Come for the Politics, Stay for the Pathologies

Monday, March 23, 2009

A Smoke and Mirror Plan For the Rest of Us

Little Timmy Geithner over at Treasury has come up with the mother of all smoke and mirror plans. If it works, it will serve to obfuscate the smoke and mirror plan it is attempting to fix. Didn’t you just know he was a little genius?

He’s finally finagled a way to bail out insolvent banks and Wall Street firms with taxpayer money without a huge public outcry. How? By pitching it as a “public/private” partnership in which private companies ostensibly price the toxic assets, aka toxic waste, at financial institutions and buy them.

Just one little problem: they’re buying them with taxpayer money. Specifically, 97% of what buyers (most likely hedge funds) pay for bad debts will be footed by us, the US taxpayer. And worse, it’s non-recourse debt, so if the hedge funds overbid and end up losing money on the transaction, they lose nothing – the US Treasury (again, you and me) is the only one on the hook. Want to see how it works?

Toxic Assets 101:

Let’s say Bank1 has $100 million in “toxic assets.” They could be in one of three forms:

  1. assets backed by cash i.e. loans and mortgages, probably in default
  2. assets backed by credit default swap (CDS) contracts. These are really synthetic paper, there are no real assets
  3. assets backed by a combination of CDS and cash.

Group one can be valued rather easily based on traditional methods. Groups 2 and 3 are nearly impenetrable – no one can readily identify the assets underlying the CDS portion. They have some value, but someone needs to figure out what the assets are first. In case you’re perplexed as to why AIG would pay retention bonuses to people in the department that created these monsters, it’s because they need them to unwind these crazy, complex transactions in order to recover any value: instruments and transactions so complicated even forensic accountants would have trouble.

So you see the problem of valuation. Bank1 says the assets are worth $60 million. The market says they’re worth $30 million: no deal.

Enter Timmy’s magic dragon: The FDIC will finance 97% of the purchase price in the form of a non-recourse loan (i.e. you can walk away). So Hedge fund 1, who last week would have offered Bank1 less than market value ($30 million) for this risky bet, this week can offer them more than they think the “asset” is worth. So they offer $70 million. They only have to come up with $2.1 million, or 3%, and taxpayers loan them the rest. So Bank1 snaps at the offer, and immediately posts a $10 million gain on their books while simultaneously dumping the toxic debt. Hedge fund1, down the road when true market value is established, might find out that the toxic mess was worth only$ 25 million. They dump it for 25 million, book a profit ($25 million less $2.1 million and accumulated interest) and walk away, leaving Treasury with the loss on the difference.

In short, Treasury is selling toxic waste at inflated prices and sticking the loss squarely on the shoulders of the taxpayer. Heads, banks and hedge funds win. Tails, taxpayers lose. But then, you knew that before I started.

As an aside, Neville at Naked Capitalist posted the following comment:

Does anybody remember that the last people who brought in 3% equity partners to take control of an off-balance sheet hedge fund in a no-loss deal designed solely to absorb toxic assets at inflated prices, were sent to jail by the government for misleading the public? Their names were Andrew Fastow, Jeffrey Skilling and a raft of other managers, at Enron.

The goal of their off balance sheet partnerships was to conceal where and when the real losses had occurred and thus who was responsible for them, until some later date when they could either be transferred back onto the public (Enron's shareholders) in a way they would not notice, or at least after the Enron managers had a chance to unload their shares.

Now we have a virtually identical scheme, but this time it's being promoted jointly by the banks and the US Treasury. Once again the effort is to construct a vehicle into which toxic assets can be transferred at inflated prices, positioning the public to take the losses while disguising them in the short term, and giving the managers of our biggest banks a chance to both profit now and then sell out ahead of the public.

Perhaps Lay, Skilling and Fastow should be hailed as innovators in the field of public finance

For another view of how this shell game works, Paul Krugman (of all people) explains here.

But even if it does get the “toxic waste” off the banks balance sheet, does it solve the woes of the economy? Quite possibly not, if you believe Henry Blodgett at Clustercock. He identifies 5 big misconceptions about what’s wrong with the economy:

  1. The trouble with the economy is that the banks aren't lending.
  2. The banks aren't lending because their balance sheets are loaded with "bad assets" that the market has temporarily mispriced.
  3. Bad assets are "bad" because the market doesn't understand how much they are really worth.
  4. Once we get the "bad assets" off bank balance sheets, the banks will start lending again.
  5. Once the banks start lending, the economy will recover.

He explains why none of these 5 are quite true. It might be because he tends to be a glass is half empty guy, but in this case I think the glass has been knocked over.

So why on earth has the market responded so positively today? I don’t know. Maybe it’s spring fever, maybe the housing numbers cheered them, maybe they’ve been sitting on the sidelines so long they were looking for any excuse to get back in the game. My guess is that once the smoke clears the excitement will abate and they won’t be any more excited than they were the last time they were dealt this hand.