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:

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.
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.

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.

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.

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.

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.”

Let Jeremy Stein Sort It All Out

Terrific news: Harvard economist Jeremy Stein is joining Obama’s team of savants who are trying to form a plan for dealing with the financial mess. I like this guy a lot. Check out this from the WSJ Real Time Economics site (the bolding is mine):

He advocated aggressive government audits of banks, aimed at separating solvent ones from insolvent ones. Once that was done, insolvent banks would be forced into closure or sale while solvent ones would be pushed to raise more private capital. In addition to dealing with the bad bank problem, putting the plan in place would remove much of the uncertainty in financial markets that the government’s ad hoc approach to banks thus far has helped instill.

Great stuff. The nationalization debate has heated up lately, with some justification as it becomes clear to everyone that many U.S. banks are insolvent. But how do you take over swaths of a banking system gracefully, effectively, without setting off a mass panic? I'm coming to the conclusion that it's a mistake to lead the discussion with the nationalization idea -- it freaks out Republicans too much and also introduces too many thorny "how do we do this and what are the effects?” questions.

A better approach: begin with aggressive government audits of the banks, as Stein proposes. Aggressive means a tough accounting of those distressed assets on their books. In the first round start out with the largest 20, 50, 100 U.S. banks -- however many you can audit in a relatively short time frame, say two to four weeks. (This exercise should be easier right now since the banks have just done their end-of-year audits.)

After round one, you have a very critical commodity that the Paulson-led Treasury never possessed or seemed much interested in: good hard information about who’s fine, who’s in some trouble, and who’s in really deep doo doo. Now you don't have to indiscriminately sling around bailout dollars; you can make calculated decisions on who is strongest and should be propped up. The insolvent ones, if they can't raise capital, should be unwound in an orderly fashion. Or, if they're too big to fail, they get nationalized as a last resort.

Two reasons why this is a good approach: one, it's not a perfect way to eliminate the moral hazard problem, but it's a vast improvement over Paulson's scattering of funds without regard to viability. Think of it as like grading along a curve. The banks that made the worst bets, or the most insolvent, will go bust. That's as it should be. Others who are solvent or who are close to solvency will be rescued.

Two, as Stein astutely points out, this process restores a degree of certainty to financial markets in an area where it matters hugely: which of the players in the financial industry are on solid financial footing. Not resolving this issue arguably contributes the most to the freezing of credit. After a series of hard-nosed audits, banks essentially will become marked as either survivors or losers, with an impartial auditor’s stamp of approval (or disapproval).

Hiring Jeremy Stein was an excellent idea. Now Obama should listen to him. Carefully.

Bush: Blissfully out of Touch Until the Very End

“The actions taken by my administration in response to the financial crisis have laid the groundwork for a return to economic growth and job creation, and they are beginning to show some early results,” President George W. Bush said in a letter to Congress that accompanied the annual Economic Report of the President.

Back in the 1980s cartoonist Garry Trudeau did a series of strips about the inside of Ronald Reagan’s brain. It was a spooky jungle of fused and drooping synapses, a no man's land of muddled thought. Sometimes I wonder what the George Bush brain would look like. A vast and empty desert of feel-good banality?

His administration is forecasting the U.S. economy to snap out of its slump in the second half of 2009. This prediction is most likely self-serving or cynical or both. Obviously, to preserve what he can of his tattered legacy, Bush would like us to believe we are poised for recovery. Then he can claim that his presidency took the body blow from the financial crisis, but he made the painful decisions that put this country on the right track.

Of course that’s -- not to mince words -- crap. Paulson and his minions have done little more than transfuse blood into an army of zombie banks. The zombies will be back for more blood after Bush is gone. The U.S. taxpayer will be asked to bare a vein once more.

What if Bush had spoken the truth in his quote? It might sound like this:

“The actions by my administration in response to the financial crisis were taken only after much foot dragging and were half-hearted; I realize what we did looks like corporate welfare of the worst kind, but that is only because we ideologically oppose government intervention in free markets even when those markets have hugely failed, in part because of a climate of regulatory indifference that I encouraged,” President George W. Bush said in a letter to Congress that accompanied the annual Economic Report of the President. “We decided a couple of months ago to tread water and not do anything radical to solve this crisis, preferring to leave an intractable mess for the incoming Democratic president so that when economic growth and job creation don't materialize, Obama and his advisers can be blamed."

