PPIP gaming in a nutshell

Divide the world into the consolidated financial sector and taxpayers. Under PPIP, each dollar a “public-private investment fund” overbids provokes a net transfer to the consolidated financial sector from taxpayers. The size of transfer to the financial sector increases with the degree to which bids are overpriced, and is maximized if the true asset value is very small relative to the price actually bid. If an asset is worth $6 dollars, and financial sector actors purchase a contract for $7 while the Treasury invests alongside, the consolidated finacial sector gains a dollar. But if financial sector actors pay $70 for the same asset, the financial sector would receive a net transfer from taxpayers of up to $118. (For more detailed arithmetic, see below.) The more financial sector actors are willing to overbid, the greater the net transfer from taxpayers to the financial sector. In theory the scale of the transfers is limited only by the quantity of asset purchases the government is willing to guarantee.

There are problems with this story. In real life there is not a consolidated financial sector, but a lot of different players who are usually in the business of competing with one another. PPIP includes rules and tools by which the government could prevent the use of taxpayer money to fund overpriced bids, and ensure that the parties who take small losses are distinct from the parties who make large gains, eliminating incentives to overbid. An important question is whether the government genuinely wishes to prevent backdoor transfers to the financial sector, or views such transfers as a desirable means of helping core financial institutions. (See Joe Weisenthal and Noam Scheiber)

It is worth noting that overcoming coordination problems so that diverse parties can collaborate on profitable ventures is precisely what the financial sector is supposed to be good at doing. Ideally, we would like the profitable ventures to be welfare-improving projects in the real economy, but there is little question that financial sector actors will gladly apply the same skillset to extracting transfers and rents when the opportunity presents itself. Attempts to regulate away intentional overbidding by cooperating parties will have to outwit some very clever professional deal makers.

A few more caveats — financial sector actors do pay taxes, so they are not distinct from the taxpayers from whom transfers are made. Qualitatively, this overlap would’t change the story very much. (Quantitatively, it’s interesting, you’d have to think hard about the realizability of “deferred tax assets” from losses the financial sector would absorb without the transfers.) The numbers I’m using are for the PPIP whole loan program. The degree of nonrecourse leverage that will be provided by the Fed towards the securities purchase program is as far as I know unspecified.

Some links:

There are way too many good links on this issue, but rortybomb’s take is my all-time fave.

Restricting to the last 24 hours or so, see also Scurvon, Carney, Sachs, Nemo, Krugman, Free Exchange, Felix Salmon, Economics of Contempt, and Cowen. See also articles in the Financial Times (ht Conor Clarke, Calculated Risk) and the New York Post (ht Yves Smith). As far as I know, Karl Denninger is the first person to have pointed out the potential for gaming. My first take on this issue is here. Mish has a very similar take (here, here, and here). I’m sure I’ve left many great posts out of this linksplatter. My apologies to the unsung pundits.


Case 1: A private fund buys an asset for $7, but pays only $1, as the rest is borrowed from the bank via an FDIC guaranteed loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6. The private fund loses its dollar, but this becomes a gain to the selling bank, causing neither a loss or gain to the consolidated financial sector. However, the Treasury also loses a dollar, which becomes a gain to the selling bank, and amounts to a transfer of $1 from taxpayers to the consolidated financial sector.

Case 2: A private fund buys the same asset for $70, of which it pays $10 cash and borrows the rest on an FDIC guaranteed nonrecourse loan. The Treasury invests along side 1:1, purchasing the same asset on the same terms. The asset is really worth $6, so each purchase amounts to a transfer of value to the bank of $64 dollars. When the value becomes known, the FDIC (indirectly) accepts the $6 asset in exchange for $60 of loan extinguishment, bearing $54 of the private investor’s $64 loss. The net effect of the private investment is a transfer of $54 from taxpayers to the consolidated financial sector. Taxpayers bear the full loss of $64 on the Treasury’s investment. So the total transfer fronm the public to the private sector is $118.


45 Responses to “PPIP gaming in a nutshell”

  1. BSG writes:

    What is also striking is that Treasury is allowing the gaming both explicitly, by saying they will allow banks to buy each other’s toxic assets for purposes of selling it at a premium to taxpayers via the PPIP, and implicitly by tailoring participation in the program. They may even allow banks to finance the private bidders (I’m not sure about that one.) All of this is, of course, with taxpayer money. So even the tiny private portion may turn out to be illusory.

    Even I’ve been surprised by the brazenness. I recall Mencius recently speculated that with the high level of scrutiny, excesses would likely be checked. There is a small indication of that in Treasury’s recent decision to allow more participants as a result of pressure, but on the whole they don’t seem to be taking any meaningful steps to prevent gaming. I wouldn’t be surprised if they are encouraging it outright.

  2. BSG writes:

    Indirectly related, I’m sure you’ll recall the recent reports of Treasury intending to use SPVs to distribute TARP cash in order to evade executive compensation limits. You know, money laundering of sorts. This after all of the kabuki outrage expressed by Geithner and his boss over extravagant compensation.

    Brazen indeed. It’s difficult to see how this sort of behavior won’t occur with the PPIP. They’re giving us the finger.

  3. Nemo writes:

    Hi, Steve. I think you are making the math more complicated than necessary.

    In your second example, the bank sold two assets worth a total of $12 for $140; that’s a $128 profit. The private investor lost $10. Therefore the total profit of the private sector was $118, which could only have come from the taxpayer. (By the Law of Conservation of Dollars, which only the Fed can violate.)

