold on: I cheated a bit. Yup, I assumed this current distressed credit market will be exactly the same in five years, with that burdensome 15 percent borrowing cost unchanged. That’s not likely. Factoring in lower borrowing rates will push down the level of overpayment.
There's also arguably a problem with my initial assumption of a 15 percent borrowing cost. On one hand, we hear that the costs of loans have soared, but then again, private investors are reportedly saying they have enough money and are champing at the bit to have at these distressed assets ... also the broader interest rate environment in the U.S. is close to zero right now, so 15 percent may not be correct at all.
For kicks, let’s change it to a 4 percent borrowing cost instead of 15 and tweak the numbers slightly to keep the math simple. Let’s assume the asset kicks out $16 million a year over five years, and again returns $100 million in principal. Got it?
So now the hedge fund would pay $100 million ($4 million a year will cover borrowing and $12 million profit). Now, lower your cost of borrowing to 2 percent because of the FDIC subsidy, and you end up overpaying ... less than 7 percent. Bad, but not nearly as bad as 45 percent. Quite a big swing in fact.
Now, what’s the reality? I honestly don’t have a good feel for this, but it’s important in figuring out the overpayment.
Anyway the bottom line remains: your bid is affected to a certain degree by the advantageous cost of borrowing through the FDIC non-recourse loan.
5. Then other questions are swirling about that will affect your bid, some practical:
Valuing complex securities can be time-consuming and expensive. You’ll have to build into your bid a percentage point or two to cover the costs of doing a lot of research but then losing out to other bidders (or having the bank turn down your bid). This will nudge your offering price a little lower.
Also, are you allowed to resell the asset into the secondary market? How would that work? Here’s the danger: You buy a $100 million five-year asset for let’s say $130 million because of the value of the FDIC subsidy and the put, then need to resell six months later. But does the buyer automatically get your FDIC subsidy and put transferred to him? It’s a problem either way. If he doesn’t, he’ll want to bid your asset closer to $100 million and you’ll refuse to sell. So in essence you’ll be married to an illiquid five-year asset (which will tend to push your initial bid lower). If he does, then the subsidy is built into the asset. That kind of approach isn’t exactly market-friendly -- the asset doesn’t get a temporary subsidy; it gets a lifelong subsidy. What’s more such a provision can distort the larger markets; if the subsidy effect is too large, it will serve to make it harder to discover true prices in the market at large.
6. And some intangibles may affect your bid:
Such as: Is this plan going to turn around and change in midstream (this is the government after all)? Are you going to be demonized for seeking a big profit? For an investor will it be a lose-lose proposition in the court of public opinion? (If you profit big, the public will hate you for doing so well. If you overpay big and the taxpayer loses big, the public will hate you for bailing out the banks.)
Okay, almost done! One note: I’m not saying the bidders will actually break down the elements of their offer this way. I’ve simply done it like this to show how many parts can be teased out of one simple bid. And they all affect price, to greater and lesser degrees, and so would be factored in.
After sketching out all these complexities, I have to admit the kicker is that all this analysis may be for nought. What could be the biggest influence on price is gaming the system, if loopholes exist. If I’m a bank that owns a private equity outfit, and I can arrange for a full-price bid, say $80, on crappy assets worth $30, why not? FDIC eats most of the losses. If the Geithner plan hasn’t taken steps to ensure arm’s length transactions, members of the Obama administration are very stupid and possibly criminal. If that worst case comes to pass (i.e., massive gaming of the system), there will be blood on the streets when the public finds out how they got fleeced by their own government.
Update: Thanks to the anonymous commenter below, I fixed my math (the overpaying under part 4. turns out to be 145 percent, not 138 percent ... I also rejiggered the other example in that section to be correct.)
Sunday, March 29, 2009
Saturday, March 28, 2009
Who Does Really Run Things? Seriously.
My wife is Chinese. When she showed up one day toting a copy of a book, in Chinese, called Currency Wars, I was encouraged. Perhaps this meant we could have discussions about one of my favorite topics, how China manages its currency and what that means for its economy. Of course I knew nothing about the book itself.
It turns out that Currency Wars -- a bestseller in China -- is one of those far-fetched, conspiracy theorist takes on U.S. finance: According to the author, there is a cabal of powerful bankers and banks that controls America's financial policy behind the scenes. I’m sure he includes in his cast of villains quite a few hook-nosed Jews who like to salivate over the clink of gold coins. When my wife began describing the contents, I just began to laugh.
