The Geithner Plan, Part 2

by hilzoy

In my last post I argued that the auctions Sec. Geithner is (by all accounts) about to propose as part of his plan to solve the problems with the banking industry might not work at all; that if they did work, they would do so by giving buyers an incentive to overpay, with both their dollars and ours, for troubled assets; and that the plan therefore represented an enormous gamble, with our money, on the proposition that those assets are presently undervalued. 

In what follows, I want to describe a different and more troubling way in which these auctions might tempt people to overpay. This is a problem I have not seen discussed elsewhere, and I have wavered about whether or not I should write about it: it might be that the reason it hasn't been discussed elsewhere is that I just don't have any idea what I'm talking about, and this really won't be a problem. I decided to go ahead and write it up, but bear in mind: I'm a philosophy professor, not an economist. That said:

A lot of the "toxic assets" are very hard to value. They are not traded all that often, and there are not a lot of comparable sales to use as a guide. This means that the prices arrived at in an auction might serve several different functions. One function is obvious: when a buyer and seller agree on a price for some asset, that asset will change hands at that price. 

In addition, though, for any asset of a kind that is (a) both rarely traded or otherwise hard to assign a price to, and (b) in some way comparable to other assets, the price that emerges from an auction might also be used as data for setting values for other, similar assets. If the auction price is low, regulators might force the owners of comparable assets to write those assets down. Thus, the owners of comparable assets would seem to have an interest in those prices being as high as possible.

If the private parties to the auction had to put up 100% of the money, then we wouldn't have to worry as much about those owners' trying to bid up the prices of the assets in order not to have to write down comparable assets: it would probably cost them too much and be too risky. But the less money they have to put on the line, the more likely it becomes that the amount they need to risk to drive prices up is less than the amount they would stand to lose if they had to write their comparable assets down. 

We are about to ask private parties to put down very little money to participate in this auction. Worse, in some cases we will guarantee against losses, which would seem to remove the risk from bidding too high. This seems like an invitation to banks that are worried about the prices that might be discovered in such an auction to bid higher than they would if they had no concerns about the value of comparable assets. Possibly quite a lot higher. 

The most obvious way to deal with this is to create rules about who can participate in the auctions. Clearly the original owners of the assets should not be allowed to bid on them. But it seems to me that for the reasons just outlined, no one who owns comparable assets should be allowed to bid on them either. Those people have a conflict of interest: as owners of comparable assets, they have an interest in having those assets seem to be more valuable than they actually are. 

It would be fairly easy to exclude these two kinds of firms, and people employed by them, from participating in the auctions. But consider a third group: firms that do not own any such assets, but that do a lot of business with firms that do, and that stand to lose a lot if any of those other firms go under. Those firms also have an interest in overpricing those assets. They would probably be pretty hard to exclude. But if they overpay for these assets, we are all on the hook.

Moreover, excluding people from firms who own comparable assets, let alone people from firms with substantial exposure to those who do, would exclude a lot of the people who would, offhand, seem most interested in participating in such an auction, and most knowledgeable about the assets being auctioned off. I, for instance, have no conflict of the kind I've just described, but that's because I have no experience whatsoever in this kind of investment. For that reason, I'd be a terrible person for the government to invite to participate in these auctions. It's worth asking just how many unconflicted firms with the expertise to make this kind of investment and do well at it there are.

As I said at the outset: I'm sure you all normally bear in mind the possibility that I might be wrong, but I'm especially likely to be wrong about this point. I'd love to hear any views about whether, and how, I am. If I'm right, though, this is one more reason why we should expect the prices set by the auctions to be too high. And if they are too high, that means we, the taxpayers, are paying too much. 

Comments

[mikkel]

No Hilzoy, you are exactly correct. If you read comments at Yves post, they postulate several ways that groups of bidders will act in a way to make their balance sheets look bigger and transfer massive amounts of risk to the government. These ways range from honest but inevitable, to dishonest but legal (think SIVs) to outright fraud. Considering the people involved, I think we have to assume a large amount of the latter two.

It is not hyperbole to say that the plan is a $3-$4 trillion (at present, it will be much much more if you count future behavior that will occur because of this auction, perhaps upwards to $8-$10 trillion IMO) gamble that this entire crisis is overreaction. If the crisis is NOT overreaction, and we are rally not going back to "normal" or in otherwords, the largest bubble ever (like Galbraith, Krugman, Volcker, Stiglitz and pretty much everyone else that doesn't buy into monetarism lock stock and barrel believes) then the government will have merely increased its debt by at least 50%, and it will just be a gigantic transfer of wealth to the people that caused the situation.

[bedtimeforbonzo]

"We are about to ask private parties to put down very little money to participate in this auction. Worse, in some cases we will guarantee against losses, which would seem to remove the risk from bidding too high."

See:

A

I

G

Geithner, apparently, has not learned from past mistakes, which tells you all you need to know about our current Treasury Secretary.

Mikkel, I've got both feet on that bandwagon you mentioned in Hilzoy's last post. But I hope you realize President Obama has given Mr. Geithner 33 votes of confidence in the past week alone.

