Free Markets, Free People

The Banking Plan

Thanks to last night’s White House info dump, we now have gotten the outlines of the White House’s banking recovery plan.  As I mentioned earlier this week, the banking problem is the fundamental issue in the current financial crisis.  We’ve been waiting for the White House to give it to us.  Now that we’ve got it, I don’t like it much.

The details, as reported, are as follows:

The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell.

In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money.

In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Securities Loan Facility, a joint venture with the Federal Reserve.

The goal of the plan is to leverage the dwindling resources of the Treasury Department’s bailout program with money from private investors to buy up as many of those toxic assets as possible and free the banks to resume more normal lending…

Although the details of the F.D.I.C. part were still being completed on Friday, it is expected that the government will provide the overwhelming bulk of the money — possibly more than 95 percent — through loans or direct investments of taxpayer money.

The hope is that such a generous taxpayer subsidy will attract private investors into the market and accelerate the recovery of the country’s banks.

The key protection for taxpayers, according to people briefed on the plan, is that the private investors will bid in auctions against each other for the assets. As a result, administration officials contend, the government will be buying the troubled loans of the banks at a deep discount to their original face value.

That last paragraphs is a howler, since it’s so self-evidently untrue.  As Ezra Klein at The American Prospect–hardly an enemy of the Obama Administration–notes:

You almost wonder if that’s a typo. It seems to imply that the protection comes because private investors will accurately price the assets. After all, they don’t want to lose money.

But it’s not their money. It’s our money. The plan uses public funds to protect and subsidize private investors. As such, 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. [Emphasis mine--EDF]

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? And who would you say is being protected: Sotheby’s or the private investors? As Calculated Risk says, “With almost no skin in the game, these investors can pay a higher than market price for the toxic assets (since there is little downside risk). This amounts to a direct subsidy from the taxpayers to the banks.”

As for the contention that “the government will be buying the troubled loans of the banks at a deep discount to their original face value,” I’m not even sure what to say about that. Their original face value was a lie. If I pretend this beautiful bic pen is worth $60 million and then sell it to you for $1.00, you’re not getting a $59,999,999 discount because I’ve come down from the imaginary price where I started. The question is what these assets are actually worth, and whether taxpayers are paying more or less than that. We’re in this mess because the original face value is wrong.

I don’t know how to explain it any better than that.  Moreover, Ezra links to Yves Smith, who further comments:

First, the banks, as in normal auctions, will presumably set a reserve price equal to the value of the assets on their books. If the price does not meet the reserve (and the level of the reserve is not disclosed to the bidders), there is no sale; in this case, the bank would keep the toxic instruments.

Having the banks realize a price at least equal to the value they hold it at on their books is a boundary condition. If the banks sell the assets as a lower level, it will result in a loss, which is a direct hit to equity. The whole point of this exercise is to get rid of the bad paper without further impairing the banks.

So presumably, the point of a competitive process (assuming enough parties show up to produce that result at any particular auction) is to elicit a high enough price that it might reach the bank’s reserve, which would be the value on the bank’s books now.

And notice the utter dishonesty: a competitive bidding process will protect taxpayers. Huh? A competitive bidding process will elicit a higher price which is BAD for taxpayers!

Dear God, the Administration really thinks the public is full of idiots. But there are so many components to the program, and a lot of moving parts in each, they no doubt expect everyone’s eyes to glaze over.

The last point is another big problem.  There are a number of other ways to accomplish recapitalization, from just purchasing the assets from the banks for cash to outright nationalization of the banks.  Whether we would actually like those options is another story, but at least they have the virtue of simplicity.  Even laymen would be able to grasp their essentials.  That certainly isn’t true is the case of what the Obama Administration has released. It is complicated.  It’s made of three different parts, all of which are complicated in their own special ways.  Ezra Klein again:

If it goes bad — and it really might go bad, and the details might prove galling in much the way that AIG’s bonuses did — the byzantine approach could well leave voters feeling tricked. That risk might make sense if this were the only viable path forward. But it’s actually hard to imagine the set of questions you ask that ends in this particular answer.

And it’s difficult to see how this  actually becomes an answer in the real world.  The trouble with these kinds of complicated plans is that they so often crash against the rocks of reality.  When one part of the plan goes awry, the whole plan breaks up.  With the triple complications of the plan leaked by the administration, there is a not insignificant chance that the plan will fail due to it’s unnecessary complexity.

I don’t think that will be helpful.