Now my laughter feels a little hollow. Not about the stereotype of the wicked Jew; that’s clearly ludicrous. (Accused Ponzi schemer Allen Stanford is about as Jewish as Mother Theresa, for instance.) But more about the idea that perhaps, just perhaps, a small group of powerful high financiers and companies have managed to capture our supposedly representative government.
It’s the only way I can make sense of the Obama administration’s response to the U.S. financial crisis. No one really dares to call out the bankers, and a culture gone bad, and say, “Guys, you really screwed up. It’s time for you to slip on your hair shirts and do a little penance. You don’t have to hari-kari, but a few apologies writ large would be nice. And you, and your investors, have to start paying the price for your bad decisions.”
Instead, after Obama told Americans their outrage about AIG is justified, he began beating a retreat, damping down his criticism of the financial industry. His economic team (the part that actually makes the decisions anyway) has been Hank Paulson Redux (including Mini-Me Geithner). Save the banks, at all costs. Avoid measures that hurt the shareholders and bondholders (who are, respectively, the owners and creditors -- in other words, the ones who should have been minding the store in the first place). Bankruptcy is unthinkable -- well, for Citigroup and friends anyway (GM, that’s a different story).
How to explain the submissive dog pose the government has struck with Wall Street (the administration pleads with the Street to play ball with the Geithner plan -- look, I’ve got news for you; they’ll show up with their bats and gloves plenty fast if there’s enough profit to be made and not otherwise, all your pleading be damned)? How to explain the arrogance and sense of entitlement that still pervade Wall Street?
Just compare the hardball U.S. government in this New York Times story (bold mine):
I know, it sounds crazy. But, with each passing day, it’s sounding less and less crazy.
It turns out that Currency Wars -- a bestseller in China -- is one of those far-fetched, conspiracy theorist takes on U.S. finance: According to the author, there is a cabal of powerful bankers and banks that controls America's financial policy behind the scenes. I’m sure he includes in his cast of villains quite a few hook-nosed Jews who like to salivate over the clink of gold coins. When my wife began describing the contents, I just began to laugh.
Now my laughter feels a little hollow. Not about the stereotype of the wicked Jew; that’s clearly ludicrous. (Accused Ponzi schemer Allen Stanford is about as Jewish as Mother Theresa, for instance.) But more about the idea that perhaps, just perhaps, a small group of powerful high financiers and companies have managed to capture our supposedly representative government.
It’s the only way I can make sense of the Obama administration’s response to the U.S. financial crisis. No one really dares to call out the bankers, and a culture gone bad, and say, “Guys, you really screwed up. It’s time for you to slip on your hair shirts and do a little penance. You don’t have to hari-kari, but a few apologies writ large would be nice. And you, and your investors, have to start paying the price for your bad decisions.”
Instead, after Obama told Americans their outrage about AIG is justified, he began beating a retreat, damping down his criticism of the financial industry. His economic team (the part that actually makes the decisions anyway) has been Hank Paulson Redux (including Mini-Me Geithner). Save the banks, at all costs. Avoid measures that hurt the shareholders and bondholders (who are, respectively, the owners and creditors -- in other words, the ones who should have been minding the store in the first place). Bankruptcy is unthinkable -- well, for Citigroup and friends anyway (GM, that’s a different story).
How to explain the submissive dog pose the government has struck with Wall Street (the administration pleads with the Street to play ball with the Geithner plan -- look, I’ve got news for you; they’ll show up with their bats and gloves plenty fast if there’s enough profit to be made and not otherwise, all your pleading be damned)? How to explain the arrogance and sense of entitlement that still pervade Wall Street?
Just compare the hardball U.S. government in this New York Times story (bold mine):
The Obama administration will probably extend more short-term aid to General Motors and Chrysler on Monday, but will impose a strict deadline for bondholders and union workers to make concessions that would help the ailing automakers become viable businesses and avert bankruptcy.To the apparent patsy in this Bloomberg story:
President Obama’s auto task force is expected to say that despite its recommendation of more federal assistance for G.M. and Chrysler, bankruptcy could still be a possibility for either company, according to people close to the discussions.