[mikkel]

bedtime: one of the best things about politics is how little credibility votes of confidence actually have. Obama could turn on him any day and claim that his prior support was specifically referring to that he didn't think he should resign over the AIG stuff, and that by failing to pass the bank plan they "need to move in another direction." Remember the stress test results are coming out soon, they could just be shocked! shocked I tell you at how bad they were as cover to take over the banks and split them up. Of course Geithner would be fired in that instance.

Obama has to realize that this could make or break him, and considering that in ideology he is much closer to Krugman, Stiglitz, etc. I think there is a chance he'll finally say enough!

[dmbeaster]

Part of what makes these assets so hard to value is that the are pyramided on other assets, which are also hard to value. It all rests on home values, repayment and default rates, and returns on defaulted mortgages. I suspect that toxic assets are trading at worst case scenarios concerning these variables, since there is so much uncertainty and so may have been burned before by vastly underestimating just how low these values could go.

The starting point in any proper work-out plan is the best analysis possible on these values, as well as a differential analysis based on differing assumptions about housing prices, etc. JP Morgan did one of these last September when it took over WAMU -- very interesting stuff.

I have yet to see anything similar being done on the current crop of toxic assets. I do not see how any intelligent policy can be formulated or defended without this basic information.

[TheWesson]

I think the whole point of this plan is to have investors over-value bank assets and have the government overpay the banks for them, thereby making banks solvent. It sort of puts a free market gloss on overvaluing bank assets, but it's not about creating liquidity (a market in toxic assets), it's about creating bank solvency by overpaying for bad assets.

Brad DeLong:

>>Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?
>>
>>A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

I think that is the greatest weakness in DeLong's argument, papered over with hand waving and apocalyptic images and unfortunately it's the central point of his argument for this bailout.

There are many scenarios in which the assets are not worth what the banks need to have them be worth, and the assets are also fundamentally worth somewhat above what the market wants to pay for them.

For example, the bank needs their $100 asset to be worth $70 in order to be solvent, and the current mark-to-market price is $30, and (if we had perfect future knowledge) the asset would be worth $50.

So let's say there's 1/4 chance the asset is worth $100, 1/4 chance the asset is worth $75, 1/4 it is worth $25, and 1/4 chance it is worth $0 (that's the same as an expected worth of $50 overall.)

Some hedge fund guy ("Hedgie") bids the price up to $75 (with good reason as it turns out - he's not insane to 'overpay')

Treasury + Hedgie are paying $11.25 for 15% of the $75 and getting a loan for the rest from the gov't ($63.75).

Hedgie pays $2.25 for their 20% of that 15%, Treasury pays $9.00.

Scenario 1: The asset is finally worth $100
The profit of $25 is split between Hedgie and Treasury 20/80 (and the loan of $63.75 is repaid.)
Hedgie gets $5 profit on his $2.25, hurrah.
Treasury gets $20 profit (this is where Brad DeLong sees this as a good deal for the Treasury.)

Scenario 2: The asset is worth $75.
The loan is repaid but nobody makes a profit.

Scenario 3: The asset is worth $25.
Hedgie loses $2.25, Treasury loses $9.00, the Gov't loss on the loan is $38.75 (assuming the loan gets paid back first.)

Scenario 4: The asset is worth $0.
Hedgie loses $2.25, Treasury loses $9.00, the Gov't loss on the loan is $63.75

Summing over these scenarios, the average outcome is that the Hedgie makes $0.125, Treasury makes $0.50, and the Gov't loan loses $18.36

(The bank ends up solvent, getting $25 over what it would have gained by holding on to this asset.)

So you can see the essential 'feature' of this plan: getting Hedgie to rationally overvalue bank assets. He's not overPAYing because he's not risking HIS money mostly - the government is overpaying.

Effectively Brad DeLong is assuming, I believe, that these assets are MASSIVELY undervalued and are in fact almost risk free. Being almost risk free is the scenario under which the government could come out ahead.

[bedtimeforbonzo]

"bedtime: one of the best things about politics is how little credibility votes of confidence actually have."

Yes, Mikkel, I was being a bit sarcastic.

Being a former sportswriter, I, for one, would not want my boss to overdo the vote-of-confidence thing. Usually, in my old business, if a coach got a VOC, it was always a good bet to get his obituary ready.

Nevertheless, Obama still keeps making them . . .

My cynical take is that even someone as wise as President Obama would not want to admit failure so soon by casting Geithner aside and, therefore, would hope the president would cast his pride aside and ditch the guy sooner rather than later. (Fwiw, I think Geitner's coziness with Wall Street is one reason we don't see any Republicans calling for his head and, just today, saw Judd Gregg praising the guy.)

[brendan]

It all rests on home values, repayment and default rates, and returns on defaulted mortgages.

Exactly. And with skyrocketing unemployment, plus the expectation that home prices will naturally revert to historical levels with a slight overshoot, the outcome is clear: this plan will not save the banks. It is just an enormous transfer of wealth to the richest people in the world.

Curious how it's only the brains in power who think this is a good idea.

[brendan]

Effectively Brad DeLong is assuming, I believe, that these assets are MASSIVELY undervalued and are in fact almost risk free. Being almost risk free is the scenario under which the government could come out ahead.

