Price Discovery
| Mon Mar. 23, 2009 10:31 AM PDT
Felix Salmon writes:
How Treasury's Bank Bailout Could Make Things Worse
....The minute the Treasury plan is put into action, we'll have a lot of public price discovery for the banks' bad assets. And if the prices don't clear — if the minimum price the bankswill accept is higher than the maximum price that the public-private partnerships are willing to pay — then no one will any longer be able to perpetuate the fiction that America's banks are solvent.
....The big hope of the Treasury plan is that the private sector will be willing to pay a higher price for leveraged assets than it would for unleveraged assets....During boom years, that was a wager that many investors were willing to take. But now? I'm not sure. Chalk it up as yet another thing-which-has-to-go-right in order for this scheme to work. There are far too many of those for comfort.
Um, how is this a bad thing? Isn't a whole bunch of very public price discovery exactly what we want? Then we get to find out for sure whether banks are solvent, as they claim, or irredeemably underwater, as a lot of us suspect. Right now they can lie about their books and no one can really prove them right or wrong. After these auctions, though, smoke and mirrors will be a lot harder.
I don't have any more insight than anyone else about whether this is a deliberate part of Geithner's plan. Oddly enough, though, his tongue-tied interviews about it make me suspect that it might be. Geithner might not be the most silver-tongued spokesman in the Obama orbit, but he's not a doofus. If he's having trouble explaining the plan in public, one reason might be that he's unable to fess up to the central pillar of the whole thing: forcing banks to put up or shut up.
Somebody is wrong about all this stuff, after all. Either the critics are wrong, and banks are actually perfectly solvent, or else the banks are wrong, and all their memos about how they're practically sagging under the weight of all their Tier 1 capital are just a bunch of hooey. Geithner's plan goes at least part of the way to figuring this out.
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Comments
Isn't a whole bunch of very
Submitted by Tim (not verified) on Mon Mar. 23, 2009 10:55 AM PDT.
Isn't a whole bunch of very public price discovery exactly what we want? Then we get to find out for sure whether banks are solvent, as they claim, or irredeemably underwater, as a lot of us suspect.
But do we find this out? Since the federal gov't is taking on most of the risk here, isn't there a real danger that these toxic assets will be overvalued?
One man's junk...
Submitted by Adagio on Mon Mar. 23, 2009 11:01 AM PDT.
Kevin, I think you have gotten to the nut of the situation. Geithner is presenting the banks with a last best offer. There is going to be immense pressure on them to accept the price offered or likely end up with zilch. Some buyers will remain on the sidelines with the intention of dumpster diving after the fall. This is the garage sale before the stuff gets pitched. Whatever the outcome, it seems like a logical step to take.
public price discovery is what every market requires
Submitted by tpx on Mon Mar. 23, 2009 11:10 AM PDT.
Public price discovery is what every market economy requires. The financial institutions with cooked books do not want public price discovery because the markets will eliminate them after their insolvency is exposed. The banks have embraced command economic theory because they cannot survive in transparent markets and because they still control the regulators.
The government throws a
Submitted by DWN (not verified) on Mon Mar. 23, 2009 11:12 AM PDT.
The government throws a party, but nobody comes (or not enough money comes). Interesting thought actually. The banks probably figure that they have it all wrapped up here. However, there is a catch. It does not take much fall in asset value to wipe out all the equity in a bank, particularly at their market capitalization right now.
Joe Stiglitz spelled it out over at tpm. Let's say the bank is worth 20 billion, but sits on a trillion dollar of assets. A fall of 1% in asset value can wipe it out. So if those assets drop far enough at this sale, and may be they could even with a 12 to 1 leverage from Unca' Sam, then it does them no good.
Seeing how there are a lot of people in banking with their heads in the sand, perhaps it does not take a high bar to go over said heads. I am a skeptic that such is the case, but since I into the old saws at the moment, the devil's in the details on this.
Solvent banks reserve how much?
Submitted by MarkH on Mon Mar. 23, 2009 5:02 PM PDT.
Joe Stiglitz spelled it out over at tpm. Let's say the bank is worth 20 billion, but sits on a trillion dollar of assets. A fall of 1% in asset value can wipe it out. So if those assets drop far enough at this sale, and may be they could even with a 12 to 1 leverage from Unca' Sam, then it does them no good.Is it realistic to imagine a bank would have $1T, have proper reserves and still only be worth $20B? That would be very very bad. What's the reserve requirement these days? 5% or so? 5% of $1T is $50B reserves. Also, it depends upon how many toxic assets they have and need to get rid of and what value those specific assets are worth in today's exotic market. Perhaps this sale is part of what Geithner is calling the stress test.