Bank executives indicated they are willing to hold onto U.S. government aid to help stabilize the financial system and pull the economy out of recession..... (implication: they don’t need it, but oh okay, they’ll keep it as a favor to us.)How do you account for the banking industry arrogance, this unabashed display of Tin Ear Syndrome? Well, one answer is the bankers really are in charge. Maybe when Obama took office, someone in a dark suit took him by the elbow and whispered, “Mr. President, please step into this small room with me. We need to have a special talk about how the country is really run and who’s really top dog. Hint: It’s not you, despite what you may think.”
TARP “has become a little bit of a scarlet letter,” Jamie Dimon, chief executive officer of JPMorgan Chase & Co., said on CNBC. JPMorgan accepted $25 billion in TARP funds. “At one point we’ll figure out a way to pay it back, Dimon said.... (meanwhile, GM execs would do a full-body grovel to get their hands on some of these “scarlet letter” TARP funds)
If populist outcries over bank compensation continue, no company will touch “any other government program with a ten-foot pole,” Stephen Stanley, chief economist at RBS Greenwich Capital Markets, wrote in a March 19 note. (in other words, taxpayers: just shut up about big bonuses if you know what’s good for you.)
I know, it sounds crazy. But, with each passing day, it’s sounding less and less crazy.
Thursday, March 26, 2009
The Joys of Blogging on the Fly!
I will return to this subject later, when I have more time, but the issue of overpaying on bank assets under the Geithner plan is much more complex than meets the eye ... ah, so many wrinkles! I'm now wavering on how much overpayment we may see -- it may be considerable after all. See this blog entry (very wonky) for a scenario that's actually real world (unlike the misleading simple models that were floating around, like Krugman's), though it contains assumptions that may turn out not to be true. Also I think there's a "cost of money" element that could cause bids to come in higher that no one is modelling yet (everyone's looking at the risk angle).
So are banks still secretly terrified of the Geithner plan (preceding entry)? I still think probably yes, but I'm going to return to that subject sometime later. First I want to do a blog entry on the private investor advantage of "free money" and how that may skew the offered prices.
So are banks still secretly terrified of the Geithner plan (preceding entry)? I still think probably yes, but I'm going to return to that subject sometime later. First I want to do a blog entry on the private investor advantage of "free money" and how that may skew the offered prices.
Wednesday, March 25, 2009
5 Reasons U.S. Banks are Secretly Terrified of Geithner's Plan
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.
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.
Tuesday, March 24, 2009
Bad Arithmetic Proliferates
Wow. That was my reaction on waking to a dreary Hong Kong morning, logging onto the Internet, and finding that Paul Krugman's flawed model on overpaying for toxic bank assets had grown wings. A blog site dangerously named “self-evident” had taken a Krugmanesque approach to show how taxpayers could get shafted under the Geithner plan. Scarily, the link appears to be spreading like wildfire through the blogosphere.
Okay, I don't like the Geithner plan either. But at least we should get the criticism right.
This blog entry, penned by Nemo, does have an admirable cleverness in that it tries to impale the Treasury Department on its own “Geithner Plan for Dummies” fact sheet. The Geithner plan of course proposes a partnership of public and private funds to buy the bad assets clogging up U.S. bank balance sheets. Here's the quick-and-dirty version of the Treasury Department example of how the program would work:
A private investor wins the bid for a pool of mortgages with a bid of $84 (of the face value of $100). The FDIC guarantees $72 of financing. Of the rest, the government puts up half ($6) and a private investor half ($6).
Now here’s Nemo:
But what does it illustrate? Consider this excerpt: suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. He claims his principle in constructing the example is basically sound because no one knows what these assets are worth. True, but -- BIG but -- that’s different from saying they’re all worth full value or nothing and there's absolutely no way of knowing which are which.
Here’s the type of “real world” that Nemo’s auction would illustrate well:
Buyers for the assets bid blindly. Either they aren't allowed to review what they are bidding on (sorry, no peeking), or it’s impossible to make ANY estimation of their value (think about it: if you have no chance of telling the difference between a $0 and $100 asset, you’re basically in the Land of Perpetual Fog). So they essentially buy a lottery ticket. Joe Hedge Fund says, “I’ll put a $6 investment on 35-46-91,” knowing he’ll either profit big (it’s worth $100) or go bust (it’s worth nothing).
Absurd? Hugely. This doesn't illustrate anything real world at all. If you want to come up with a model for overpayment, you would do best to start with a few realistic baseline assumptions about how the bidding will work. Motives of private investors are simple: they want to make money, and the more of it the better.