Yup, and it's also the same assumption that our brilliant employees at AIG made for five years. Maybe we should give DeLong a nice fat bonus too.

[iocaste]

You might like this column, from when reverse auctions were first proposed as part of TARP:

http://www.bloomberg.com/apps/news?pid=20601039&refer=columnist_weil&sid=aK6vnh_5ZknM

[Bernard Yomtov]

I'm not so sure hilzoy's third group is a real danger. If you do business with a bank and are worried about them failing there are lots of ways to help out other than overpaying for assets in this auction. You could just buy equity, for example.

As for the holders being allowed to bid, the issue is whether they are required to sell at the high bid price. If not, they are effectively bidding.

There is another reason why bidders may overpay. These auctions are a good example of a case where the Winner's Curse can come into play.

The idea originally arose in the context of auctions for oil leases. It works when the item being auctioned has some unknown market value which the bidders estimate. Clearly, the bidder with the highest estimate will end up buying the item, but the highest estimate in a group is likely to be too high. So the tendency is to overpay.

[Pithlord]

This whole thing brings out the side of the left that is more about resentment than about making the world a better place.

There's some possibility that the USG will make money on this whole thing. De Long makes the case. But even if it doesn't, it is very likely that the loss doing things this way will be less than the loss if the banks are nationalized. Krugman never even tries to quantify that loss, but it would be enormous.

[bedtimeforbonzo]

"But even if it doesn't, it is very likely that the loss doing things this way will be less than the loss if the banks are nationalized."

Pithlord: So a bad plan (if it turns out as such) is better than no plan at all?

[J. Michael Neal]

Again, people are conflating two separate issues. Whether or not we nationalize the banks really isn't the same question as whether or not we funnel money to the banks' creditors. The Geithner auction plan is about the second question, not the first. Nothing in it precludes taking over the banks. In fact, if some predictions are correct, and the auction fails because no one is willing to pay what the banks insist on as a price for the assets, then this looks like an attempt to grease the skids to a government takeover.

While the Geithner plan probably gives up some of the upside on asset appreciation, it also probably lessens the downside to the taxpayer, although by only a small amount. If the government takes over the banks, it is taking all of the downside risk of the assets, rather than getting the hedgies to take some.

The plan has some problems. There are some things I would change, though a lot depends upon the specifics that we don't have yet; it could be significantly better, or it could be pretty bad. Regardless, I don't think that it's the apocalyptic event some are claiming.

[J. Michael Neal]

So a bad plan (if it turns out as such) is better than no plan at all?

Right now? Yes. Though, as I said above, if the plan fails altogether, that's not necessarily the end of the world.

[ThatLeftTurnInABQ]

Again, people are conflating two separate issues. Whether or not we nationalize the banks really isn't the same question as whether or not we funnel money to the banks' creditors. The Geithner auction plan is about the second question, not the first. Nothing in it precludes taking over the banks. In fact, if some predictions are correct, and the auction fails because no one is willing to pay what the banks insist on as a price for the assets, then this looks like an attempt to grease the skids to a government takeover.

Something that isn't clear to me in the nationalize-now plans (being hawked by folks like Krugman and supported by bloggers like Yves) is, what do we do after we've nationalized? At that point we have a choice to either recapitalize the nationalized firm directly with taxpayer money, or liquidate it and let counterparties eat the damage. If the second is an unacceptable course of action because of the consequences which follow, then what have we gained by nationalizing? It seem to me that it only makes sense to nationalize once we reach the point where we are prepared and willing to give a one-fingered salute to the counterparties.

Are we there yet? I haven't read anybody apart from William Buiter who is ready to come right out and say, "yes, let's put the screws to 'em. Do it now". Or at least not anybody who seems to know what they are talking about in detail, is arguing from calm rather than anger, and appears to have a clue how extensive and complex the counterparty relationships may be.

That suggests to me that the best alternative to the Geithner plan would be to do nothing and hang on waiting for further events as they develop, rather than to proceed directly to nationalization right now.

[bedtimeforbonzo]

That's comforting, JMN. (Be nice to get a plan that works eventually.)

Read your blog comments on CNBC being a cluster----. For all of its evil ways, however, CNBC is profitable, the reason for which I think goes back to Tony P's excellent Master of the Universe "theory" in one of the recent posts.

[bedtimeforbonzo]

"At that point we have a choice to either recapitalize the nationalized firm directly with taxpayer money, or liquidate it and let counterparties eat the damage."

Of course, we are already doing the first thing.

Fwiw, I don't think it's in our capitalist blood to go the nationalized route -- unless and until there is no alternative.

[mikkel]

Well I for one have always thought that the pro-nationalization people were exceedingly clear that they were for most of the losses to go to the bond holders. They've also been rather clear that it would open up the ability to renegotiate with counter parties and ferret out fraudlent or speculative originations.

Of course, I still think that a viable alternative to nationalization is simply setting up a parallel banking system that would have "lots" of government capital in the beginning (say $400-$500 billion) spread out amongst several new entities that would have very tight regulations, and then just letting the chips fall where they may.