9 Responses to The Banking Plan

  • I have an undergraduate degree in finance, a graduate degree in international finance, and years ago worked in commercial banking for about 13 years.  However, I have been out of that business for quite some time now.   Why do a recite this education?  Because, as much as I hate to admit it, this “toxic assets and related stuff confuses the heck out of me.  (Believe me – it is use it or lose it when it comes to finance knowledge!)  I am sure if I took the time to study it, it would start to come back to me.  But if I, with some background in finance, am this confused what do you think the average American is wondering?!  They don’t have a clue!  This makes them ripe to be taken advantage of, which I think our government is counting on.

    Does anyone know of a good site that has condensed this toxic mess into a form most people could understand?

  • There is a lot going on in those short few paragraphs.  I get a “throw everything against the wall and see what sticks” feeling combined with a “more of the same” feeling combined with yet another “the government has no idea what to do, knows this and is panicking” feeling.  I have the same questions about this as with everything that has been tried in the various stimulus projects.
    -Where is the money coming from to pay for this (although I suspect I know the answer to this one)?
    -With respect to the private firms that participate in these programs, what kind of agreements will they have with the government?  Considering what happened to AIG, I can only imagine how they will try to protect themselves.  In the alternative, would quality firms bother to participate?  I expect a lot of confidentiality clauses and arguments over “transparency” and other meaningless buzzwords.  Imagine the outcry if the value of the acquired assets increases when Congress sees the returns to the private firms as compared to the amount of equity they actually provide. 
    -I still do not understand the protection of the private bidding. 
    If the idea is to drive up the price of the assets by creating the artificial demand of multiple bidders (even if they are all using the same source of funds), that is the opposite of taxpayer protection.  It would ensure that taxpayers will pay more for the assets.
    If the idea is to drive down the price of the assets (through due diligence maybe? I still don’t understand if this reasoning.), that would provide less funds for the banks and does nothing to deal with solvency issues.  You don’t expand a capital base by selling assets at a discount.  If the government is going to make up the difference with funds from another source, TALF or otherwise, why bother in adding the cost and complexity of a multi-part plan?  In the end, this may just be another direct transfer of funds to the banks disguised as “market-based” something or other.

    It could be that I am making the mistake of assuming they are using whatever value is currently on the books of the institutions rather than the original face value as noted in the Ezra Klein article.  I understand this is coming from the NY Times, and I do not trust their reporters to understand and report this distinction, not to mention any of the concepts involved generally.
    Hopefully, just the fact that there is a plan and people finally know somewhat what the government is going to do will provide some level of comfort to various participants in the economy in general. 
    Hopefully, the drafters of the plan know more than I do and have created the proper plan.
    However, I fear that this type of flailing around will fail to inspire any confidence in the banking system, the economy, Congress or the administration.
     

  • hyperinflation on Weimar scales is on the way thanks to Helicopter Ben!

    http://tinyurl.com/clck4y

    mB

    •  I made the unwise decision to buy a townhouse in the DC area about three years ago (a few months before the market started to turn), so I’m pretty far underwater.  I don’t have any problem making payments, but i”m in the military so the prospect of moving would force me to rent the place since I can’t afford to sell. A dark corner of my mind thinks inflation on a less massive scale would be good for me since it would return the dollar value of my house to the price that I paid for it. I only bring it up because some economists have said it’s the people that are upside-down on their mortgages that are walking away.
         Pure speculation, but is there a chance the administration wants some inflation so it can lessen the number of borrowers that are underwater without the government writing down the principal by giving the money away? At least it would affect all homes, not just ones targeted for a loan (and principal)modification.

      • It’s certainly possible.  But it strikes me as a very bad idea to kick off inflation and hope that it will help homeowners for any number of reasons.   For one thing, messing with inflation affects the whole economy, just not housing.  For another, it’s far from clear that higher inflation would be a net plus for the economy.  Oh, and just how many homeowners who are underwater are going to hang on to their house and mortgage because higher inflation will make their dollars cheaper?  (I have no idea, and I doubt anyone else does).   And come to think of it, higher inflation would result in higher interest rates, so only those with fixed rate mortgages would benefit.  Those with ARMs (and that’s most, right?) would see their interest rate jump at the next reset.   And finally, inflation isn’t very tame; once you’ve kicked it up or down, it tends to continue in that direction.  The US had an unhappy experience with that during Jimmy Carter’s presidency.  Similarly, Japan has been fighting deflation for what, the past decade, with little but staggering debt to show for it.

  • Ted,
    The government doesn’t care about specific borrowers so much as it cares about the massive amount of  federal debt they’re busily racking up.  Inflation would be a rather convenient means of dealing with it.  The question is how much will they be able to get away with before scaring off foreign purchase of treasuries or having foreigners dumping USD assets.