Geithner's plan does not address price discovery
Submitted by Mitch on Mon Mar. 23, 2009 11:15 AM PDT.
Kevin,
Geithner's plan does not address “price discovery” because it does not alter the markets’ current pricing mechanism by, for example, providing hitherto secret information about the securitized assets. No, it will change prices only to the extent that people believe they can game the system. This is because the Geithner plan is nothing more than a subsidy to those private investors chosen to participate. Prices will not change to reflect the private investors’ shrewder appraisal of the risk inherent in these assets. Rather, the prices will reflect the extent to which those investors are willing to gamble comparatively tiny sums against potentially huge profits in a financial universe where their loses are underwritten by the government.
You also seem to be temporizing about your belief in the “free market”. If the “invisible hand” is so much more effective at pricing assets than government bureaucrats that their participation is essential to the successful rescue of the banks, what difference does it make whether they are at risk for 7% or 12% or even 1%? Your belief that the private investors should have “more skin” in the game begs the more fundamental question of why they are needed at all if the taxpayers are to participate so insignificantly in any profits but subsidize virtually all of the potential losses. This seems like a can’t lose proposition for those privileged few who are chosen to participate.
Another question: There is a "free market" in all of these bonds right now. If these assets are, in fact, so significantly undervalued why haven’t private investors been buying them at the current depressed prices, even without a guarantee from the government that they won’t lose much money? Why aren't private investors buying them or even bidding for them? The answer is that they can’t value these assets any better than other people. What these so-called private investors actually have (which the rest of us lack) is an administration prepared underwrite their potential losses, while allowing them to reap the lions share of any profits. In short, this plan is another example of “lemon socialism” in which losses are socialized while profits are privatized.
Here’s a different idea, and one which Republicans could surely support: Private investors participating in the plan would buy the designated “toxic assets” using their own money, at the fair market value. Private investors would bear any loss but, in return,they would also keep all of the profits. As a “sweetener” any profits would be free of capital gains taxes.
Mitch Guthman
It's not like I have a great
Submitted by Barbara (not verified) on Mon Mar. 23, 2009 11:19 AM PDT.
It's not like I have a great deal of trust in Geithner, et al. but I am astonished at the number of newly minted financial industry experts that have emerged out of the woodwork. I know that many, like Krugman, have a much broader scope of understanding than I do, but I also feel like a lot of the arrows are being aimed because there is simply no plan that is likely to work at all, and certainly none that is likely to work without costing you and me a great deal of money. There are pieces of the bail out that I really do question (like paying 100 cents on the dollar for anything at this point), but I am not buying the "nationalize or bust" crowd. I mean, if we nationalize, we own all the failure, no? We do get the upside -- and I guess that's what Krugman is most distressed about, that if we are going to take the risk we might as well get the upside. I just don't know enough about what has been proposed. It really goes to show how important trust is . . .
Its a bad thing if you still believe
Submitted by Kahner (not verified) on Mon Mar. 23, 2009 11:19 AM PDT.
the market is wrong. That even with the support from the government, the private investors will still greatly undervalue the assets. Thus we will still falsely be showing the banks as insolvent instead of just illiquid and unnecessarily force costly, difficult nationalization. I don't happen to believe this, but i suppose its possible. Also, you could view public price discovery showing all the banks as insolvent as a "bad" thing, while still realizing its better than not knowing. As in, "Its a bad thing I was diagnosed with cancer, but at least now I can start treatment". But from the title "How Treasury's Bank Bailout Could Make Things Worse", this doesn't seem to be what Salmon meant.
The way we live now.
Submitted by jhm on Mon Mar. 23, 2009 12:00 PM PDT.
Right now they can lie about their books and no one can really prove them right or wrong.You no doubt meant to say: "No one can prove them right or wrong as long as they keep sending them the funds to keep them above the tide."
"The big hope of the
Submitted by Robert Waldmann (not verified) on Mon Mar. 23, 2009 12:02 PM PDT.
"The big hope of the Treasury plan is that the private sector will be willing to pay a higher price for leveraged assets than it would for unleveraged assets....During boom years, that was a wager that many investors were willing to take. But now? I'm not sure."
Huh ? These are no recourse loans. It's not like borrowing on the full faith and credit of your firm (or mortgaging your house) to gamble on the market. This plan is not *just* a plan for leverage. It gives private partners a Geithner put where their downside risk is limited and not by their personal bankruptcy or that of their firm.