[Pithlord]

I'm no economist, just a lawyer and not a transactional lawyer. But I do know that share purchase and asset purchase transactions are basically interchangeable. So whether the USG takes the assets by nationalizing or by buying them is beside the point -- it can only make the counter-parties whole (or even close to whole) by overpaying for the assets, at least relative to their current market value. Now maybe they will ultimately be worth enough that the taxpayer wins when they get sold again -- but that depends on being lucky. But Krugman's plan would require even more luck than Geithner's.

[Nell]

J. Michael Neal: The plan has some problems. There are some things I would change, though a lot depends upon the specifics that we don't have yet; it could be significantly better, or it could be pretty bad.

What are the question marks, JMN? That is, what are the kinds of specifics that would help you decide whether the plan is significantly better or pretty bad? (Leaving aside when or whether we'll have access to any of those specifics any time soon.)

[TheWesson]

Somebody or another has to take the losses.

The alternative to some bailout plan is to get the holders of unsecured debt (bondholders) to pay.

I suppose a debt-to-equity swap might be part of nationalization.

One problem with a haircut for the bondholders is that a lot of the bondholders are pension funds, etc - these bonds were supposed to be ultra safe.

One option is for the government to support some of these bondholders - bailing out pension funds, for example.

Willem Buiter discusses this:

http://blogs.ft.com/maverecon/2009/03/slaughtering-sacred-cows-its-the-turn-of-the-unsecured-creditors-now/#more-898

[brendan]

This whole thing brings out the side of the left that is more about resentment than about making the world a better place.

Well, four words that might be worth unpacking here.

1) "thing": By this I take it that you mean the looting of the American economy by the leaders (and indeed, indirectly & perhaps not culpably, the shareholders) of financial institutions.

2) "left" :By this I guess you probably mean US Democrats, and I guess you take it to describe a group of people who adopt a similar pose, or share a similar attitude, rather than an intellectual tradition.

3) "resentment": Um. Yes. Definitely. But why is resentment incompatible with trying to make the world a better place? I wouldn't think it is at all.

4) "better": By this I take it that you mean "richer". But that's not all it could mean. This scandal has laid bare the thoroughly rotten nature of our political and financial elites. Removing them from power is a prerequisite for a "better" world.

[Nell]

Pithlord: This whole thing brings out the side of the left that is more about resentment than about making the world a better place.

And it brings out the same thing in the right.

And lately, in "the center".

So I'm thinking that anxiety, fear, complexity, and sharp declines in personal or community well-being bring out the mistrust and resentment in human beings.

As such a human being, I'm grateful to TheWesson for the hypothetical run-through of various scenarios wrt the 'toxic assets' auctions.

[bedtimeforbonzo]

What Brendan said.

And Nell.

It's why I don't think you have to be a financial expert to see or comment on how the so-called experts have driven our economy in the ground.

Perhaps if we non-experts were clued in a little more before Wall Street's collapse -- and all of the 401k money that went with it -- the SEC, among others, would have been sent a clear message long before this about the need to do its damn job.

[J. Michael Neal]

What are the question marks, JMN? That is, what are the kinds of specifics that would help you decide whether the plan is significantly better or pretty bad? (Leaving aside when or whether we'll have access to any of those specifics any time soon.)

They pretty much all revolve around exactly how the plan would arrive at the prices offered for the assets.

I want some rules that would prevent the hedge funds involved from hedging away their risk on the purchase. Given the ratios of money involved, they might be able to set up an arbitrage position that would eliminate all their risk, which reduces their incentive to bid low.

I would like some mechanism that prevents isolated high bids turning into a new fair value estimate for assets that the banks hold on to. The whole point is to get the assets off of the bank balance sheets. If you establish new marks for them, then a few high bids could eliminate their need to sell. (This is exactly the worry Hilzoy has in the original post.) However, there's a catch here. It doesn't look as if the stress tests are going to be based upon mark-to-market fair value calculations. They involve looking at the underlying assets, applying forecasts as to what the actual cash flows will be under different economic scenarios. If that's the case, getting higher marks on the assets won't actually help the banks when they are stress tested.

There are some other technical things. On the whole, if it is structured in ways that prevent too much inflation of the prices paid, then I think this idea is all right, particularly compared to the alternatives. There is going to be some overpaying. There isn't any other way to recapitalize the banks if you don't.

One thing informing my position is that I don't think that the nationalization alternative is really an option. Absent more regulatory authority getting passed by Congress, I'm not sure that the administration *can* nationalize. How good a bill do you think is going to get past Evan Bayh and a Republican filibuster? That's aside from the international issues involved.

[MarcinAsia]

Hilzoy you are right. The issue is not the subsidy the plan gives to the equity investors in the funds, but the market power.

The core problem is that a 3% stake is not enough to ensure that the interest of the hedge funds are aligned with the interests of their co-investor (the taxpayers.)

The idea of co-investing makes sense. We harness all of the abilities of the best money managers, including their knowledge of how banks may try to cheat them and their ability to hire the best at attractive compensation rates. Since we (the taxpayers) are their partners, if they make money for themselves they are also making money for us, so everyone is happy. Yes there may be a subsidy, but if we can get these assets off the banks' books and also capture most of the upside, that is a good return for however many billions earned by the fund managers.