    Although to be a stickler, both of your numbers are off by a factor of two. The Treasury does not buy a second identical asset; it actually commits half of the capital to the fund itself. So in your first example, the Treasury would contribute $0.50 and the investor would contribute $0.50. In your second example, the Treasury and investor would each contribute $5.00. The final numbers are half of those in your examples, because your examples just double everything. (For instance, in your second example, the bank would sell the $6 asset for $70, which is a $64 profit. The private investor would lose his $5. Thus the total public-to-private transfer would be $59. You do not need to keep track of the Treasury’s investment; you only have to work out the total gain for the private sector. Conservation law again.)

  4. missing the point writes:

    Isnt the whole point to shift money to the banks so that there isnt another Great Depression or something. Do people want to keep their taxes and have no job or what?

  5. SW:

    I agree with Mish and the rest of the critics.

  6. Yancey Ward writes:

    Missing the point, of course, points out the obvious. Say what you will about Hank Paulson’s original intention with TARP I, it was light years more honest than anything we have witnessed since.

  7. john c. halasz writes:

    There are so many inter-linkages between different financial markets/instruments that it’s hard to believe that any set of formal rules could effectively exclude collusive gaming of pee-pip. No doubt, there are game-theoretic, action coordination type problems,- not least is the honor-among-thieves problem of divvying up the loot-, but, as SRW noted,- and I made a similar comment the weekend before the official announcement-, these finance guys are precisely past-masters at resolving such problems. My guess is that the top honchos at the mega-banks would simply ask their subordinates to examine the books and come up with proposed offerings-for-sale, while leaving it up to those bonus-incentizived underlings to circulate amongst their contacts and come up with the schemes, to preserve plausible-deniability at the top. It’s not hard to imagine that they could come up with a suitably abstruse set of CDS trades, (while avoiding any e-mail trail), to set up de facto a behind-the-scenes index for hedging the bidders, without even obviously severely underpricing the CDS contracts, since multiple contracts could be netted out, such that, word out, winning bidders could be assured of getting a net return on their over-bids. Then again, buying call options on the relevant bank equities ahead of the results to be announced would be an additional cheap hedge. But no doubt, being outside the circle of fire, my imagination is too impoverished to exactly anticipate such schemes. Still, if the whole aim of pee-pip is to establish accurate pricings of mummy-securities on behalf of zombie banks, then the progra/om will fail. The only rationale would be that the program would succeed in re-capitalizing mega-banks precisely through its own aggregate failure. So, insofar as gaming schemes are successfully disallowed, -(though they definitely will be tried, since the grey areas will be larger than the law,- or the relatively paltry enforcement powers accorded to it),- then the whole program will fail. Leaving the game to the next moves of the pieces on the board, at some considerable public cost.

    Yves Smith posted today an interesting paper on the financial economics of the current downturn. I just skimmed the fancy math, but it seems entirely to the point.

  8. JKH writes:

    Here’s a lone dissenter:



  9. It’s The Rocky Horror Picture (PPIP) Show. In the market for lemons the PPIP cannot work. There is no need of too much mathematics to prove it…

  10. babar writes:

    First, in all of your cases PE gets nothing — I don’t see this happening in aggregate. But that’s not what I was going to say.

    Your view of the ‘consolidated financial sector’ makes sense — except in the case where a bank is nationalized. In that case the government directly assumes banks’ losses and the picture is more ‘private equity and banks’ versus ‘the consolidated government plus nationalized banks’ sector.

    That is likely to happen if the losses in aggregate are large.

    In that case private equity is going to lose in aggregate (because they will have overbid, like everyone) and the consolidated govt + nationalized bank sector will be a net winner. Essentially PE will have eaten a chunk of the losses otherwise assumed by the govt.

  11. lone dissenter dissenter writes:

    That story by Michael Spence is so pathetic it makes you think that the plan is a scam afterall.

  12. babar — that’s only true to the degree that the financial sector winners are the same as the ones nationalized, and to the degree that nationalized firms are certain not to haircut creditors. “consolidated financial sector” is a simplified first pass, which i hope i unsimplified adequately in the second paragraph.

    you can come up with scenarios under which PPIP is gamed, but the profits all go to insolvent banks who remain insolvent despite the program, so that the subsidy is recaptured in a nationalization while some private actors have been goaded into absorb a bit of the loss. that strikes me as unlikely, but it is possible. i think it is more likely that some already viable banks receive subsidy, and some banks that are a priori insolvent receive sufficient subsidy to leave them viable and then some, in which cases substantial net subsidy remains with the private sector even relative to scenarios where all bank bondholders are guaranteed. i have a hard time evaluating the probability of various scenarios, but i think the net small private loss scenario is particularly unlikely.

    (i think there’s a significant chance that PPIP will fail to move many assets at all, and a significant chance that it will move a whole lot of assets at exaggerated prices. it depends on perceptions of legal and political risk by financial sector assets, and the degree to which FDIC/Fed/Treasury genuinely work to prevent gaming or give it winks of encouragement. these things are hard to know and weigh.)

  13. babar writes:

    SRW: i absolutely agree.

    the fact that PPIP is susceptible to gaming which is prohibited on paper makes it very difficult to assess.

    if the goal is to stabilize asset and loan valuations so that private investors are more confident putting up capital to some banks, the program needs to be run spotlessly. i have my doubts…

  14. mittelwerk writes:

    the fine print says that the FDIC-insured debt is tradeable. i assume the paper will be issued by the PPIV’s themselves. it’s a non-recourse default swap market!