So they might craft their bid by first running economic scenarios, tweaking variables a little this way and that way. In the spirit of Nemo’s example, let’s say they run the scenarios 100 times on an asset worth somewhere between nothing and $100. And let's say its true worth, known only to God, is $50.
One hundred data points result. Most are likely to be clustered around $50. The farther out you go toward the extremes ($0 and $100), the fewer points you find. Let’s say that between $17 and $83 you find 90 percent (and that’s likely a conservative figure) of the outcomes.
No Wall Street investor worth his salt would bid anywhere near $84, knowing that there’s a 90 percent chance he’s overpaying, based on his own number-crunching. (Note: This assumes that taxpayers and private investors share profits and losses, let’s say 50-50, in BOTH directions, at least until that FDIC backstop kicks in on the way down).
Is there a simple way to illustrate the magnitude of the real overpayment problem? I don't think so (it’s fairly sophisticated unfortunately), but the takeaway seems to be that
(1) as long as the profit gains (and losses) are divvied fairly and
(2) there aren’t ways to “game the system”
overpayment will be modest, maybe a few percent?
The Geithner plan’s real problems lie elsewhere, such as with the chasm that currently exists between the market price for these assets and what the banks have booked them for. The plan risks being a high-profile dud, with blaring trumpets and scurrying about at the front end ... and no assets at all changing hands after all is said and done.
Okay, I don't like the Geithner plan either. But at least we should get the criticism right.
This blog entry, penned by Nemo, does have an admirable cleverness in that it tries to impale the Treasury Department on its own “Geithner Plan for Dummies” fact sheet. The Geithner plan of course proposes a partnership of public and private funds to buy the bad assets clogging up U.S. bank balance sheets. Here's the quick-and-dirty version of the Treasury Department example of how the program would work:
A private investor wins the bid for a pool of mortgages with a bid of $84 (of the face value of $100). The FDIC guarantees $72 of financing. Of the rest, the government puts up half ($6) and a private investor half ($6).
Now here’s Nemo:
Let’s flesh this out by repeating it 100 times. So say a bank has 100 of these $100 loan pools. And just by way of example, suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. (These numbers are made up but the principle is sound. Nobody knows what the assets are really worth because it depends on future events, like who actually defaults on their mortgages.)In an update, Nemo admits that his example is “totally unrealistic.” Further, he says, “It was not meant to be realistic; it was meant to be illustrative.”
Thus, on average the pools are worth $50 each and the true value of all 100 pools is $5000.
The FDIC provides 6:1 leverage to purchase each pool, and some investor (e.g., a private equity firm) takes them up on it, bidding $84 apiece. Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools but only puts in $600 of its own money.
Half of the pools wind up worthless, so the investor loses $300 total on those. But the other half wind up worth $100 each for a $16 profit. $16 times 50 pools equals $800 total profit which is split 1:1 with the Treasury. So the investor gains $400 on these winning pools. A $400 gain plus a $300 loss equals a $100 net gain, so the investor risked $600 to make $100, a tidy 16.7% return.
The bank unloaded assets worth $5000 for $8400. So the private investor gained $100, the Treasury gained $100, and the bank gained $3400. Somebody must therefore have lost $3600…
…and that would be the FDIC, who was so foolish as to offer 6:1 leverage to purchase assets with a 50% chance of being worthless. But no worries. As long as the FDIC has more expertise in evaluating the risk of toxic assets than the entire private equity and banking worlds combined, there is no way they could be taken to the cleaners like this. What could possibly go wrong?
But what does it illustrate? Consider this excerpt: suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. He claims his principle in constructing the example is basically sound because no one knows what these assets are worth. True, but -- BIG but -- that’s different from saying they’re all worth full value or nothing and there's absolutely no way of knowing which are which.
Here’s the type of “real world” that Nemo’s auction would illustrate well:
Buyers for the assets bid blindly. Either they aren't allowed to review what they are bidding on (sorry, no peeking), or it’s impossible to make ANY estimation of their value (think about it: if you have no chance of telling the difference between a $0 and $100 asset, you’re basically in the Land of Perpetual Fog). So they essentially buy a lottery ticket. Joe Hedge Fund says, “I’ll put a $6 investment on 35-46-91,” knowing he’ll either profit big (it’s worth $100) or go bust (it’s worth nothing).
Absurd? Hugely. This doesn't illustrate anything real world at all. If you want to come up with a model for overpayment, you would do best to start with a few realistic baseline assumptions about how the bidding will work. Motives of private investors are simple: they want to make money, and the more of it the better.