The problem is that with only a 3% investment required, we don't ensure that the private investors have their 'skin in the game' -- i.e. that they have the same cares as us. One dollar invested in these funds allows them to control 30 dollars of purchasing power. This is huge market power leverage. Some funds may decide that 3% is a cheap price for that much power, and use the fund not to maximize its value but to help themselves in other ways. I've seen several mentioned already of varying degrees of ethicality and legality, but almost all very difficult to stop.

[bob mcmanus]

Absent more regulatory authority getting passed by Congress, I'm not sure that the administration *can* nationalize.

I am pretty sure the FDIC, and one step removed by demanding an audit the OTS, can shut a banks's doors at will. The FDIC has been doing about one smaller bank a week.

[gwangung]

I am pretty sure the FDIC, and one step removed by demanding an audit the OTS, can shut a banks's doors at will. The FDIC has been doing about one smaller bank a week.

I'm pretty sure AIG is not a bank.

I'm also kinda sure that holding companies with international holdings may not play out the same as with smaller banks.

[bedtimeforbonzo]

"I'm pretty sure AIG is not a bank."

You are right, gwangung.

FDIC chairwoman Sheila Bair -- who has stood out as the most competent person during the whole financial crisis -- made that point in a CNN interview last night.

---

Vote of Confidence Update: President Obama said on tonight's "60 Minutes" -- in an otherwise non-newsmaking interview with Steve Kroft -- that he would not accept Geithner's resignation even if it were offered to him.

Tammy Wynette could not stand behind her man any stronger than that.

[bobbytwotimes]

I have a possibly dumb question and a very underwater mortgage: If the banks are selling bundles of mortgages below their stated value, why can't they break the bundles up and resell individual mortgages back to individual mortgage holders or other bidders?

[bob mcmanus]

I'm pretty sure AIG is not a bank.

Damfino exactly what AIG is anymore. AIG are Us!

holding companies with international holdings may not play out the same as with smaller banks.

I didn't promise you it would be pretty, just that the FDIC could do it without prior Congressional authorization. With holding companies, which include things like GMAC and insurance companies, the OTS gets to play.

Here is a recent Naked Capitalism post on the FDIC and the "Systemic Risk Exception." As I understand it, by law (after Continental Illinois) the FDIC may not bailout bondholders or anyone but insured depositors during recievership, except when...well read the post if you like. This law may inhibit nationalizations.

[bedtimeforbonzo]

"why can't they break the bundles up and resell individual mortgages back to individual mortgage holders or other bidders?"

bobbytwotimes: I hope J. Michael Neal, or someone, will provide a good answer to your question. But I'd go so far as to suggest that individual mortgage holders would not want to touch the unbundled (and, presumably, some of at least being toxic) mortgages that they were probably happy to sell off in the first place. (Like the moniker, btw.)

[Johnny Canuck]

Bedtime: "It's why I don't think you have to be a financial expert to see or comment on how the so-called experts have driven our economy in the ground."

You've heard the definition of an expert? An "ex" is a has been; and a "spurt" is a drip under pressure.

Bedtime: "Fwiw, I don't think it's in our capitalist blood to go the nationalized route -- unless and until there is no alternative."

As a Canadian, it amazes me how differently we react compared to Americans, and how once a label is attached it is virtually impossible for Americans to move towards something. (eg. socialized medicine- which Canada doesn't have)

Perhaps it was because our conservative party was more paternalistic, perhaps when you are smaller, you more quickly rely on government to solve problems. During the period up to 1980 when our Conservative party began to be infected with American conservative ideology, it was our Conservative politicians who were as likely as not to put government into service.

In the early 1900s we had 3 transcontinental railways, which was at least one too many. The government nationalized 2 of them, using a concept of a Crown corporation- belonged to the people but was run independently of the politicians. It is my impression that the government owned railway CN and the privately owned railway CP competed vigorously for business and both prospered.

Worked so well that it formed the model to start an airline (now Air Canada) in the 1930's.

In the Thatcher period both CN and Air Canada were privatized.

My point is it is possible theoretically and practically to have a privately and government owned institution coexisting side by side.

Perhaps America needs to educate itself about the meaning of nationalization- doesn't have to mean Soviet style central planning; can be temporary; doesn't have to be all the banks; doesn't have to mean one kind is given unfair competitive advantage.

[TalithaTwoBlade]

Tiny Tim Geithner and Helicopter Ben Bernanke are going to ruin this country. They both need to GO!

http://fargoneworld.blogspot.com

[liberal japonicus]

I first note that I am even less reasonably well-informed than everyone here, but in discussing the Geithner plan, I think the folks are forgetting that there is a a group that has a rather deep investment in Obama failing, and that investment trumps all else, and this doesn't just mean Rush and Santelli, but the Republicans that have prevented Obama and Geithner from filling in the positions under him. And if Obama plays hardball on that, the media will, as it did a week or so ago, ask why Obama is going back on his pledge of bipartisianship. johnnycanuck suggested that Obama play the sheriff but in this western, the villians who want to bring the town back under the thumb of the cattle barons are waiting in the wings. While the plan isn't the most economically efficient, it seems that many of the points that people are objecting to are more for political cover than for some sort of nefarious conspiracy, though I understand from a certain distance, the two are undistinguishable.

