James Surowiecki has been pushing the idea (first mooted by John Hempton) that since bank financing always involves non-recourse by taxpayer (via government deposit insurance), it's no big deal that the Geithner Plan is built around generous non-recourse lending. Surowiecki:
There is one detail of the plan, though, that people are particularly bothered by, and that is the fact that the plan involves the FDIC guaranteeing loans to private investors. (The way the plan to buy pools of mortgages is set up, investors will be able to borrow six dollars for every one dollar they invest. If their bets go bad, they lose only the one dollar they invested—the FDIC is responsible for paying back all the borrowed money.) Paul Krugman, for instance, calls this the “central issue,” and argues that because the non-recourse loans are a massive subsidy to investors—which they are—the plan will distort the prices that investors are willing to pay for these assets, and therefore "has nothing to do with letting markets work." Ezra Klein, similarly, argues that because the plan relies on these "non-recourse” loans, the prices it will produce will be in some way “artificial." Their point is that the Geithner plan, among other things, is supposed to produce real market prices for these toxic assets, which will then give us a better picture of banks' balance sheets and allow us to avoid valuing these assets at prices that the government thinks have become unduly low because investors are so risk-averse. But by creating a plan in which investors have only a small downside and a big upside, we're supposedly creating fake prices.
There's no doubt that the non-recourse loans constitute a big subsidy: while investors' downside risk isn't eliminated, since they can still lose all the money they invest, that risk is significantly limited, while their potential upside is significantly increased (since they're leveraging every dollar they invest six-to-one). Yet for all the criticism of this subsidy, the truth is that the plan's reliance on non-recourse loans is not an especially radical idea. In fact, it's essentially the same kind of subsidy that the entire U.S. banking system has depended on for the last seventy-five years. What are FDIC-insured bank deposits, after all? They're non-recourse loans to banks. You deposit money with a bank—that is, you lend it your money. The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it's invested. All the rest of the bank's losses are paid for by the FDIC. This is precisely the same arrangement — down to the loans being guaranteed by the FDIC—that the Geithner plan sets up. In effect, it just extends to outside investors, for the purpose of acquiring toxic assets, the same subsidy that banks have been receiving since 1933.
Surowiecki is right in a superficial way, but he misses crucial details. His analogy breaks down in ways that I think are informative.
Non-recourse financing involves bundling a valuable put option along with a loan. The value of that option hinges on the details of the arrangement: An "at-the-money" option is more valuable than an "out-of-the-money" option. The "moneyness" of the implicit put option in a non-recourse arrangement is determined by the degree of leverage the borrower is allowed. The Geithner plan permits a maximum leverage of 7:1 assets to equity. As Surowiecki points out, that degree of leverage is less than the leverage of a traditional bank.
But notional "moneyness" is not the only thing that determines the value of an option. In particular, options are most valuable when the assets that underlie them are very volatile. In order to limit the degree to which banks maximize the value of the deposit insurance option at the taxpayers' expense, banks are supposed to submit to onerous, intrusive regulation that limits the riskiness, the volatility of the assets they can purchase.
Under the Geithner plan, the government will extend its non-recourse option to investors without preventing them from "swinging for the fences" on risk in order to extract value from the option. On the contrary, the government is insisting its loans be used to purchase assets that have already proved themselves unsuitable for purchase by a regulated entity, by virtue of being volatile and difficult to price. It's as if an insurance company that ordinarily refuses to cover homes in hurricane states suddenly offered policies only to purchasers looking to build homes on Gulf-coast barrier islands.
Sometimes an option is costly to exercise. Exercise costs reduce the value of an option to its owner along with the expected liability of the option writer. The traditional deposit insurance option was very costly for banks to exercise. Banks were only allowed to exercise the option by being put out of business. That sharply limited the value of the FDIC option to bank employees and shareholders. Usually the "franchise value" of a bank is greater than its regulatory capital. In order to extract value from the option, bank stakeholders must take bets whose (probability-weighted) payoff in a good outcome exceeds not only the loss of regulatory capital, but also the value of the business as an ongoing concern. Moreover, if we are valuing the "traditional" FDIC option, we should go back just a few decades to when most banks were privately held and run by lifers. A typical bank's owners and employees had an illiquid, undiversified exposure to the well-being of their institution. Calculating franchise value from the price/book of Citi pre-crisis would dramatically underestimate the value of a traditional bank to its controlling stakeholders. Exercise of the FDIC option used to be costly indeed for the owners and managers of banks. There were, if you'll excuse the terms, "synergies" between regulation and a high cost of exercise: If triggering a deposit insurance payout is very painful, strategies designed to monetize the option need a fly-to-the-moon upside to be worth the risk. But spaceports are more likely to be flagged by regulators than an extra 100 bps on a "AAA" CPDO.
Unlike deposit insurance, the non-recourse option offered to investors in the Geithner plan is completely costless to exercise, once it is in the money. Surrender of the collateral constitutes fulfillment of the lending contract full stop. Pace Megan McArdle, it is not like the non-recourse option implicit in the typical home mortgage, where exercising the option involves a hit to ones credit. There is no default of any sort involved in surrendering the assets rather than repaying the loans. The right to do so will be written into the deals.
Finally, the FDIC option didn't used to be free. Banks paid a fee in exchange for the deposit insurance. Under the Geithner plan, borrowers will be charged a fee as well, but then they'll be borrowing at rates dramatically lower than they could on their own. This works with Surowiecki's story — banks borrow very cheaply from depositors because of the FDIC guarantee. But, as always, the question is price: Given the volatility and uncertainty surrounding the underlying assets and the near-zero cost of exercise, will the FDIC charge a fee high enough to cover the expected liability of the option? I'll leave that for readers to decide.
Surowiecki's analogy does work pretty well if we compare the Geithner plan not to traditional banking thirty years ago, but to recent practices of the industry. Thanks to hands-off government and structured-finance shell games, banks were recently able to amass high risk, high yield investment portfolios despite being ostensibly regulated institutions. Institutional changes, including changing norms about the length and terms of bank employment and dominance of the industry by large, heavily-traded limited-liability corporations, decreased the expected cost of exercise to bank employees and informed shareholders, making volatility maximizing strategies more attractive. The option premium, the FDIC fee, was severely underpriced (it was reduced to zero from 1996 to 2006).
If Surowiecki wants to argue that the non-recourse option embedded in the Geithner plan would basically reproduce the subsidy to the banking system offered circa 2006, I'll readily agree. But it is not reasonable to argue that non-recourse loans offered on generous terms to unregulated investors for the express purpose of purchasing unusually volatile assets represent the "same subsidy that banks have been receiving since 1933."
|Steve Randy Waldman — Wednesday March 25, 2009 at 7:29pm||permalink|