...Archive for February 2009

How to fund financial system stablization

Word on the street today is that the Obama administration’s proposed budget includes a $250 “placeholder” for support of the financial system. (ht Economics of Contempt, Calculated Risk) President Obama made an admirable commitment “to restoring a sense of honesty and accountability to our budget”. However, his administration has failed to live up to that commitment with respect to financial system support. Unusually for government expenditures, the budgeted $250 billion dollars represents an estimated “net cost”. It presumes recovery of a substantial fraction of funds “invested” and actually enables cash payments that might amount to $750B. (See EoC, Marc Ambinder.). In plain English, buried in a $3.55 trillion dollar budget as a $250 billion dollar placeholder is a plan to more than double the controversial and unpopular TARP program, whose original enactment nearly tore the political system apart.

We do have a bit more transparency this time about how the “Capital Assistance Program” will be managed. Taxpayers will purchase securities at prices which, as Michael Shedlock points out, appear to have been back-dated in order to give taxpayers a raw deal. In an astonishing abuse of the customary language of finance, the “convertible preferred” shares the government intends to purchase, in addition to mandatory conversion after seven years, are convertible to common stock at the option of the the banks, rather than at the option of the taxpayers holding the securities. James Kwak unearthed this bit of chicanery in the must read piece of the day. In addition, existing bank shareholders would be protected upon any conversion by “customary anti-dilution adjustments”. God forbid that shareholders in bankrupt institutions who would otherwise be wiped out entirely get diluted. The poor dears. (To be fair, it is inaccurate to characterize all institutions that will receive “capital assistance” as bankrupt. The new Treasury Secretary will almost certainly continue the old Treasury Secretary’s strategy of “encouraging” healthy institutions to take government money, so that angry taxpayers cannot use acceptance of funds as evidence that a bank is in trouble. Under the new program, any publicly listed US bank can apply for a capital infusion of up to 2% of risk-weighted assets as a matter of course.)

President Obama’s obvious intellect, idealism, and diplomacy are a breath of fresh air for a nation whose economic and political institutions have suffered a near catastrophic collapse. But the President cannot put his imprimatur on continued financial obscurantism and expect to retain a reputation for honesty and transparent government. It is wonderful that the President intends to come clean and account for the wars in Iraq and Afghanistan on-budget. But Mr. President, past and proposed expenditures to support the financial system dwarf the total financial costs of both those wars combined. This is not a small thing. You can’t hide the terms of these transfers in fine-print befitting a credit-card agreement and expect to retain your reputation with the American people for forthrightness.

Here is my advice to the U.S. Congress: Put $750B in the budget, right up front, for financial system stabilization. But don’t contribute another dime to Secretary Geithner and Neal Kashkari‘s little slush fund. Allocate funds to the sole use of the FDIC, for resolution of troubled banks as foreseen by Congress under the FDICIA (text). See this excellent piece by former bank regulator William Black. The government has been flouting the terms of a binding legal regime designed precisely to resolve insolvent and near insolvent banks transparently, at least cost to the taxpayer, in a manner that minimizes both moral hazard and systemic risk. Former Secretary Paulson’s ad hoc let’s-pretend approach has been tried, and has failed. Why not try following our own laws?

We have a new administration in Washington that claims to be committed to the rule of law and good governance. Congress should help the President achieve these goals by funding an accountable FDIC rather than by putting more discretionary funds into the hands of a compromised Treasury secretary.


Update: The always excellent Nemo also noticed the odd reverse-optionality of CAP “convertible preferreds”. He finds the coincidence of widely publicized insider purchases during CAP’s price-determining 20-day window to be intriguing as well. Purchasing shares with the intention of increasing their effective price to taxpayers under a foreseen government relief program would certainly constitute a crime. What did Ken Lewis know, and when did he know it?

(It’s worth mentioning that the allegation of backdating and that of insider price manipulation are mutually inconsistent — if insiders knew that the window would be 20 days preceding Feb 9 in late January, that implies the price-determining date was appropriately set in the future. You can either suggest that the date was chosen retrospectively, or that it was chosen in advance and shares were bought and talked up, but you’ve got to pick one conspiracy and stick with it. I guess if you’re really cynical, you might suggest that Feb 9 was tentatively chosen in advance, but only finalized when it was clear in retrospect that prices were advantageous, relatively speaking…)

Update History:
  • 26-Feb-2009, 5:15 p.m. EST: Added update re Nemo’s posts.
  • 26-Feb-2009, 5:25 p.m. EST: Added bit about inconsistency between back-dating and price-manipulation stories, and hedged the main text a bit, saying that the window appears to have been backdated rather than stating that as though it were fact.
  • 26-Feb-2009, 6:05 p.m. EST: Removed an “as the” to split an overlong compound sentence about Geithner countinuing to encourage healthy institutions to accept money so the zombies blend in.