  15. Nemo writes:

    Someone should ask Spence why the loans should be non-recourse, other than as a deliberate attempt to create a non-transparent subsidy to private equity and the banking system. Why should private equity get to keep the winners but saddle the taxpayer with the worst losers?

  16. JKH writes:


    I’ve had trouble analyzing this PPIP all along, particularly getting stuck on the correct meaning of recourse and non-recourse in the context of PPIP collateralized lending, versus, say, FDIC insurance. I’m still not there. But here is some rough thinking on PPIP in general using a somewhat different intuitive process. I’m assuming actual outcomes and counterfactuals for insolvency here that don’t necessarily include haircuts for bondholders, and where the government is at risk for losses beyond equity holders – the “no more Lehmans” resolution mode, I guess. That comparison may not be right, depending on your point of view. If so, the analysis could be adjusted further to allow for the effective reduction of government subsidies via debt haircuts in insolvency.

    This analysis is separate from the issue of gaming and self-dealing per se. A lot has been written on that. Obviously this is a potentially huge risk, but separate from the question of analyzing the economics of PPIP as intended. In fact, I think the analysis of gaming possibilities is somewhat simpler than gauging the full effect of PPIP as intended without gaming. I think you may allude to this in your 5:05 comment above.

    So, first split the deals between those on which PPIP private equity makes money and those on which it loses.

    Assume the measure of whether private equity makes or loses money is a function of whether or not the maturity value of assets purchased exceeds or falls short of the purchase price.

    If you assume this, and I don’t know why you wouldn’t, then the maturity value of any assets sold to PPIP is the same maturity value experienced in the counterfactual, where the selling bank instead retains the assets.

    So, maturity value in this sense is a yet unknown parameter that is nevertheless fixed in the case of both PPIP sales and the counterfactual of bank retention.

    Next, if private equity makes money on individual deals, it is only because the assets sold were underpriced by the selling bank. Therefore, based on what turns out to be the true economic value for the assets, there is no government “subsidy” for the selling bank, solvent or insolvent. In fact, both private equity and the government alongside it have extracted value from the selling bank, because the selling bank would have realized greater value had it held the assets to maturity. This is the case whether the selling bank is solvent or insolvent. (Even more than that, it is the case whether or not solvency or insolvency is even being measured correctly or incorrectly at the time).

    Next, if private equity loses money on individual deals, it means the assets bought were overpriced by PPIP at purchase. Then there is an immediate subsidy effect, since the bank sold assets for a greater price than it would have realized by holding them to maturity. Based on true economic value for the sold assets, there is both a private equity and a government equity subsidy for the selling bank. In addition, if the government “put” is in the money, there is an additional government subsidy. The total immediate subsidy is effective whether the selling bank is solvent or insolvent. The total size depends on the degree to which losses eat into PPIP equity and debt.

    This is the immediate subsidy effect. The full effect depends on whether or not the selling bank is solvent or insolvent.

    If the selling bank is solvent, the immediate subsidy effect is the full subsidy effect. It is a gift for the participating bank, due to poor risk judgement on the part of PPIP.

    If the selling bank is insolvent, the immediate government subsidy via PPIP is only part of the full subsidy. It is a cost that would have been incurred via insolvency resolution, with or without the asset sale. Nevertheless, the full subsidy cost is reduced by what it might have been without PPIP by the amount of private equity losses incurred via PPIP. So the government in a sense gains on a relative basis due to private equity losses, compared to the case without PPIP.

    The odd case is where the proceeds from a PPIP subsidy by overpricing assets make an insolvent bank solvent. Then the amount of government subsidization required to reach the solvency threshold is a cost that would have been borne without the PPIP sale (reduced by private equity losses) and the amount exceeding the threshold becomes the net subsidy.

    The final result of PPIP is then the sum of the actual distribution of these various permutations of individual equity gains and losses, plus debt losses, compared to the counterfactual result without asset sales to PPIP.

    Again, this leaves out self dealing risk, which has already been described extensively, and which is a potential horror show without some sort of specifically targeted restrictions in place.

    I found Spence’s article somewhat interesting because it assumed that the government would make judgements about different acceptable leverage ratios for different deals, based on different assessments of risk. I hadn’t seen that idea figure much elsewhere, but have no idea how they would design and implement such an approach. Most people are focused more on the substantial self dealing risk at this point, which Spence mostly ignored.

  17. Taunter writes:

    Heartbroken my version of the scam didn’t make the list –


    But I have to admit Karl was the first on the draw…

    Nemo’s 9:22pm post is dead-on, and should be the question for any remotely serious defender of the plan. If the issue is liquidity, just make the loans recourse. If the issue is a desire to inflate the market, well, that’s what we are going to be dealing with.