[Eric Martin]

Well I for one have always thought that the pro-nationalization people were exceedingly clear that they were for most of the losses to go to the bond holders. They've also been rather clear that it would open up the ability to renegotiate with counter parties and ferret out fraudlent or speculative originations.

That, and correct me if I'm wrong, but nationalization would allow the USG to participate in the upside to a greater extent - should there be an upside.

Under the Geithner plan, the private funds get a huge piece of the upside should it materialize, yet aren't really risking much at all to capture that profit.

So nationalization benefits us by cutting out that middle man who will siphon off upside while putting very little down. Actually, while bidding on these securities with skewed incentives and moral hazards.

Unless I'm missing something.

[jrudkis]

http://www.npr.org/templates/
story/story.php?storyId=102185942

IS a good pod cast from NPR about the Phil Gramm part of this story.

[bobbyp]

"Unless I'm missing something."

Rest easy. You are not. Imagine going to a local sheriff's auction on forclosed homes and being guaranteed that 85% of your risk is at somebody else's expense.

What a deal! Couple this with the concept of "limited liability" and what do you have?

Gambler's paradise.

[Nell]

why can't they break the bundles up and resell individual mortgages back to individual mortgage holders or other bidders?"

My understanding is that the "mortgage-backed" securities divided up and recombined the underlying mortgages in ways that make this exceedingly difficult: e.g., one security is based on the interest for the next ten years on a given collection of mortgages, another is the principal of the last ten years of another set, etc. And there are even less intuitive ways of slicing and dicing.

If they'd simply combined a whole lot of individual whole mortgages, it would have been harder to hide the trashiness of the resulting securities, even from ratings agencies whose models didn't include the situation of housing prices going down. (?!?Were the laws of supply and demand simply suspended? I'm with Dean Baker here; industry people need to be forced to use the words 'housing bubble'.)

Had the securities been based on collections of whole individual mortgages, it would be correspondingly easier now to assign values to them.

[publius]

Just joining in, so I apologize if extensively covered above. but aren't we protected to some extent by collective action problems?

I mean, everyone benefits if assets get auctioned up. it seems like that creates a pretty huge free rider/cooperation costs problem.

[bedtimeforbonzo]

Johnny Canuck: My Russian-born wife, who has only been in this country five years and is still assimilating, makes the same points you did to me all the time and constantly points to what she feels are the advantages of such things as socialized medicine.

When she sees me struggling to figure out our health-care statements and how they match up with my employer's revised 2009 medical plan, she can be quite convincing. And when she sees us facing bankruptcy and fighting off foreclosure, she ribs me about the benefits of "your" capitalism -- "go and defend it." Hers is an easy attitude to take seeing how she arrived here just in time for capitalism gone amok and Wall Street bringing down whatever it can while making sure to take home their retention bonuses before the door hit them ass on the way out while the TV news is showing reports of tent cities going up in Los Angeles and families occupying them who aren't a whole hell of lot different than ours.

But she also understands that we're a working-class family trying to reap the benefits of what this country has to offer and, if we can keep our home and my business picks up and our son stays happy and healthy, then we will be in a better position to do that. At the end of the day, I'm more concerned about keep my family and home intact and, if nationalization proves to be a better way to do that, then I'd welcome it. Good night.

[Pithlord]

Eric,

Geithner and nationalization both give the US Taxpayer a piece of the upside, but in neither case is it very likely that an upside will materialize (or at least, the smart bet is that the USG will lose money, one way or the other). That's because in both cases the goal is to limit the loss to the creditors. In some cases those creditors are actually federally-insured depositors, but in most cases it is just politically impossible to let them take the loss.

To make it more concrete, let's say we have financially entity C. Its equity has a market value of $2B, but that's really just people waiting to see what the Government might come up with. It has fairly solid assets of $100B. It has shaky assets that no one can quite value, but it says are worth another $100B and which couldn't be sold at present for more than $20B. And it has liabilities of $150B, much of them to pension funds and grannies who weren't compensated for risk.

The USG could pay $60B for the shaky assets, which ultimately get sold for $50B after the private sector commission. That costs $10B, but it saves Granny. Or it could take over C, get a lawsuit under the Fifth Amendment from the equity holders and (definitely) from junior bondholders, and take on all the liabilities. It gets the assets too, but those are ultimately sold for $110B because of the chaos created. Now USG is down $40B.

Obviously, I'm just making these scenarios up. Maybe the USG wins under nationalization. But if it wins under nationalization, it probably also wins on Geithner.

[Johnny Canuck]

"the advantages of such things as socialized medicine."

I understand the term "socialized medicine" to mean doctors working for the state and on salary.

In no way would a Canadian think we had socialized medicine. Doctors work for themselves; patients select their doctors; it is just that the doctor bills the government according to a tariff for servicess the patient never sees the invoice. It is like each of our provincial govenments was a giant insurance company.

I understand Canada spends significantly lower percentage of its GDP on health care, and get better results over all, if longevity is the ultimate criteria.

