Tuesday, April 7, 2009

Government Incompetence Squared (or Is It Cubed?)

Let me see, now---the last time I visited the subject of our government's incompetence, it was printing money like a madman, and planning on printing ten times more than ever since this country began. And that was just one month ago. 

The new story concerns Tim Geithner's proposed plan for a "public-private partnership" to purchase toxic assets from the banks that invested too heavily in them. After you understand how this plan is proposed to operate, I wonder whether or not you will have any room left for outrage. It is simply too incompetent for words. In fact, it is so incompetent that one has to suspect that it can only be intentionally designed the way it is in order to let the banks enrich themselves even more at taxpayer expense. Here are the details; you decide.

First, a little introduction for those not used to the arcane world of high finance. "Toxic assets" simply means things like mortgage-backed securities that are no longer worth what the banks paid for them. Mortgage-backed securities are shares in a pool of mortgages. The problem is that a lot of those mortgages have gone sour. Some borrowers couldn't afford them in the first place, but the loans were made anyway; other borrowers have lost their jobs, and can no longer make the loan payments. Still others have walked away from the mortgages and left their houses to the banks, because the houses are no longer worth what the borrowers agreed to pay for them. So for a variety of reasons, a huge percentage of the mortgages in the pool are no longer being regularly paid. This drives down the price of the mortgage-backed securities in the market, which in turn creates problems for the banks that own them.

Here is a concrete example, using arbitrary numbers to make things easy to understand. Say that a pool of mortgages sold shares (securities) for $100 apiece. This was when the mortgages were new, and the income stream from them paid a return of $0.667 per month, or $2 per quarter, for an annual return of eight percent ($8 per year on an investment of $100). If everything had worked as planned, by the time all the mortgages had been paid off, the investor would have gotten back his $100, plus that steady return of 8% per year.

Now, however, three years later, the stream of income has fallen by, say, 40%, from $8 per year to just $4.80 per year.  Moreover, because many of the homes being foreclosed upon are not selling at prices sufficient to pay back the mortgages on them, the investor will no longer get his full $100 back, but quite a bit less. Worse still, the cycle shows signs of deteriorating still further, and there is no improvement on the immediate horizon.

As a result of these factors, the investor (in our case, say, a major bank---like Citibank) can get only $30 on the market today for each $100 security it wants to sell. Both the bank and the person willing to pay $30 know that if the securities are held until maturity (that is, twenty or more years from now, when all the remaining good mortgages in the pool will have been paid off), the total return might come to, say, $80. So if the bank sells today, it will get just thirty cents on the dollar for something it strongly believes is worth at least eighty cents on the dollar. In such a market, the gap between willing sellers and willing buyers is just too great, and no transactions are taking place.

The problem for the banks, however, is that financial accounting rules require them to assign today's value to those securities on their balance sheets. So if they had originally bought 100 of these mortgage-backed securities, for a total investment of $10,000 on their balance sheet, they now can show those shares as worth only $3,000, based on what buyers are currently willing to pay for them. Multiply this effect many times over, and the banks are left with inadequate capital on their books for the number of obligations they have outstanding. 

(Remember, things are just the opposite for a bank on its balance sheet: loans to borrowers are shown as assets, because they represent money which (hopefully) will come back to the bank, while deposits, like the money that you and I put in our accounts with them, are shown as liabilities---because the bank is supposed to pay that money back to us when we ask for it.  So when a bank's assets drop, that causes worry because it may not be able to repay all its depositors. If the worry becomes too great, what takes place is a run on the bank, and it collapses. Then the Government steps in, in the form of the Federal Deposit Insurance Corporation ["FDIC"], pays off the depositors and sells what assets remain to another, hopefully more solvent, bank. To provide the money to pay off the depositors of failed banks, the FDIC charges insurance premiums to all member banks.)    