So they might craft their bid by first running economic scenarios, tweaking variables a little this way and that way. In the spirit of Nemo’s example, let’s say they run the scenarios 100 times on an asset worth somewhere between nothing and $100. And let's say its true worth, known only to God, is $50.
One hundred data points result. Most are likely to be clustered around $50. The farther out you go toward the extremes ($0 and $100), the fewer points you find. Let’s say that between $17 and $83 you find 90 percent (and that’s likely a conservative figure) of the outcomes.
No Wall Street investor worth his salt would bid anywhere near $84, knowing that there’s a 90 percent chance he’s overpaying, based on his own number-crunching. (Note: This assumes that taxpayers and private investors share profits and losses, let’s say 50-50, in BOTH directions, at least until that FDIC backstop kicks in on the way down).
Is there a simple way to illustrate the magnitude of the real overpayment problem? I don't think so (it’s fairly sophisticated unfortunately), but the takeaway seems to be that
(1) as long as the profit gains (and losses) are divvied fairly and
(2) there aren’t ways to “game the system”
overpayment will be modest, maybe a few percent?
The Geithner plan’s real problems lie elsewhere, such as with the chasm that currently exists between the market price for these assets and what the banks have booked them for. The plan risks being a high-profile dud, with blaring trumpets and scurrying about at the front end ... and no assets at all changing hands after all is said and done.
Monday, March 23, 2009
What's wrong with Paul Krugman's arithmetic?
I like Paul Krugman a lot. I like his skepticism a lot. Further, he has a magic touch for simplifying complex and arcane topics in economics. But in this blog entry, I think he goes a simplification too far.
He is attacking the “subsidy effect” of the Geithner plan. The Treasury Secretary unveiled a proposal Monday that would have the government partner with private investors to buy distressed banking assets. The FDIC would finance 85 percent of the purchases with non-recourse loans. That, Krugman argues with the following example, invites what looks like a great deal of overpaying:
What's more likely with an asset of uncertain value is a bit more complex. You crunch the numbers (and indeed, this is exactly what these private investors preparing bids will do) for a bunch of scenarios. Let's say you conclude the asset will wind up with a value of between 50 (worst scenario) or 150 (best scenario).
Now, if you run different scenarios, this doesn't lead to a binary data set of outcomes. In fact, “50” and “150” are the least likely values, lying at the far end of the distribution curves. Assuming a fairly normal bell curve, if you looked at 1,000 scenarios, most resulting values would cluster in the middle, then taper off toward the ends.
So you're most likely to wind up with an asset having a value between 90 and 110. A smaller batch of data points will occur between 80-90 and 110-120. A smaller batch still will populate the next bands (70-80 and 120-130). Let’s say, for the sake of argument, that 90 percent of the probable values lie between 70 and 130 (if anything, this may be conservative).
Returning to Krugman's example, he states that the private investor, who stands to lose at most only 15 percent of the purchase price, would be willing to pay slightly over 130 for the asset. That's a whopping overpayment of 30 percent.
He's right if you accept the casino model. But for a more realistic model (as laid out above), it's not true at all. In that model, the investor who bids 130 stands a 90 percent chance of losing part, or all, of his money. Actually, it's even grimmer than that because most results are clustered around the 90-110 mark.
It may seem like I'm picking a nit, but it's worth putting the arithmetic in the proper perspective. Krugman is right that there will be overpaying, but I don't think it will be nearly as bad as he envisions (a few percent?). (Of course I'm assuming that loss- and profit-sharing are fairly split between the public and private entities.)
What seems like a greater potential threat, and the one the government needs to keep a sharp eye on, is the possibility of investors gaming the system. I'm not sure exactly how it would work, or if anyone on Wall Street still has the chutzpah to attempt it, considering how vilified the Street has become.
But the possibility is certainly there because private investors will be buying highly leveraged investments with dumb money partners (yup, that’s us, the U.S. taxpayer) who will take a huge chunk of the downside risk.
He is attacking the “subsidy effect” of the Geithner plan. The Treasury Secretary unveiled a proposal Monday that would have the government partner with private investors to buy distressed banking assets. The FDIC would finance 85 percent of the purchases with non-recourse loans. That, Krugman argues with the following example, invites what looks like a great deal of overpaying:
Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100.The trouble with his example: he's using a casino-type model that doesn't translate well to the real world. In his attempt to simplify, he assumes an equal chance of the asset ending up worth either 150 or 50. In other words, you win if you land on black but you lose if you come up red -- like a roulette wheel.