There’s no reason for non-recourse

We don’t know exactly what Timothy Geithner has in mind for the “Public-Private Investment Fund”. But we do have a few hints. First, we know that among its purposes is that it

allows private sector buyers to determine the price for current troubled and previously illiquid assets.

And we also know, that on the very day Mr. Geithner offered his outline of a financial stability plan, the Federal Reserve announced its intention to expand its Term Asset-Backed Securities Lending Facility, or “TALF” to up to a trillion dollars, coincidentally the round number that Geithner suggested the “PPIF” might expand to. Hmmm. What is the TALF again?

Under the TALF, the Federal Reserve Bank of New York will provide non-recourse funding to any eligible borrower owning eligible collateral… As the loan is non-recourse, if the borrower does not repay the loan, the New York Fed will enforce its rights in the collateral and sell the collateral to a special purpose vehicle (SPV) established specifically for the purpose of managing such assets… The TALF loan is non-recourse except for breaches of representations, warranties and covenants, as further specified in the MLSA.

Does your head spin, acronym upon acronym, non-recourse, warranties, and covenants? Well, unspin it. The New York Fed is telling us, in plain and simple legalese, that it is planning to make a very generous gift to investors that participate in this program (and indirectly to the banks that sell assets to them). A non-recourse loan bundles an ordinary loan with an option to “put” the collateral back to the lender instead of paying off the loan. Sometimes this is not much of a gift: When a pawnbroker lends you half of what your Fender Stratocaster is worth, and the fact that you can surrender the guitar rather than pay off the loan is cold comfort. But if someone fronts you substantially all of what an asset is worth, and the value of that asset is uncertain and volatile, then the put option bundled into the “loan” becomes extraordinarily valuable. If the asset appreciates, you take the profits and “ka-ching!”. If the asset falls in value, the lender takes the trash and eats the loss.

A near-the-money option is itself a valuable asset. Offering non-recourse loans to participants in the PPIF would directly contradict the program’s goal of “allow[ing] private sector buyers to determine the price for… troubled… assets.” Private sector buyers would not be pricing the assets themselves: they would be pricing a portfolio containing a troubled asset and a free, three-year put option, courtesy of the Fed. Depending on how much of the transaction the government is willing to finance, the value of the put option could represent a substantial fraction of the value of the asset being priced. This is a subsidy, that would be incorporated in the sales price of the asset and split by banks and private investors. It amounts to the government bribing investors to certify banks as more solvent than they are, by overvaluing bank assets in subsidized purchases.

John Hempton wrote a very brilliant essay on what it means for a bank to be solvent. If you haven’t read it, go do. Hempton’s definitions 2 and 3 of bank solvency — current accounting value (which implies mark-to-market valuation for many assets) and economic value as an ongoing enterprise — diverge because the cost of funding for investors in risky bank assets is unusually high. Under these condition, Hempton reasonably suggests, private fund managers will be unable bid assets up to their best estimates of “hold-to-maturity value”, less a “normal” risk premium, because investors are desperately unwilling to hold anything other than government guaranteed securities. Definition 3 is a very generous view of what it means for a bank to be solvent, because it implies that the actual market risk premium is wrong, that an estimate of hold-to-maturity asset values by a reasonable analyst, even accounting for risk, would put those values above current market bids. But in evaluating bank solvency we should be generous: Since an insolvent bank must be nationalized (reorganized, received, conserved, preprivatized, whatever), we should try to avoid declaring as insolvent banks that do have positive economic value, since that would amount to a capricious expropriation of private property.

But generosity in evaluation is distinct from a generous cash gifts from taxpayers to banks and investment funds. What is required to get a generous but still accurate evaluation of bank solvency is inexpensive funding, so that analysts willing to bet on what a “toxic asset” is worth can borrow the funds they need to back their spreadsheets with shekels without giving away all the upside to nervous lenders. What is not needed, what is in fact positively counterproductive, is to give investors a special bonus in the form of a free option if they buy the asset. This guarantees that assets will not be accurately priced (they will be overpriced), and reduces analyst incentives to value assets carefully and generate reliable market prices.