So the present worry is that the banks' assets have to be valued too low, and that this in turn might cause fears about their solvency that could lead to a run. Up steps the Treasury, with a plan from Mr. Geithner, to solve this problem. Here is a simplified version of how it will work, taken straight from the horse's mouth:
Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
What this means is that if the private investor agrees to put up, say, $12 of his own money, the FDIC will then make a (non-recourse) loan to the investor of six times that amount, or $72, to help him buy the mortgage-backed securities. And notice, please, that the amount of money the government determines it will loan is based on the face value of the assets ($100), not their current market value, which is much, much lower. Are you concerned yet? You haven't seen anything yet:

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

All right, backed by the FDIC's promise to loan the money, the private investor has bid $84 to purchase the $100 in face value of securities, which the day before the Treasury's plan went into effect, was supposedly worth only $30. Do you smell a rat here? Let's continue:
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
What's this??! The FDIC guarantees six times the investor's money, but then the Treasury steps in and provides 50% of the remaining equity! Oh, I see---that is the "public" part of the "Public-Private Investment Fund". As you will see, however, it is just the window-dressing, to be able to claim with a straight face that the "public" can make a "profit" from this deal. So now, let's continue:
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.
All right, let's see what is really happening when the smoke and mirrors are all cleared away. The investor, as we see, puts up just $6 of his own money, for which he gets to purchase for $84 assets which are only worth $30 on the current market. He does this for the chance of a longer-term return, because he hopes that if the mortgages go to full maturity, he will get back at least $84 in funds---after twenty or more years. If he does so, the FDIC is paid back its $72, and the investor and the Treasury split the remaining $12, or $6 apiece. So, after twenty years or so, our hypothetical investor has just made his money back, with a zero return on his investment.

Sure sounds fishy, doesn't it? Why would anyone in his right mind put any money at all into such a deal?

Ah, but now suppose the "investor" we are talking about is Citibank, or one of the other big banks that owns a fair amount of these troubled assets. Now the regulations say that Citibank cannot form a fund to invest in its own troubled assets, but there is nothing to keep Citibank from buying, say, troubled assets of Bank of America, or of some other big bank.

So now, let's look at the profit-and-loss statement from Citibank's point of view. It lays out $6 of its own funds, which---if all goes as planned---it gets back after twenty-plus years. Nothing to crow about there. But if the auction works as designed, Citibank gets to sell assets that are worth just $30 on its balance sheet for more than twice that amount---for $84 (the assumed high bid). Now we are talking---by putting up just $6, Citibank realizes $54 that it cannot otherwise earn without Mr. Geithner's marvelous auction. That is a 900% return on its investment in the auction, and allows it to absorb just a $16 loss on its securities ($100 face value that it paid originally, minus the $84 it gets from the auction) with ease. Do you begin to see how this works?

Sure, Citibank cannot buy its own toxic assets, but it can buy Bank of America's---mostly with the taxpayer's money, and very little of its own! There does not have to be actual collusion going on, but with human nature being what it is, you just know that there will be. What's to stop a trader at the Citibank fund from making a discreet phone call, to the effect of "Hey, if you bid X for my shares, I'll bid X for yours"? And in that case, the price that Citibank realized might just be $100 instead of $84---because if the government provides 6 to 1 leveraged financing, plus 50% of the required equity, the difference between borrowing $84 and $100 is just not all that great.

In fact, the big banks and the traders cannot wait for this marvelous plan to go into effect. Why? Because it reminds them of the glorious days of 2000, when there was a similar scheme put into effect to allow a congested energy market to move excess supply around to where it was supposedly needed, and where there were people willing to pay high auction prices to get it. Think Enron, paid to move energy from, say, Utah to California under a similar auction system:
It is August, 2000. Let’s say you are a trader for Enron. You know your energy in California is worth $50, and you also know the energy that Reliant Energy has is worth $50. You call your buddy up, the trader at Reliant, and make a deal. Happens all the time - you even have a nickname for it, The Daisy Chain Swap. You go to bid, and you bid $80 for Reliant’s energy. Then you wait. If Reliant doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your energy - $80 from Reliant. You have each bid up each others assets and traded them. And now the government is screwed, because it has to pay you $80. Let’s chart out that payment:

[Click the diagram to enlarge it. Note: Green represents money (or value) received; red indicates money (or value) paid out. So California ends up paying $80 apiece for two lots of energy which it could have bought directly for just $50 apiece. It winds up losing $60 on the "auction", which in turn ends up as $30 profit in each of the colluders' pockets ("Enron A" and "Enron B") in the diagram. The post continues:]
You can go ahead and replace an Enron subsidiary for Reliant in that example, as I did in the chart. Enron did, and the banks are probably going to now. My friend was very excited telling me all the strategies Enron deployed - “Forney Perpetual Loop”, “Ricochet”, “Ping Pong”, “Black Widow”, “Red Congo”, “Get Shorty”, the whole works - and how all of them will be reliable guides for gaming the legacy asset market here. Buy assets high, write them down, then pay back with “fees.” Got it. Create SIV to bid up the profits. Brilliant.
Yes, brilliant, all right---if you are one of the big banks that has already been handed billions and billions of taxpayer money. That money had to be paid back, at least theoretically, since it is in the form of shares. But this new "auction" scheme is going to rake in billions and billions more which you are going to get for unloading toxic assets, and so which you get to keep. 

What is the most likely net effect of this crazy "Public-Private Investment Fund" plan? The toxic assets will just get moved from one big bank to another. But since they will not have had to lay out anywhere near $100 of their own money for them, they will not have to show up on the balance sheet any more at that price. No, remember---under the numbers used in our example, they had to lay out just $6 for their 50% of $84 in assets---and since the price paid was an actual, good-to-God auction price, why then, those securities have been valued by the market at $84 (or whatever the high bid was for them---remember that the pressure from collusion will probably bid them up even higher). So by paying out $6, you get to show an asset on your books as worth $42! And you don't have to show the $36 you borrowed, because the FDIC loan is non-recourse, meaning that you have to pay it back only if you can pay it back after those mortgage securities pay off in twenty years or so. If they turn out to be worth a lot less, it's the FDIC that gets stuck with the loss, not you. It's a no-lose proposition: the Government is telling the banks "Heads you win, tails we lose."

If you have trouble believing all this, don't take just my word for it. Read this article about what a professor of economics thinks of the scheme: "an unconscionably large rip-off". Or read this post about the "criminal" Sheila Blair, who is head of the FDIC. Or this one, which explains how the taxpayers will be the ones left holding the bag. There are literally hundreds of articles on the Web criticizing the scheme, but nothing thus far in the New York Times or the Washington Post. Wonder no more about why they are going bankrupt---they just don't have friends in the Treasury (at least not yet; but they can always hope---after all, the Obama administration is still in its first 90 days).

[UPDATE 04/08/09: Finally the New York Times runs an article on this scandal. And surprise! it actually does a very good job of explaining how the FDIC is manipulating the numbers to get around a limitation on how much it is allowed to lend---it simply projects "zero losses" on all the loans it will make to buy toxic assets. The article states the obvious: since the FDIC is supposed to fund its operations from the premiums it charges to the banks, how will it be able to make good on its loan guarantees when banks who have borrowed from it fail, and cannot pay those premiums? You guessed it: the bill goes to the taxpayers---the FDIC and the banks are playing a variation on Monopoly with your money.  H/T: Kendall Harmon.]

I don't usually do this, but extraordinary times call for extraordinary measures (click here for the lyrics---"You Ain't Seen Nothin' Yet"):

1 comment:

  1. I was going to use a lifeline on this one, but the NYT article helps me understand that there is more than meets the eye when Sheila Blair says when asked how much the FDIC might lose,

    “We project no losses, Our accountants have signed off on no net losses...”

    She is either blind, dumb, or lying.

    Such a statement would not earn her a promotion unless she is spinning a yarn for the benefit of someone else.

    I hope this story has legs.