But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset?
The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.
Notice that the government equity stake doesn’t matter — the calculation is the same whether private investors put up all or only part of the equity. It’s the loan that provides the subsidy.
And in this example it’s a large subsidy — 30 percent.
What's more likely with an asset of uncertain value is a bit more complex. You crunch the numbers (and indeed, this is exactly what these private investors preparing bids will do) for a bunch of scenarios. Let's say you conclude the asset will wind up with a value of between 50 (worst scenario) or 150 (best scenario).
Now, if you run different scenarios, this doesn't lead to a binary data set of outcomes. In fact, “50” and “150” are the least likely values, lying at the far end of the distribution curves. Assuming a fairly normal bell curve, if you looked at 1,000 scenarios, most resulting values would cluster in the middle, then taper off toward the ends.
So you're most likely to wind up with an asset having a value between 90 and 110. A smaller batch of data points will occur between 80-90 and 110-120. A smaller batch still will populate the next bands (70-80 and 120-130). Let’s say, for the sake of argument, that 90 percent of the probable values lie between 70 and 130 (if anything, this may be conservative).
Returning to Krugman's example, he states that the private investor, who stands to lose at most only 15 percent of the purchase price, would be willing to pay slightly over 130 for the asset. That's a whopping overpayment of 30 percent.
He's right if you accept the casino model. But for a more realistic model (as laid out above), it's not true at all. In that model, the investor who bids 130 stands a 90 percent chance of losing part, or all, of his money. Actually, it's even grimmer than that because most results are clustered around the 90-110 mark.
It may seem like I'm picking a nit, but it's worth putting the arithmetic in the proper perspective. Krugman is right that there will be overpaying, but I don't think it will be nearly as bad as he envisions (a few percent?). (Of course I'm assuming that loss- and profit-sharing are fairly split between the public and private entities.)
What seems like a greater potential threat, and the one the government needs to keep a sharp eye on, is the possibility of investors gaming the system. I'm not sure exactly how it would work, or if anyone on Wall Street still has the chutzpah to attempt it, considering how vilified the Street has become.
But the possibility is certainly there because private investors will be buying highly leveraged investments with dumb money partners (yup, that’s us, the U.S. taxpayer) who will take a huge chunk of the downside risk.
Sunday, March 22, 2009
The Geithner Plan: One Big Problem, One Big Question
Uh oh. It's that time of the financial crisis again. A new plan is about to be rolled out to save the U.S. banking industry. Sketchy details have been leaked in advance of course. (The New York Times summary is here.)
Much of the blogosphere commentariat has been withering in its criticism. Paul Krugman hates the plan, as it currently appears to be constituted. Yves Smith hates it.
Superficially, the plan appears to take a giant step in the right direction. The government would partner with sharp-witted private investors to buy toxic assets that are weighing down the balance sheets of the country's major banks. The Wall Street guys would be the brains: they figure out how much the toxic dreck is really worth, then bid against each other for it. The U.S. government would be the money: taxpayers fund most of the purchase price, then ideally scoop up a nice profit at the end of the day.
Sounds good. What's wrong with this picture?
The one big problem:
Since the Geithner plan has all the moving parts of a Hail Mary play, a little clarity is called for. Forget the left tackle swapping places with the right tackle and the multiple laterals; here’s the key take-home point: the U.S. government may pay as much as 97 percent of the purchase price, while our co-investors (hedge funds, private equity firms) chip in as little as 3 percent.
That feature of the plan has been attacked on the grounds of “that's not fair, our partners won't have enough skin in the game.” That's misleading. That shouldn't be perceived as a dealbreaker. Think of it this way: If you had a smart friend with no money, and you had money but not much smarts, you could still work nicely together as a team. He finds a great investment opportunity, you supply the cash, and you both pocket a nifty profit.
The problem enters when you think about what situation this scenario really applies to. It's roughly the following one: There's a great investment opportunity, and let's say it’s pretty widely known, but no one steps forward. Why? Well, they can't scrape together the money. Credit is tight. Interest rates are too high.
