Geithner's Toxic Asset Plan

[August1991]

IMHO, this is by far the best, simplest explanation of what Geithner's plan is.

From the US Treasury website:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.

Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.

Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.

Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.

Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.

Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

Then over to Nemo at selfevident:

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.)

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 valuing 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?

IMV, this might work and given that any alternative solution poses numerous problems, Geithner's plan is the only one that's probably viable (or even on the table). Incidentally, this guy proposed something similar in October 2008:

The Bush administration, which is changing its bailout plans every day, now intends to buy stakes in major American banks and perhaps guarantee their loans, but it's also still proceeding with Treasury Secretary Henry Paulson's original idea, which is to buy up a bunch of assets that nobody else wants. The big question about those distressed assets is: What price should Treasury pay for them?

IOW, this is old wine in a new bottle.

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What are the negatives? Well, other than that the scheme may not work...

One, it is going to cost the FDIC a whack of money. But then, the US federal government has very, very deep pockets and logically that's what the FDIC is there for.

Two, this subsidy/bailout/plan is going to create one mother of a moral hazard problem. Many of America's bankers just dodged a bullet (thanks to America's taxpayers) and the bankers will now feel invincible. I'd say we may well be back in this situation around, say, 2016 or so.

There are two groups pushing the envelope to see how close they can get it to the edge of the table before it falls off: US politicians who borrow and US bankers who lend.

Edited March 23, 2009 by August1991

[punked]

It's just a bad bank. I said he was going to do that.

[bush_cheney2004]

...IOW, this is old wine in a new bottle....

Correct, it's a different shade of lipstick on the same pig.

Japan needed over a decade to flush.....but with Geithner's plan...the US will take far longer!

[Shady]

They still need to get rid of mark-to-market.

[August1991]

They still need to get rid of mark-to-market.

Geithner's plan does that - or rather, the new market price is heavily subsidized by the US Treasury and the FDIC.

All of this is under the assumption that the banks bidding for/selling these toxic assets don't game the system. The potential for fraud is tremendous.

Krugman makes the same observation as my OP.

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Incidentally, there are two economics Nobel Prize laureats on opposite sides of this policy proposal: Paul Krugman opposes and Michael Spence favours. Link

Spence appreciates that the plan lets private players in auctions decide the price of these toxic assets. That's good.

Krugman argues that the plan delays the inevitable. It doesn't really solve the problem.

I know what Bernanke would say to Krugman: "The perfect is the enemy of the good."

Edited March 24, 2009 by August1991

[bush_cheney2004]

Seems that AIG was too big to fail, and Mr. Geithner is too complicit with Goldman-Sachs to give an objective answer to Congress. Try as they might today at the hearing, beating the Geithner - Bernanke pinata didn't yield any candy for US taxpayers.

[August1991]

Seems that AIG was too big to fail, and Mr. Geithner is too complicit with Goldman-Sachs to give an objective answer to Congress. Try as they might today at the hearing, beating the Geithner - Bernanke pinata didn't yield any candy for US taxpayers.

I don't agree with this meme that Goldman-Sachs has received special treatment.

Paulson strikes me as a hard-nosed right winger who made a bundle and then chose to go to Washington to fix things. Faced with this crisis, he wanted to make people at Bear Stearns and Lehmans suffer. Geithner strikes me as the US version of an Ottawa mandarin. (I was surprised when I looked at his CV. He is what I would call a flakey, over-achiever, workaholic. Another best and brightest who knows the price of everything but the value of nothing. Government bureaucracies have many such people - or their wannabes).

Neither want to give a special deal to G-S. And anyway, foreign banks got the most out of the AIG bailout.

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In case anyone here cares, IMHO, this is the best link circulating now with a reasonable solution to this US banking crisis/toxic asset problem.