  18. JKH — I think that you’re thinking this through basically correctly. If “no more lehmans” means all bank bonholders will be made whole, then subsidies (however defined) up to the point of solvency represent a financial cost taxpayers would have had to bear anyway. (This is John Hempton’s argument.) BUT, that’s much too simple an analysis. 1) Any subsidy above the point of barest viability is a taxpayer giveaway relative to the baseline of consolidating gov’t and bank balance sheets; 2) even if the subsides aren’t sufficient to bring the system as a whole to barest viability (i don’t think they can be at the scale currently announced), some participating banks will be viable or near viable, and extract a fiscal subsidies that adds to the total taxpayer liability; 3) if gov’t assumed bank balance sheets explicitly, taxpayers would have future upside in exchange for a by-assumption fixed cost of paying up creditors. if we assume bank liabilities by subterfuge, the restored “franchise value” is privatized, representing a subsidy relative to alternative no-haircut scenarios; 4) there’s no need to assume no haircut scenarios. “no more lehmans” can be interpreted as a commitment carefully managed reorganizations rather than as a commitment to make all creditors whole.

    fdic always has the right to price deals as it sees fit. the question is will. this is an organization that wrote the largest and most important put option in the world at no cost for a decade, because it and the government that manages it was largely captured by the parties benefiting from the option. if fdic is serious, tough, and sufficiently staffed, it absolutely could refuse to guarantee financing except on taxpayer advantageous terms. but that assumes that fdic is committed in fact, as it is by law, to a least-cost resolution. i don’t believe that is the case — i think fdic has volunteered willingly and knowingly to be a conduit for a large deferred wealth transfer, on the false theory that what’s good for incumbent banks is necessary for the broad economy. that’s just an opinion, although I think a fairly considered one that I could support circumstantially. what do you think?

  19. mittelwork — can you elaborate a bit?

    taunter — sorry about that… i hadn’t seen you post. one is never as exhaustive as one means to be…

  20. Taunter writes:


    No problem. The abundance of scams is actually the most striking thing about the PPIP. It was the first thing that came to mind for anyone with a background in hedge funds, private equity, or energy, and it had to be blindingly obvious to the folks at Treasury.

    Since every scam would be defeated by making the loans fully recourse and ensuring capital adequacy at the parent, you have to assume that encouraging the scams is a feature, not a bug. And that is terribly depressing.

    Needless to say, they are right back to the Doublespeak with the stress tests:


  21. babar writes:

    i’m going to try to answer Nemo’s question, as to why the loans are non-recourse. here are the reasons that i have been able to ferret out.

    1) start with the premise that the treasury knew they had, say, $100B to work with from TARP and didn’t see the political will to get more without proof that it was required. the treasury wanted to leverage this as much as possible. that’s not anywhere near the amount required to ‘fix the problem’. so attracting private capital on terms that are favorable to private capital was necessary. if you want terms that are less favorable to private capital, you have to scale up the public contribution so that you need less private capital.

    2) economically, you would expect the securities to end up on the balance sheet of the party with the highest subsidy. in many cases institutions are already backstopped by the government. in that case, follow the Hempton logic about “all bank funding [to backstopped banks] is non-recourse”. these securities, when they exist on the banks’ balance sheets, have an implicit put option. if they are sold to a private investor which is not backstopped, that put option is not there. this is one reason why a private buyer would not pay near what the bank would sell them that. in this case you are essentially transferring an existing subsidy to a new party; if the government does this properly it will not cost much more than the existing subsidy.

    3) the assumption behind the program is that these securities are to be held to maturity. recourse loans do not allow this to happen. without limited liability, the treasury has to monitor the creditworthiness of the participants, manage collateral posting requirements, continuously monitor and value collateral, and foreclose on collateral when the (disputed) value of the securities goes below a threshold. as a use case: say I have $2B and I want to put up $1B to buy $7B under the PPIF. the treasury has the obligation to foreclose on me if the value of the securities drops by nearly $2B. first, the whole point of the program is that the securities are ‘impossible to value’, so you would have difficulty defining that trigger. second, the treasury would presumably (given that the loan is recourse) have the right to demand additional collateral posting. this means that i could get wiped out before maturity.

    4) embedded in the above argument is the fact that the treasury does not run a credit desk and has no means for doing so. this is not a trivial or cheap enterprise.

    5) also embedded in the above argument is that if the loans were recourse, large players (with a lot of potential liability) would pay less for the loans than small players (with little liability). if you are going to use PPIF prices for pricing information (there are problems with this already, true) you will have trouble designing an auction where varying liability of the external parties is not a big factor.

    that’s my sense.

  22. JKH writes:


    Your point about government assuming bank balance sheets and thereby capturing the restored franchise value for the benefit of the taxpayer is interesting. In part it recalls the MTM discussion. One of the advantages of government is that it has the staying power to be able to restructure a bank balance sheet without being subject to the MTM urgency of explicit recapitalization faced by banks on their own (an argument also supporting MTM relief). As discussed previously, this beneficial effect for the government in dealing with the existing book of assets and liabilities could account for at least some portion of the franchise value recapture. The rest could come almost as easily, given the profound skittishness of markets in capitalizing full franchise viability when that viability is close to the edge. That volatility and potential value recapture on behalf of the taxpayer would seem to immunize at least some of the standard moral hazard involved in the full process of a government “rescue”. Maybe one way of thinking about the interconnection between MTM, capital adequacy, and franchise value is that in the process of seizing the balance sheet, the government instantaneously extends the time horizon for the call option value of the franchise, thereby increasing its value per se. Whereas the bank operating on its own, subject to the urgency of MTM and knock-on capital adequacy and franchise value risk, is effectively offering call option value that is subject to potentially accelerating time decay.