In other words, this smart guy-deep pockets team makes perfect sense when the problem is liquidity. The partners can make out like bandits because a lack of cash has sidelined their rivals. But what if liquidity isn't the issue? What if the investment opportunity really isn't that good? What if all those assets (turning to our current crisis) that American banks are so anxious to unload can’t be sold because they want an unreasonable price for them, not because of a credit shortage?
Then the Geithner plan looks completely wrongheaded. His public-private partnership would work great in a liquidity crisis, as private investors introduce price discovery while leveraging their small stakes. The same concept isn't suitable for a solvency crisis, where the main problem is that the banks can't accept a “true value” for their assets, as they’d be forced to declare themselves insolvent.
However the really interesting part of the plan lies in:
The one big question:
How are profits to be shared between the partners on the way up and losses to be shared on the way down? This is a HUGE point that I haven't read anything about yet (to be fair, the plan hasn't officially been unveiled), but it's absolutely critical to understand. One thing you can be sure of: our smart private investor partners will be all over this angle, looking for clever ways to profit.
The fairest way to divvy risk, of course, would be proportional in both directions. If Joe's Hedge Fund throws in 5 percent of the purchase price, it gets one-twentieth of the profits and also absorbs one-twentieth of the losses. That's not likely to happen. Joe’s Hedge Fund likely will want a sweeter deal.
Another scenario: since apparently up to 85 percent of the price will be covered by FDIC non-recourse loans, you could treat that as "free” money and focus on the remaining 15 percent. If 10 percent of the overall comes from the government, and the other 5 percent from Joe’s Hedge Fund, then the U.S. could take two-thirds of the profit, and the hedge fund the rest.
Ah, but what happens when money is lost? Fair treatment would dictate the same split on the way down. But I would watch very carefully to see if down matches up (whatever the agreement). I doubt that it will. I bet that somehow the private partner will be protected against losses.
Why? Because otherwise the private partner won't have an incentive to bid higher than the current market price for these distressed assets. The banks won't accept that “fire sale” price, knowing it would push them into insolvency. The plan will be a complete bust, in the sense that nothing will happen. The banks will keep all the crappy assets. We'll be right back at square one.
Obama’s economic team is making the same bad kinds of decisions that the Bush crowd did. Let's hope that they discover this is a solvency, not liquidity, crisis before they've squandered all their political capital and we’re in a terrible mess.
Much of the blogosphere commentariat has been withering in its criticism. Paul Krugman hates the plan, as it currently appears to be constituted. Yves Smith hates it.
Superficially, the plan appears to take a giant step in the right direction. The government would partner with sharp-witted private investors to buy toxic assets that are weighing down the balance sheets of the country's major banks. The Wall Street guys would be the brains: they figure out how much the toxic dreck is really worth, then bid against each other for it. The U.S. government would be the money: taxpayers fund most of the purchase price, then ideally scoop up a nice profit at the end of the day.
Sounds good. What's wrong with this picture?
The one big problem:
Since the Geithner plan has all the moving parts of a Hail Mary play, a little clarity is called for. Forget the left tackle swapping places with the right tackle and the multiple laterals; here’s the key take-home point: the U.S. government may pay as much as 97 percent of the purchase price, while our co-investors (hedge funds, private equity firms) chip in as little as 3 percent.
That feature of the plan has been attacked on the grounds of “that's not fair, our partners won't have enough skin in the game.” That's misleading. That shouldn't be perceived as a dealbreaker. Think of it this way: If you had a smart friend with no money, and you had money but not much smarts, you could still work nicely together as a team. He finds a great investment opportunity, you supply the cash, and you both pocket a nifty profit.
The problem enters when you think about what situation this scenario really applies to. It's roughly the following one: There's a great investment opportunity, and let's say it’s pretty widely known, but no one steps forward. Why? Well, they can't scrape together the money. Credit is tight. Interest rates are too high.
In other words, this smart guy-deep pockets team makes perfect sense when the problem is liquidity. The partners can make out like bandits because a lack of cash has sidelined their rivals. But what if liquidity isn't the issue? What if the investment opportunity really isn't that good? What if all those assets (turning to our current crisis) that American banks are so anxious to unload can’t be sold because they want an unreasonable price for them, not because of a credit shortage?
Then the Geithner plan looks completely wrongheaded. His public-private partnership would work great in a liquidity crisis, as private investors introduce price discovery while leveraging their small stakes. The same concept isn't suitable for a solvency crisis, where the main problem is that the banks can't accept a “true value” for their assets, as they’d be forced to declare themselves insolvent.