I think the problem is that US has actually got away from the economists model of pure capitalism- perfect markets; perfect information; no monopolies or oligopolies.
On reflection, what America needs to do its reform its current system and restore capitalism!! Down with the Wall Street bankers who abandoned capitalism.

[liberal japonicus]

JC, You might want to take a listen to this recording of St. Ronnie talking about Medicare being the first step on the road to socialism or 'statism'. Here is some background on the campaign that the recording was a part of. (scroll down to 'Coffee-Klatch Politics')This isn't to say that you are wrong, but the prism thru which the term socialism is viewed is quite different here.

[Johnny Canuck]

liberal japonicus, thank you for the homework. I just listened and took a quick peek at the article. It was enlightening to listen to St Ronnie - a bit scary. Of course I was a bit scared when US elected him.

While it happens to be true that the Canadian form of health insurance was started in Saskatchewan by a democratic socialist government headed by Tommy Douglas (irrelevant trivia, grandfather of Kiefer Sutherland), it spread across the country, first to cover hospitalization and then virtually all medical services. It is so fundamentally ingrained that no conservative party in Canada would attempt to overthrow it, in fact would defend it as a fundamental right of Canadians.

In 2004 CBC ran a contest to determine the greatest Canadian of all times. Obviously it was a popularity contest with CBC listeners doing the voting and not in any way scientific but, Tommy Douglas came in Number 1 on the strength of being the father of Medicare. sorry I don't know how to link: http://www.cbc.ca/greatest/

To the best of my knowledge,in Canada, doctors are not government employees (except maybe those hired to serve our military), incentives may be offered to doctors to relocate in underserviced areas, but I don't think they have ever been told where to practice.

I am intrigued by your handle "japonicus". I have been very interested in Japan and have actually visited there on several occasions.

[Pithlord]

Medicare was not introduced to Saskatchewan under Tommy Douglas. (He had a hospital insurance plan). It was introduced under Woodrow Lloyd, our greatest Welsh-Canadian. Tommy was in federal politics by then.

[PhoenixRising]

This seems like an invitation to banks that are worried about the prices that might be discovered in such an auction to bid higher than they would if they had no concerns about the value of comparable assets.

Other than the phrases 'seems like' and 'might be', you nailed it.

It's as simple as you think: The people bidding at the auction with (mostly) your money really, really need the winning bid to be as high as can be, to support the prices they hope to obtain when their stuff goes onto the block.

This is no different from any other auction of a luxury item that is part of a class of luxury items, in that respect. Art items, fine wines, etc. are notoriously hard to accurately value--which is why such items are often auctioned.

So you've correctly identified a bug in the 'auction' aspect, the expectation of parties' running up the bidding on the USG's tab, that isn't being discussed chiefly because it is perceived in some circles as a feature.

[shah8]

I...don't...really...think

you all are really processing Brad Delong's water, needles, and ammo comment. I've been a doomer for some weeks now. Delong is entirely focused on stopping a deflationary spiral. To the extent that Delong's comment meant anything, this was true of

All Paths Out.

As in, nationalization or no, we are critically dependent on reflation (maybe the creation of new?)of assets-- the subsidization of the financial players is about buying time. The debate over nationalization is utter, completely besides the point besides being utterly impractical politically and administratively--even if you believe in only a decapitation, that is still something like 100 or so capable people you're going to need. Where I think we are going wrong is that we should be trying to *manage* the deflation, force all organization to net out opposite bets, force people out of half-abandoned neighborhood with mandatory residence density laws and other financial conservation measures. Then with the last little capital we are going to be able to raise, do the mother of all infrastructure project. Not spread out among different topic. Just pick *one* thing, like electrical grids, and spend all of the money on that one thing. End usury and raise wages. Give money to the autoparts suppliers and not so much to the bankers.

People, we are in a vastly more dangerous situation than some of you really realize. We *really* can go Mad Max if we don't get a grip on it.

[liberal japonicus]

JC,
I teach at a private university in Southern Japan. The handle is a tribute to those Roadrunner/Coyote, though I had a girlfriend tell me that I am more a cross between Pepe Le Pew and Foghorn Leghorn... Feel free to come by the TiO blog if you want some Japan info, I'd be happy to oblige.

[TJ]

Well, for the non-economist all you really have to know is Geithner's plan is essentially to let the hedge funds save us.

Personally I think a surer route to Mad Max is to use the last amount of capital the U.S. is going to ever see and use it to try and re-inflate a bubble. Spend it on the real economy and an actual viable banking system will develop from the smaller healthy banks. Blow it on the investment banksters in a futile attempt to bring back the good old days and you won't even buy enough time to get thru Obama's first and only term. Reality will assert itself long before that.

[Rich S]

Pithlord, your comments about taking over an institution and having chaos and lawsuits is certainly a possibility, but with a probability approaching zero. The FDIC could step in and take over many federally chartered institutions today, likely including Citi, and there would be no lawsuit filed that would not be tossed virtually immediately. If you're insolvent, however technical vs. real that may be, the regulators can step in and take you over with the implication that the bondholders are potentially going to eat the losses and do so almost immediately. I take much of the talk about chaos as generated by bondholders who don't want to take a haircut and are raising that bogeyman. (Not to put you in that category, although you may have been taken in by their rhetoric.) It hasn't happened in prior financial crises.