It argues that, rather than look at the toxic assets of banks, the government should look at the liabilities/debts of banks - that is, it should look at depositors and other people who expect to receive money from the banks:

For example, in the U.S. system the order of priority for debts is the following: (1) administrative expense of liquidation; (2) secured claims up to the value of collateral; (3) domestic deposits (both insured and uninsured); (4) foreign deposits and other general creditor claims; (5) subordinated creditor claims; and (6) equity investors. Recently issued subordinated debt has been guaranteed by the government, which would therefore take any loss on those securities in a reorganisation. (The UK prioritisation is a little different; in particular, it does not make domestic deposits senior to foreign deposits or other general creditors).

For a large bank like Citi or Bank of America the first three categories would be placed in the new bank, and so would be fully protected. Foreign depositors should probably also be made whole.

IOW, the Administration should be looking at protecting people who have placed money with US banks rather than looking at protecting the value of what "assets" the US banks hold. This is tantamount to accepting the fact that some US banks are going to go into receivership.

It's just a bad bank. I said he was going to do that.

??? Edited March 26, 2009 by August1991

[bush_cheney2004]

I don't agree with this meme that Goldman-Sachs has received special treatment....

If you mean that AIG "counterparties" besides G-S received many billions of dollars, then I guess they aren't so special...to wit:

Goldman Sachs $12.90 billion

.

Soc Gen $11.90 billion

.

Deutsche Bank $11.80 billion

'

Barclays $8.50 billion

.

Merrill Lynch $6.80 billion

.

Bank of America $5.20 billion

.

UBS $5.00 billion

.

BNP Paribas $4.90 billion

.

HSBC $3.50 billion

.

Calyon $2.30 billion

.

Citigroup $2.30 billion

.

Dresdner $2.20 billion

.

DZ Bank $1.70 billion

.

Wachovia $1.50 billion

.

ING $1.50 billion

.

Morgan Stanley $1.20 billion

.

Bank of Montreal $1.10 billion

.

Rabobank $0.80 billion

.

Royal Bank of Scotland $0.70 billion

.

AIG Int'l $0.60 billion

.

KFW $0.50 billion

.

JP Morgan $0.40 billion

.

Credit Suisse $0.40 billion

.

Santander $0.30 billion

.

Paloma $0.20 billion

.

Citadel $0.20 billion

.

Danske $0.20 billion

.

Reconstruction Finance Corp $0.20 billion

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[August1991]

If you mean that AIG "counterparties" besides G-S received many billions of dollars, then I guess they aren't so special...to wit:

Goldman Sachs $12.90 billion

Even if I take your numbers, and add them up, Goldman-Sachs is a "small" percentage. Three foreign banks get far more. (b_c, to be clear, I have no stake in this game. My sister-in-law is not a legal at Goldman Sachs.)

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Here's a take on this Obama/Geithner plan: If people are arguing fairness (as you are doing - IYHO, G-S will get a bigger share), then the plan will fail.

America's banks must work honestly. I think Obama instinctively understood this when he said that there is no "magic bullet".

Edited March 26, 2009 by August1991

[bush_cheney2004]

Even if I take your numbers, and add them up, Goldman-Sachs is a "small" percentage. (b_c, to be clear, I have no stake in this game. My sister-in-law is not a legal at Goldman Sachs.)

A "small percentage" while leading the pack of "counterparties"....what a novel way of looking at things.

Here's a take on this Obama/Geithner plan: If people are arguing fairness (as you are doing - IYHO, G-S will get a bigger share), then the plan will fail.

I think the "plan" has already failed...going back to the last administration.

America's banks must work honestly. I think Obama instinctively understood this when he said that there is no "magic bullet".

Obama will not have the "high ground" for honesty with the incestuous relationships of his team and G-S, among others. There is a "magic bullet"...and it includes FIRE failures. {Finance, Insurance, Real Estate} > the biggest campaign donors in Washington DC.

[August1991]

It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries.

The plan’s essence is to use government off-budget money to overpay for banks’ toxic assets, perhaps by a factor of two or more. This is done by creating a one-way bet for private-sector bidders for the toxic assets, then cynically calling it “private sector price discovery”

Jeffrey Sachs