However the really interesting part of the plan lies in:
The one big question:
How are profits to be shared between the partners on the way up and losses to be shared on the way down? This is a HUGE point that I haven't read anything about yet (to be fair, the plan hasn't officially been unveiled), but it's absolutely critical to understand. One thing you can be sure of: our smart private investor partners will be all over this angle, looking for clever ways to profit.
The fairest way to divvy risk, of course, would be proportional in both directions. If Joe's Hedge Fund throws in 5 percent of the purchase price, it gets one-twentieth of the profits and also absorbs one-twentieth of the losses. That's not likely to happen. Joe’s Hedge Fund likely will want a sweeter deal.
Another scenario: since apparently up to 85 percent of the price will be covered by FDIC non-recourse loans, you could treat that as "free” money and focus on the remaining 15 percent. If 10 percent of the overall comes from the government, and the other 5 percent from Joe’s Hedge Fund, then the U.S. could take two-thirds of the profit, and the hedge fund the rest.
Ah, but what happens when money is lost? Fair treatment would dictate the same split on the way down. But I would watch very carefully to see if down matches up (whatever the agreement). I doubt that it will. I bet that somehow the private partner will be protected against losses.
Why? Because otherwise the private partner won't have an incentive to bid higher than the current market price for these distressed assets. The banks won't accept that “fire sale” price, knowing it would push them into insolvency. The plan will be a complete bust, in the sense that nothing will happen. The banks will keep all the crappy assets. We'll be right back at square one.
Obama’s economic team is making the same bad kinds of decisions that the Bush crowd did. Let's hope that they discover this is a solvency, not liquidity, crisis before they've squandered all their political capital and we’re in a terrible mess.
Friday, March 6, 2009
A Big Lie in the Banking Crisis: “It's a Liquidity Problem.”
I remember hearing this line early on, months before the catastrophic Lehman Brothers meltdown, when credit markets were starting to tighten. It later became all the vogue when the banks claimed they couldn't sell their stockpiles of crappy assets. At least not for a “fair” value.
“Liquidity problem” is a clever banker’s smokescreen. It basically means there's not enough liquidity, or money, available to meet the broader demand. That's the problem that you darkly hint of when you say things like, “credit markets are frozen.”
For a pathological finger pointer, it's a great excuse. You're not the one to blame. It's the system. “In a normal, liquid market, these assets would sell for much more,” the banker whines.
Now, if the banking industry can convince the government that the problem really is liquidity, here's what happens: The government cuts interest rates as low as zero and sets up a bunch of emergency credit facilities. (Sound familiar?) The market is awash in money. The liquidity problem goes away. The country is saved!
If injecting funds this way doesn't cure the ill, then you have to consider a different, and more likely, possibility: it isn't a liquidity problem at all. It's a bubble-deflating problem under which the assets could keep losing value, very easily.
Parse the banker’s statement to see what he's really saying:
Original: “In a normal, liquid market, these assets would sell for much more.”
Translation: “In a bubble market, these assets sold very well at a higher price. That helped make them more liquid as investments. Now the assets (securities often backed by home mortgages) aren’t desirable because of their complexity and housing price declines. But we're not willing to lower our price, so we'll blame liquidity.”
“Liquidity problem” is a clever banker’s smokescreen. It basically means there's not enough liquidity, or money, available to meet the broader demand. That's the problem that you darkly hint of when you say things like, “credit markets are frozen.”
For a pathological finger pointer, it's a great excuse. You're not the one to blame. It's the system. “In a normal, liquid market, these assets would sell for much more,” the banker whines.
Now, if the banking industry can convince the government that the problem really is liquidity, here's what happens: The government cuts interest rates as low as zero and sets up a bunch of emergency credit facilities. (Sound familiar?) The market is awash in money. The liquidity problem goes away. The country is saved!
If injecting funds this way doesn't cure the ill, then you have to consider a different, and more likely, possibility: it isn't a liquidity problem at all. It's a bubble-deflating problem under which the assets could keep losing value, very easily.
Parse the banker’s statement to see what he's really saying:
Original: “In a normal, liquid market, these assets would sell for much more.”
Translation: “In a bubble market, these assets sold very well at a higher price. That helped make them more liquid as investments. Now the assets (securities often backed by home mortgages) aren’t desirable because of their complexity and housing price declines. But we're not willing to lower our price, so we'll blame liquidity.”
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