    I had a particular problem with Hempton’s argument at an analytical level. Consider a given portfolio of assets funded either by a bank or by a PPIF (or a set of PPIF’s). The bank’s liabilities (assume deposits + other) are protected by an FDIC put. This is protection at the portfolio level. On the other hand, the PPIF(s)’ liabilities are protected by a set of FDIC puts, based on asset collateralization. Non-recourse in the case of bank liabilities means non-recourse to the non-portfolio assets of the equity owners (equivalent to LLC non-recourse). But it means effective recourse to all portfolio assets. Non-recourse in the case of PPIP liabilities means non-recourse to the non-portfolio assets of the equity owners. But for each liability it also means non-recourse to portfolio assets other than those used as collateral for the specific liability in question. Therefore, the non-recourse provision for each PPIP liability is more restrictive than the non-recourse provision for each bank liability. That means the PPIP non-recourse put value in total is greater than the bank put value. The bank put is subject to the portfolio effect; the PPIP put is not. It was on this basis that I argued contra Hempton pro Krugman that it was not necessarily inconsistent to oppose PPIP while acknowledging “no more Lehmans”. Hempton produced four posts in a persistent effort to stamp Krugman as illogical. Granted, that seems to be a popular ambition among economic bloggers. Perhaps it should have its own Nobel Prize.

    The Fed, Treasury, and the FDIC have all expanded their normal functions. The Fed has undertaken credit easing, Treasury has made equity investments, and the FDIC has expanded liability guarantees. One can argue against the exact partitioning of various pieces among the different entities and question the related notion of the independence of the Fed. But the partitioning is not a huge deal to the degree that everything puts the taxpayer at risk. All of it amounts to active taxpayer risk in the banking sector. They’re all conduits for a risk transfer, which may result in a wealth transfer, size yet to be determined. Somebody who’s actually executed the nationalization of a US bank is Bill Isaac, Chairman of the FDIC when it took over Continental Illinois. When interviewed recently, he basically said it was an operational hell. I think this in their minds still.

  23. JKH writes:

    I don’t know that the right question necessarily is why the loans should be non-recourse. I think an equally legitimate and important question is why the loans shouldn’t be non-recourse, provided reasonable analysis is done in pricing them. Loan pricing seems to be overlooked in most discussions, as if the put option were being given away for free. The pricing of the put should be reflected in the risk premium embedded in the loan interest. Do we know that this is not being done?

  24. mittelwerk writes:

    can someone explain this? seems the FDIC loans will take the form of secured debt issued by the PPIFs themselves, placed with the sellers and presumably paying interest. so they’re tradeable IOUs. the participating bank, i gather, would sell them in order to monetize; the buyer, i assume, would receive a discount for this reason? no?

    from the “legacy loans program summary”:

    “How will the PPIFs’ debt be structured?

    The PPIF will issue debt that is guaranteed by the FDIC. This debt will initially be placed at the

    participant bank. The participant banks will be able to resell this debt into the market if they


  25. babar & nemo — I think the loans should be non-recourse, and made only to creditworthy individuals (not limited liability investment funds that can synthesize the non-recourse option if they can get recourse loans against modest capital). I’d point out that recourse loans don’t have to be margined loans, and don’t need a high cost of management. They can be be simple term loans, collateralized by purchased securities but with full recourse to other assets, that impose no “mark-to-market” risk on their holders. In the end, the securities either pay or they do not, the holders of the securities either pay or submit to personal bankruptcy. that’s it. market pricing with no liquidity constraints by human beings, the ultimate holders of all assets, where the price includes the cost of bearing risk of ownership without complex layers of financial engineering skewing the process.

    of course, that’s precisely what the designers of PPIP are unwilling to allow to be seen.

  26. jkh — i thought your comments re john hempton’s posts were spot on. there are lots of ways that ppip can be more expensive than full assumption of large bank liabilities. your distinctions about what assets their is recourse to is ultimately a claim about the ability of banks under PPIP to have ex-post positive net worth not captured by the government, where as under a nationalization scenario, an positive net-worth of bank portfolios would be used to offset publicly provided subsidies. i think you used the concept of “granularity” in your hempton comments, which is right. incidentally, a similar point in a very different context is attributed to shiller here.

  27. Taunter writes:

    Babar (10:27am):

    Isn’t the issue we are all dancing around #2 on your list? What does it mean that the “institution” is backstopped today?

    The assets where they stand now are pledged to some combination of federally insured deposits, bonds, and equity.

    After they are moved to the acquisition vehicle, they are 85% pledged to a federal guarantee (the non-recourse FDIC funding), some portion pledged to the Treasury in equity, and the rest pledged to the private investor.

    If you begin with the position that the banks’ bonds are sacrosanct, I accept your point that there is no substantive change in guarantee (the banks have more than 85% leverage as things stand). But my problem is accepting the idea that the bonds of existing banks should be immune from impairment. In fact, it is precisely because I think the bondholders should be impaired that I want the Bulow Plan or other method of receivership.

    I disagree with #3 on its face – no one is going to hold 2006 mortgages to 2036 – but even if it were true, limiting the pool to well-collateralized players eliminates the serious concern, as well as taking out #5; the Treasury has already said it won’t allow anyone to come off the street and bid, so the thin-cap approach should be off the table anyway.

    As for #4, isn’t there a saying that if you can’t afford the lawyer you shouldn’t sign the contract? Managing a portfolio of securities requires monitoring resources; if you cannot or will not do so, don’t play the game. At least, don’t play the game with my tax dollars.