Wake up Washington!!!

This is a short entry as I sit and stew in frustration. Bank of America just got $20 billion more in federal funds and guarantees of support on $118 billion of assets. These bailouts will go on and on and on and on until Washington understands a very basic fact about this financial crisis:

The major banks in the U.S. are insolvent.

One more time: insolvent.

That's spelled I-N-S-O-L-V-E-N-T.

Nationalize them. Or let them perish. Just stop, please stop, dumping money into these bottomless pits.

The Real Reasons Why Hank Paulson Screwed Up

For Hank Paulson's detractors (and there are many), the U.S. Treasury Secretary's main mistakes in dealing with the 2009 financial crisis often boil down to: 1. Letting Lehman Brothers go bankrupt. 2. Relying on an ad hoc approach: one day the $700 billion bailout is about buying bad assets, the next it's about recapitalizing struggling banks (remember the quote from a Washington lawmaker accusing him of flying a $700 billion plane by the seat of his pants).

But is this really where the former Goldman Sachs chairman blundered?

First, Lehman Brothers: Did its collapse really play such a large role in ushering in the nuclear winter in credit markets? It's not that hard to imagine that, absent a Lehman going belly up, a different bankruptcy or dire event would have brought us to the same juncture. Remember too that Lehman was revealed to be in worse shape than anyone imagined: its bonds wound up fetching a paltry nine cents on the dollar. Its implosion spooked markets partly because investors saw how much rot had spread through asset books of financial companies.

Of course a countervailing argument is that letting a Lehman perish isn't smart because of the outsized effect on money flows. Fear and caution become ascendant to an irrational degree; overnight lending rates between banks skyrocket as everyone wonders where the next Lehman Brothers may be hiding. The system is too fragile to allow such a big company to fail.

But imagine the Treasury made a mighty 11th hour effort; there was no bankruptcy; Lehman was saved. Then what would we have today? For one, an even more entrenched corporate bailout culture. Loans would flow a bit more smoothly for a while, while the underlying weaknesses remained the same. The financial system would still be highly susceptible to small shocks.

Now what about the second Paulson criticism: Does he deserve to be pilloried for being too quick to change direction? This seems misplaced. Steadfastness may be a virtue for a 50-year marriage; its value is much less clear for a complex, fast-changing crisis that has global ramifications. Should we favor hardheadedness and inflexibility over what may be a smarter, pragmatic approach that happens to look a bit messy?

So how did Paulson screw up? The best answer to that question comes from contrasting the American and British responses to the crisis. Paulson failed to:

1. Aggressively recapitalize and resolve uncertainty around struggling banks. The Treasury Secretary and Fed should be coordinating efforts to audit banks to determine who's really insolvent and who simply needs more capital to weather hard times. The insolvent companies need to be merged with healthier rivals or unwound. This would go a long way toward restoring confidence in the industry. This requires the political will to grab the bull by the horns; Bush's free-market ideologues have been reluctant to do so.

2. Strike hard bargains in return for bailout funds. Britain did this more effectively. The U.S. government should offer money on conditions close to what the private sector would demand: preferred stock, board seats, maybe a top-level reshuffle (throw out a president or two -- or three or four). When Barclays saw what the British government wanted in exchange for assistance, it promptly began looking elsewhere for capital. The benefits to knuckling down are many, including: 1. Lessening moral hazard risk. 2. Creating more opportunities for taxpayers to benefit from providing the rescue funds. 3. Necessitating fewer bailouts, meaning less government involvement and less money being paid out by an overburdened Treasury. 4. Encouraging private capital to move off the sidelines to recapitalize banks (private capital no longer has to compete with a government that offers sweetheart deals). That then helps establish a floor price for bank valuations -- and that, of course, is a necessary prelude to any long-term recovery.

Forget Lehman. Forget the ad hoc policy. These are the real failures Hank Paulson should answer for.