I actually think having the government offer cheap, full-recourse loans on a maturity-matched basis to investors willing to bear the risk of holding currently disfavored assets is a clever idea. (“Maturity-matched” means investors don’t have to worry about margin calls: as long as they get the long-term values right, they can ride out any tempests in mark-to-maket prices.) We do need a market in these assets, and if it is true that funds availability for people willing and able to bear the risk of ownership is preventing such a market from arising, then by all means, that’s a “market failure” the government can correct. But the key point is that a market price is the price at which private parties are willing to bear that risk. If funds are provided non-recourse, much or all of the risk of ownership is absorbed by the lender. Any prices that result from “private” purchases by investors funded at high-leverage on a non-recourse basis are not market prices at all. Such prices would be sham prices, smoke-and-mirror prices, sneaky off-balance sheet public subsidy prices.

We are all tired of the lies, Mr. Geithner. By all means, let nationalization be a last resort, and do all you can to offer liquidity to private parties willing to take both the upside and downside of speculating in questionable paper. But if you keep nationalizing the downside and privatizing the upside, it will not be very long at all before the public concludes that stress tests and market prices are just a sleight-of-hand for Davos man while he picks our pockets, again. Act fairly, and you may end up nationalizing the worst few of the larger banks. Keep up the games, and we will insist that you nationalize them all. It is getting hard to believe that there is a banker in the land who has not already robbed us. Eventually we will tire of drawing fine distinctions.


Afterthought: There’s another way to generate price transparency and liquidity for all the alphabet soup assets buried on bank balance sheets that would require no government lending or taxpayer risk-taking at all. Take all the ABS and CDOs and whatchamahaveyous, divvy all tranches into $100 par value claims, put all extant information about the securities on a website, give ‘em a ticker symbol, and put ‘em on an exchange. I know it’s out of fashion in a world ruined by hedge funds and 401-Ks and the unbearable orthodoxy of index investing. But I have a great deal of respect for that much maligned and nearly extinct species, the individual investor actively managing her own account. Individual investors screw up, but they are never too big to fail. When things go wrong, they take their lumps and move along. And despite everything the professionals tell you, a lot of smart and interested amateurs could build portfolios that match or beat the managers upon whose conflicted hands they have been persuaded to rely. Nothing generates a market price like a sea of independent minds making thousands of small trades, back and forth and back and forth.

Thank goodness…

…for Yves Smith.

If you aren’t shrill, you aren’t paying attention. Weren’t we supposed to be done with shrill now?

Bank insolvency: tips & tricks

So, your banking sector is basically insolvent, and your economy is teetering on the brink. No question, that’s a rough situation. Never fear, Interfluidity is here. With the help of this uncredentialed blogger, you can turn your banking system around, save civilization as we know it, and still have time to do the laundry.

  1. Never, ever feed the zombies!

    Zombie banks beg for money. They are very clever. They come up with ways you can give them money while pretending not to give them money, such as guaranteeing their assets, guaranteeing new debt issues, or buying up assets at “hold to maturity” values. Just say no! A healthy financial system cannot be run by zombies. “Rescuing” insolvent banks makes about as much sense as tying string to the arms of a loved one’s corpse so it can come to the dinner table as a marionette. For a while that may be comforting (or not), but pretty soon it’s sure to smell really bad, and it’s gonna ooze. If you think you have engineered a miraculous turnaround, you have only made matters worse. An undead bank is an abomination. It will pretend good health but hide a rot. It will afflict you, over and over and over again, with harrowing near insolvencies (cf Citibank). Dead banks must be allowed to die.

  2. Help private individuals save good banks.

    A bank is insolvent if no one will save it. Do what John Hempton recommends for a hypothetical, troubled GothamBank:

    The government could inject some capital into the bank as a temporary subordinated loan. A third party could then be appointed… to produce fair accounts for Gotham. Ten weeks should do it… The management of Gotham can go to the markets. If the management can raise [sufficient private capital to ensure the bank's viability] then the shareholders keep Gotham. Sure existing shareholders might get diluted — but at least they get to have a decent go at keeping their capital stake. If they can’t or won’t fund the bank in full knowledge of its position then it is nationalised.

    The government might go a step farther: It could provide loans at near-Treasury interest rates to creditworthy individuals willing to commit capital to ailing banks. Individuals who take the loans would agree to hold the bank’s shares until the loan was fully paid.