  28. babar writes:


    I don’t accept the idea that bonds of existing banks should be immune from impairment either, but I think it is a useful starting point for understanding the mindset of the PPIP.

    I could be clearer on my points #3-#5 but not with my cloudy present mind.


    No, in the full recourse state the treasury needs to move quickly and foreclose as fast as it can to preserve its interest if values are falling. In my example above, if the value falls slowly from $7B to $3B, the treasury needs to liquidate the portfolio by the time the value reaches $5B. Also as I have read several times on this site, financial institutions which are highly liquid but highly insolvent are quite hazardous as they are prone to extreme bets — so the T will not want to create them.

  29. babar — no, that’s a choice.

    again, i’m proposing lend to individuals non-recourse, not create funds or institutions. and i’m proposing full stop eliminating mark-to-market risk for those individuals. if an individual borrows $7B and makes periodic payments on that, even if the market value of purchased assets falls to $3B, no problem. the individual had to have been very wealthy for this to be a reasonable loan in the first place, because we are not really talking about a loan against margin or collateral, but a loan against an individual’s wealth and earning capacity. it’s like a full-recourse home mortgage: the collateral is out there, but you don’t margin, and in the end you go back to the borrower for satisfaction.

    you might argue that this is impractical, in the sense that if the gov’t lends full recourse, nonmarginable to creditworthy individuals, the fraction of assets that could be purchased would be small relative to bank balance sheets. maybe, maybe not. all wealth is ultimately held by households, it’d be an empirical question of distribution of wealth and willingness. but more to the point, you don’t need transfers of all the assets to make a market. given free financing at treasury rates without mark-to-market risks, if Treasury is right that current prices are firesale prices, lots of buyers should be willing to take a piece. if the assets are “too big” for households to buy, the government can subdivide them easily enough and sell fractional shares (without retranching or any craziness like that).

  30. babar writes:


    You’re right, the treasury could abandon prudence and not enforce any sort of margining or mark to market. The courts would enforce mark to market after the fact through fraudulent conveyance statutes. (Did I mention I send my kid to an expensive private school run by my brother?)

    Less sarcastically: what you are suggesting has very different goals than the PPIP. When you say ‘you don’t need transfers of all the assets to make a market’ you are invalidating one of the key premises of the PPIP — one of its primary purposes is to remove these assets from bank balance sheets. In my posting I am specifically not addressing larger issues. I am just trying to describe why, given the assumptions and goals the treasury started with, non-recourse funding is reasonable. (So I am resorting to non-recourse logic here.)

    My arguments are also non-recourse in that I will not stand behind them personally. I am just trying to figure out how they got from their goals to this program. I would do something very different, which you would probably like even less.

  31. JKH writes:

    As a matter of interest, just how does one evaluate the put option on full recourse lending? Surely a put option still exists – just more out of the money. Wouldn’t the out-of-moneyness correlate with the complete wealth position of the equity investor? If there were no effective put, wouldn’t full recourse risk be priced at the risk free rate? That seems absurd. So again, how does one evaluate the put option on full recourse lending?

  32. Nemo writes:

    Steve —

    You are talking about a single non-recourse loan to each individual, right? Or can I, as an individual, take out multiple non-recourse loans, each one collateralized by a different asset I purchase?

    The phrase “non-recourse” is vague enough that it can result in extremely fuzzy thinking and ridiculous arguments (cf. Hempton). The real question is, with recourse to what?

    FDIC bank insurance is with recourse to all of the assets of the bank. The PPIF insurance is with recourse to each pool of assets. This simple observation is what makes Hempton’s argument nonsense. (Well, that, and the “all bank bonds are now full faith and credit of the U.S.” premise.)

    Your proposal, if I understand it correctly, is to make the loans full recourse with respect to the individual’s other assets. But when you say “non-recourse”, it implies that the individual can surrender the collateral and thus discharge the loan. I am pretty sure that is not what you mean, since you mentioned “bankruptcy”, but I suggest you take care to be more clear.

    Steve and Taunter have already responded to babar. “Margin calls” are optional in any event; “make all bondholders whole” is absurd policy; etc.

    It is pretty clear (to me, at least) that the Treasury has intentionally designed this structure to transfer taxpayer wealth to the banking system without requiring a Congressional vote. In my view, not only does this exceed their statutory authority, but it is a fully conscious and deliberate effort to do precisely that.

  33. babar writes:

    JKH: you are right. the put option still exists, but varies daily depending on the liquidation value of the investor. if there is no effective put, the leverage is worthless.

    in SRW’s world you would let the investor become insolvent but not call in the loan until maturity. i don’t understand this.

  34. JKH writes:

    Nemo’s general point is exactly right:

    “The phrase “non-recourse” is vague enough that it can result in extremely fuzzy thinking and ridiculous arguments (cf. Hempton). The real question is, with recourse to what?”

    “Non-recourse” is an unfortunate and truly illogical term. There’s no such thing as “non-recourse”, not really. There are only degrees of recourse, which must be specified in order to have an intelligent analysis.

    PPIP recourse is more restrictive than FDIC recourse. That means the creditor put option in total is more out of the money under PPIP than under FDIC. That means the equity call option is worth more under PPIP than under FDIC. All of that means Hempton is wrong.

  35. JKH writes:

    I suppose I’d like to see the world categorized as full recourse or partial recourse (specified by degree), and then outlaw the term “non-recourse”. People would probably start communicating a lot more effectively on the subject. It’s a matter of logical Boolean algebra.