If you go back to the resolution of the S&L crisis, there was only one lawsuit to come out of all those closures and it never went anywhere. Some of the potentially aggrieved parties this time out likely have much deeper pockets and may be more litiginously-inclined, but that doesn't change the basic facts of a bank charter. It does mean, of course, that the regulator can seize the bank part of the firm, e.g. WaMu, but cannot seize the non-bank part. In most cases, however, WaMu again being a good example, seizing the bank will be sufficient to send the holding company into receivership as well.

Finally, the bottom line is that there are losses yet to be recognized and the questions become (1) how can we minimize them and (2) who should bear them? It's not clear to me that any plan has a clear advantage on the first. There are simply too many alternate scenarios and too many moving parts to be able to state definitely nationalization vs. the so-called Geithner plan is a clear winner. I can construct scenarios where Geithner's plan looks great or lousy; same for nationalization. Change the probabilities or the assumptions and you change the conclusions. On the second, I've yet to hear a convincing argument why taxpayers should replace bondholders as the loss-bearers, assuming that the equity holders have already been wiped out. Collectively, bondholders and taxpayers are both "us" but they are different "us"'s. And the bondholders do understand - or should have - that even with AAA bonds there is some probability of default. (There's an extensive academic literature on calculating those default probabilities.)

[liberal japonicus]

Some of the potentially aggrieved parties this time out likely have much deeper pockets and may be more litiginously-inclined

Are some of these parties potentially foreign governments? Or at least sovereign wealth funds? That makes the problem no one of litigiousness, but of foreign relations.

[Eric Martin]

Maybe the USG wins under nationalization. But if it wins under nationalization, it probably also wins on Geithner.

Yes, but again, if there is any upside, we get LESS of it under Geithner. And the upside to the Geithner plan vs. nationalization?

I cede my response to Rich S.

I don't see the lawsuit risk as a real factor.

The bottom line is: who takes the biggest hit. Under nationalization, the shareholders and, to a lesser extent, bondholders do.

Under the Geithner plan, the taxpayers do.

I like option A.

[Bernard Yomtov]

On the whole, if it is structured in ways that prevent too much inflation of the prices paid, then I think this idea is all right, particularly compared to the alternatives. There is going to be some overpaying. There isn't any other way to recapitalize the banks if you don't.

It strikes me that the whole point of the plan is to get buyers to raise their bids by reducing their risk. After all, if the banks won't take a bid of thirty cents on the dollar from investors today, why will they take it from whatever these new entities are called? So the idea seems to be to get the bids up. Having multiple entities bidding also will have this effect.

OTOH, is it possible that the message to the banks is,

"This is the last stop before nationalization? So lower your asking price as much as you can."

[GoodOleBoy]

This is one of the most informative posts I have seen here with some of the most intelligent comments. I'm inclined to agree with TJ that whatever we have left be spent to support and revitalize smaller basically healthy banks that have not gone crazy trying to make all the money in the world. To shift topic somewhat, I wonder if we are facing similarly stupid greediness with self-interested parties running up the costs of our healthcare and education services just to make certain they can get every available dollar. With what we are seeing on the part of government with respect to the financial debacle, I have no good feelings about turning them loose with healthcare and education. Would rather just get busy and figure out how to fix what's out there. I know its broken but turning it over to Washington is really scary.

[TheWesson]

My understanding is that the "mortgage-backed" securities divided up and recombined the underlying mortgages in ways that make this exceedingly difficult: e.g., one security is based on the interest for the next ten years on a given collection of mortgages, another is the principal of the last ten years of another set, etc. And there are even less intuitive ways of slicing and dicing.

[...]

Had the securities been based on collections of whole individual mortgages, it would be correspondingly easier now to assign values to them.

And yet, somehow, when a mortgage in this pool is paid back or refinanced or foreclosed on, somehow the servicer manages to figure it out. Perhaps their advanced devices ("comp yoo tars") help in doing this somehow.

In other words, not buying this "too complex to evaluate / modify" argument.

[bob mcmanus]

Bruce Wilder ...explains it all for you. At Thoma's place

When Geithner asserts that these assets are worth more than the market, he is really saying that ordinary American households are good for it. He wants to settle the doubts about whether they are good for it, by converting those doubts into a "heads you lose, tails you lose" bet.

Either American households hold on and make their mortgage payments on homes where they have little or no equity, or the government will step in, and use taxes to finance those fund flows to the banks and the financial elite...

Either way, Geithner's plan is to keep the plutocracy in place, at the expense of destroying the government's credit and/or the middle class's wealth.

[bedtimeforbonzo]

Today's 500-point surge in the Dow seems to indicate that Wall Street likes the Geithner Plan.

Whether that's positive or negative, I guess one could make an argument either way: Does Wall Street figure the plan can help things get back to the way they like in their Masters of the Universe world? Or does it show that Main Street will benefit from a trickle down effect?

[Johnny Canuck]

Dow, positive or negative?:
maybe simply relieve that there is enough of a plan that the day of nationalization is postponed!