    In effect, the government would help bail out tenuous banks. But it would require private citizens to certify banks’ viability by putting their wealth on the line first. Investors would have to accept personal bankruptcy before taxpayers take a loss. (Of course, investors could skip the loan and put up cash if they prefer.) If investors fail to provide capital on these terms, then a bank is clearly not worth keeping alive. There can be no question that the bank is “illiquid but not insolvent”, since the government has offered liquidity on generous terms to help get the deal done.

    (For the record, I view this procedure as too generous. As far as I’m concerned, banks that have extracted asset guarantees from taxpayers — yes, that means Citibank and Bank of America — have conceded their insolvency and been purchased by the state. If private capital swoops to the rescue now, the new owners will benefit from a substantial public transfer. Nevertheless, in deference to people’s heebeegeebies about the government owning what it pays for, I’d put up with that if we had a fair procedure for evaluating and enforcing bank solvency going forward.)

  3. Nationalize, reorganize, privatize spin-off to taxpayers.

    Insolvent banks become wards of the state. They are nationalized. The “N-word”, as Paul Krugman put it may seem un-American, but any time a US bank fails, it is taken into some form of receivership by the FDIC. Often the operations of the dead bank are quickly merged with a healthy bank so we can pretend we live in a capitalist utopia. But that doesn’t change the story. The old bank is nationalized, its good assets are sold to another bank (which pays by assuming dead-bank liabilities), and the FDIC takes control of what remains. When we talk about “nationalizing”, say, Citibank, we are asking nothing more than that it should be treated like Suburban Federal Savings Bank, CenterState Bank, and MagnetBank were this very weekend. There is not actually any controversy over nationalizing banks. There is controversy over nationalizing large and politically influential banks, and there is controversy over having banks operate for more than a brief period under direct control of the state.

    Obviously, banks that had Robert Rubin on their boards are entitled to no gentler treatment than Suburban Federal enjoyed this weekend. The trouble with big banks is that they are too big to be merged into someone else, but are deemed too “systemically important” to be liquidated. That means if the FDIC takes such a bank into receivership, it would have to operate under state control. Americans are legitimately nervous about this. What we need is some means by which the government could commit to restoring banks to private ownership after they are reorganized and recapitalized.

    Henry Blodget suggests we

    refloat the banks immediately, so the government is not in the business of forcing banks to make stupid loans or determining what is and isn’t appropriate for people to get paid.

    But refloating is hard. If the government were to rush-sell a generously capitalized bank with a one-shot whole-company IPO, taxpayers would end up with a raw deal. No private owner would sell a large firm this way, because it would be a very dumb thing to do. (IPOs typically only offer a fraction of a firms shares, and are known to fetch poor prices. The famous IPO “pop” goes to flippers, not to the firm or its original shareholders. There’s a deep literature on the phenomenon of “IPO underpricing”.)

    Here’s an idea. The government should commit to fully reprivatizing nationalized banks (really their sliced-up and reorganized successors) within a year of taking a bank into receivership. But rather than selling the reorganized banks, the government should structure the divestitures as spin-offs. The government should distribute equal numbers of shares to every adult US citizen. Individuals could decide whether to hold the shares or sell them. The new banks would be publicly listed, so they’d quickly have frenetic market prices like every other firm. The government would spread the transfers out over several months. (People who need immediate cash will sell their shares as soon as they get them. If everyone gets shares at the same time, motivated sellers might flood the market and end up selling at a crappy price.) To promote efficient pricing of the new banks, prior to the spin-off the government would remove hard-to-value “toxic” assets into asset management companies, which would not be privatized, but managed conventionally to maximize taxpayer value.

    This proposal ensures that US taxpayers, in aggregate, get what they pay for when they rescue a bank. It puts banks into private hands while avoiding the corruption and theft of public wealth that invariably attends privatization. It would function as a mild “stimulus” — even though no public cash would be disbursed, the distributed shares would increase consumption. (Liquidity constrained individuals would sell their shares to savers, whose cash is then mobilized to buy stuff.) Having the government recapitalize banks and then give them away might seem rough on the budget, but it’s far less costly to taxpayers broadly than offering windfalls to zombie bank shareholders and management by subterfuge, which is our current practice. If the exercise were made revenue neutral by raising taxes to recoup the recapitalization cost, the whole thing would amount to a flat transfer, which is good policy anyway.


Incidentally, the Winterbug post inspired an intense comment thread. The extraordinary JKH offered a view of public finance that has tax payments as purchases of government equity, and state benefits as equity buybacks. The analogy is interesting, quite because it is imperfect. “Compare and contrast” is a fruitful exercise. The spin-off idea owes something to this perspective.