  36. JKH writes:

    “Banks are non-recourse” gets the prize for most magnificent blur; awarded to John Hempton.

  37. JKH writes:


    “in SRW’s world you would let the investor become insolvent but not call in the loan until maturity. i don’t understand this.”

    I think Steve’s approach is best illustrated when he says:

    “It’s like a full-recourse home mortgage: the collateral is out there, but you don’t margin, and in the end you go back to the borrower for satisfaction.”

    My guess as to the rationale:

    Full recourse increases the borrower’s risk, other things equal. Recourse only at maturity reduces the borrower’s risk, other things equal. The borrower is fully committed in terms of capital, but is allowed to work out his investment over the full extent of the intended time horizon. That seems to me like a fairly productive trade off between two risks and two counterparties.

  38. jkh has me pretty much right.

    babar, in a mark-to-market world, you never know whether you are “lett[ing] the investor become insolvent but not call[ing] in the loan”, or whether there is a market downspike unrelated to the actual cash flows that will be realized from the asset.

    (even if markets were perfectly efficient, jkh’s point would hold, not margining would leave a borrower with an out-of-the-money call upon redemption, and redemption is always possible due to unforseeable shocks. in a world with imperfect markets, it’s quite possible that assets are bid below some “ideal” expectation of cash flow value. margin leverage leaves investors open to being right all along, but getting liquidated at a loss along the way. i think that banks should be subject to mark-to-market discipline, because no one can agree on a true, nonmarket expected asset value, and path-dependent margining requirements encourage caution and prudence. but there’s nothing at all absurd or inconsistent about absorbing path risk for some investors willing to stand behind at-maturity valuations and of whom we wish to encourage risk-taking.)

    i’m also with jkh on terminology. reading through this discussion, i think it’s probably always a good idea to use the formulation “with recourse to”, rather than non-recourse or full-recourse. all loans are with recourse to something, but for all loans that recourse is limited. “non-recourse” is with recourse to explicitly agreed collateral, loans to banks are with recourse to bank capital, “full recourse” loans to individuals are with recourse to all personal assets except for those that may be sheltered in a bankruptcy proceeding.

    (that said, “with recourse to blah” is precise but longwinded, i’m sure i’ll still end up using the lazy formulations a lot.)

    nemo — i meant single <i>full</i> recourse loans to individuals. if i said non-recourse, that was my usual mental confusion. i think liquidity constraints and path risks should be removed from individual investors willing to price bank assets, and stand behind their valuations with full recourse to their nonbankruptcy shieldable assets if they are wrong. the scale of loans should be commensurate with the scale of the borrower’s finances, so that the costs of bankruptcy are large relative to the gains that would be realized by investors who treat participation as a lottery. it ain’t rocket science, though. people should be able to borrow against these assets on roughly the same terms and in roughly the same amounts that they would be able borrow against home or real-estate investment purchases during “ordinary” (not-credit-bubble) times, but with explicit recourse to noncollateral assets.

  39. JKH writes:

    Speaking of recourse:

    April 10 (Bloomberg) — Bernard Madoff may be forced into personal bankruptcy to ensure that all his assets are used to pay the investors he stole from, a federal judge ruled.

  40. babar writes:

    > “It’s like a full-recourse home mortgage: the collateral is out there, but you don’t margin, and in the end you go back to the borrower for satisfaction.”

    Ok, I understand it now. My understanding was obscured by the fact that I was thinking in terms of a three year time frame — which would make ‘working it out over time’ kind of silly. i am not even sure PPIP has a three year horizon — that’s built into TALF but probably not PPIP. in any case i get it.

    but i still see two problems with it.

    first, i think that the treasury wants to encourage participation, and i don’t think people would lever themselves up to do this. maybe i’m wrong about this. (but i personally wouldn’t. i have had the option to lever myself up to buy stocks and never have done it. i am in principle fine with the stocks i own going to zero — but that’s enough risk.)

    second — and this is another important point — i think that another (unstated) goal of the program is to put a floor on the prices of some legacy assets in order to break a potential forced sale dynamic (intermediary insolvency causes delevering causes forced sales causes asset price drops causes intermediary insolvency etc) if other large institutions fail or if deleveraging speeds up as it may.

    in short i think that they are looking at debt-deflation — with deleveraging brought on by liquidation of holding companies — as a real possibility and attempting to put a floor (through a potentially large subsidy) on market values for a class of assets that hold large places on the balance sheets of these intermediaries.

    when you say that the treasury is allowed to ignore mark to market risk that doesn’t mean that the holder is allowed to ignore it — i might panic sell if i was looking at possible insolvency.

    personally i think that any solution to the crisis will involve some sort of hiving off of legacy assets — a split into good and bad banks or a split into old and new assets. the only reason to mark old assets at all is to get a sense of what and where the losses are. they will be what they will be in the end. if these are too big for an institution to bear and the institution needs to be shut down, then i think we should do it — but i think we should do it without liquidating the legacy assets, because liquidation would bring lower asset prices which could bring down otherwise solvent intermediaries. this plan has a little of that — it hives off some of the tail risk of these assets.

    anyway, i am just sort of rambling here; and this is pretty far off the topic of the post anyway. perhaps it would be better for me to write out my ideas clearly.

    and in any case i think there is a big chance of this going nowhere. the loans side, probably nowhere, given where they are marked. the securities side, probably some securities move.

  41. babar — i don’t think we’ve too much to quibble over. i think you’re right in your critique that what i propose doesn’t do what the past and current administration want a plan to do, which is get the assets off bank balance sheets at prices that don’t show them to be irredeemably insolvent. non-recourse loans to individuals wouldn’t put a floor under asset prices, and might well not encourage bulk participation. my view is that those goals are illegitimate: getting assets off bank balance sheets in bulk at non-insolvency-triggering prices implies a large public subsidy to existing bank managers and shareholders if in fact the real value of asset cash flows is well below the insolvency threshold. i think my proposal would fail to meet the purposes of the designers of PPIP, but it would succeed at my purpose: offering financing at Treasury interest rates, with loan maturities matched to asset maturities and no margining, would make it very clear that any bids are not, in fact, a matter of illiquidity, but a matter of people’s risk adjusted valuations of hold-to-maturity cash flows. my suggestion is aimed at giving banks a liquid market for hold-to-maturity cashflows, and using prices from that to market to mark bank assets, in order to provide a basis for recapitalizing or winding down banks on terms fair to the taxpayer if private sector capital cannot be raised to fill the gaps. the foreseeable outcome of this approach would be full government ownership of several banks (maybe but not necessarily receiverships, gov’t could recapitalize neg equity banks for 100% equity if it chose to offer a “Swedish guarantee” to creditors). but that is not by design, that outcome is forseeable only because we know that several major banks are in fact insolvent under an nongovernmental entity’s valuation of their assets.

    this approach avoids the “fire-sale” liquidation outcome you dislike, because banks are in the end indifferent about whether to sell or hold assets if the sales prices are not subsidized above solvency marks. they are screwed either way. again, only a sample of assets needs to sell to get decent marks, at least if the program is designed well (so that banks can’t claim that the transacted assets are unrepresentative).

    anyway, yeah, this is all way off topic. (the interfluidity post most relevant to this discussion is here.) what i’m after (a fair evaluation, with minimal subsidy) vs what Treasury is after (market prices that bring only good news), are dramatically different. one way or another, we will end up hiving off troblesome assets. the question is the total fiscal cost to taxpayers, and whether we will have a fair or muddied accouning of who paid for what, who got bailed out, who got screwed, and to whom upside (in the form of future equity interests in ongoing frachises) is owed.

    re PPIP — at some level i wait with baited breath. the scenario you describe, securities (mostly marked down already) fly, loans don’t is plausible. unfortunately, a highly gamed everything goes scenario is also plausible, although the very public paranoia about that possibility may help. we will see.

    you never have to apologize for rambling on interfluidity. it’s all i ever do.

  42. himaginary writes:

    Hello. I’m a regular reader, and always very intrigued by your post.

    I’ve set up my blog a couple of days ago, and have elaborated some arithmetic on PPIP. I also did some simulation using lognormal PDF. Maybe some results may serve as food for thought.

    I’ve made four posts so far. In the first one I derived general formula of break-even purchase price, and in the second I described fund position using option formua, and in the third I related two-state model to more general form of PDF, and in the fourth I did some simulation using lognormal PDF.

  43. babar writes:

    thanks for the discussion. yes, the real question is who pays the tab, how it is decided, and how the tab-paying affects the tab, how much transparency there is. absolutely. i wish that we could, as a society, just cut to the chase on this. or maybe i mean Chase? because what is positively annoying about anything being floated is the level of unnecessary window dressing. why can’t we just be honest, say we screwed up, and soul search a bit for a good solution?

    i wonder if you have seen this document: http://www.brookings.edu/economics /bpea/~/media/Files/Programs/ES/BPEA /2009_spring_bpea_papers/2009_spring_bpea_swagel.pdf

    this is a rambling memoir from philip swangel, who was an assistant of paulson’s. i found it quite interesting to read an insider’s view. i think he is mostly being truthful. (very interestingly, he comes close to calling the AIG rescue a mistake; certainly in his memoir it sounds like a questionable decision made by a very tired and frazzled group of people with their backs against the wall than anything else.)

    if losses are anywhere near the $4T that the world bank and roubini are now suggesting — I believe this is on $13T of loans? — then we will be living through this for a long time.

  44. babar writes:

    quick clarification: it’s the IMF not world bank, and it’s $3.3T of US originated loans and $4T worldwide.

  45. raivo pommer writes:

    raivo pommer-www.google.ee


    Wall Street erwartet gespannt Bankbilanzen

    Mit großer Spannung erwartet die Wall Street nach den Ostertagen die Quartalsbilanzen mehrerer Schwergewichte unter den US-Banken. Nach positiven Andeutungen einiger Bankchefs erhoffen sich die Anleger erste Signale einer beginnenden Erholung der Branche in der Finanzkrise.

    Eine Reihe von Analysten warnte aber bereits vor zu hohen Erwartungen. Die Spannbreite der Ergebnisse dürfte groß werden: Mit Goldman Sachs und J.P. Morgan Chase wird bei zwei Institute mit Gewinnen gerechnet, die sich in der Krise bisher noch vergleichsweise gut schlugen. Erneut rote Zahlen erwarten Analysten dagegen bei der Citigroup, die zu den weltweit größten Opfern der Turbulenzen gehört. Bereits kurz vor Ostern hatte die Großbank Wells Fargo mit der Ankündigung eines Rekordgewinns für eine Überraschung gesorgt.