I agree with you that a price discovery plan which shows that the banks are insolvent for reasons other than hedge fund cash flow problems or their managers' risk aversion would be a wonderful thing.
However, that is not the Geithner plan. I disagree with Felix Salmon twice. I don't think the plan will reveal if banks would be insolvent without public subsidies (under the plan in the form of giving private partners Geithner puts only if they buy banks' assets) *and* I think a plan should do that.
That's why I oppose the Geithner plan and support instead a plan which which would relieves any alleged problems which are supposed to cause unreasonable low prices and does not make paying more for assets than their expected present value (discounted at treasury interest rates) profitable for private partners.
The best blackly-comedic
Submitted by Neal (not verified) on Mon Mar. 23, 2009 1:05 PM PDT.
The best blackly-comedic finish to this would be for Henry Paulson to set up a hedge fund to buy Goldman Sachs "assets" at top dollar, with majority participation from the taxpayer.
Don't think it couldn't happen.
Geithner plan is just another giveaway to Wall St.
Submitted by Mitch on Mon Mar. 23, 2009 1:49 PM PDT.
I would like to suggest another flaw in the Geithner plan. Leaving aside the economic value of the “Geithner put” which I discussed earlier, the plan is premised on the assumption that these “toxic assets” are actually worth more (if held to maturity) than the value which the banks are forced to assign to them. This, in fact, mirrors the banks’ objections to both the “mark to market” rules and to the various nationalization plans. The banks have argued that they would be totally solvent if only they were permitted to mark to the supposedly higher value which these securities would have if held to maturity.
As I have said, the underlying assumption of the Geithner plan is that the infusion of new “private” money will save the banks because “private investors” will place a higher value these “toxic assets” than that which is allowed under the “mark to market” rules. This will save the banks by recapitalizing them through unlocking the hidden value in these “toxic assets. Yet, it seems clear that all bids from a private buyer would necessarily be lower than the current market price because there are no buyers at the moment. Moreover, buyers under the Geithner plan would probably bid much lower then the current market prices because of their need to build in both significant profit and an equally significant margin for error.
Again, if Geithner is correct about the true price of these securities, then the main effects of his plan are the making by the taxpayers of a Yeltsin-like gift of the supposed “toxic assets” to the lucky—or well connected—private investors. And, too, if he’s right about the hidden value of these “toxic assets” then the banks are also necessarily right in their claim that the solvency crisis would be largely resolved by allowing them to place a higher value on their holdings.
Clearly, if Geithner is correct about the value of these “toxic assets” then the only possible reason why he would choose this plan over simply allowing the banks to revalue their holding is if he specifically intended to provide a massive government sponsored windfall for the so-called private investors.
Apart from my concern about the cost to the taxpayers of this massive giveaway of public money, there is also the risk of cascading failures if banks are forced accept what I argue will be lowball bids. There would be a substantial risk of a worldwide, systemic banking crash because these assets will now have to be “marked” to the new, “Geithner plan”established market price (which I have argued will always be much lower than the current, already discounted price). Even healthy banks will likely be swept up in this cascading effect as they too are forced to market down assets from the current price to the new, heavily discounted price set by the “private investors” bid. I doubt whether any money center bank (including those now regarded as healthy) could survive the process.
Mitch Guthman
Another Felix Salmon post
Submitted by Detlef (not verified) on Mon Mar. 23, 2009 2:32 PM PDT.
with a link to
https://self-evident.org/?p=502
So say a bank has 100 of these $100 loan pools. And just by way of example, suppose half of them are actually worth $100 and half of them are actually worth zero, and nobody knows which are which. (These numbers are made up but the principle is sound. Nobody knows what the assets are really worth because it depends on future events, like who actually defaults on their mortgages.)
Thus, on average the pools are worth $50 each and the true value of all 100 pools is $5000.
The FDIC provides 6:1 leverage to purchase each pool, and some investor (e.g., a private equity firm) takes them up on it, bidding $84 apiece. Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools but only puts in $600 of its own money.
Half of the pools wind up worthless, so the investor loses $300 total on those. But the other half wind up worth $100 each for a $16 profit. $16 times 50 pools equals $800 total profit which is split 1:1 with the Treasury. So the investor gains $400 on these winning pools. A $400 gain plus a $300 loss equals a $100 net gain, so the investor risked $600 to make $100, a tidy 16.7% return.
The bank unloaded assets worth $5000 for $8400. So the private investor gained $100, the Treasury gained $100, and the bank gained $3400. Somebody must therefore have lost $3600…
…and that would be the FDIC, who was so foolish as to offer 6:1 leverage to purchase assets with a 50% chance of being worthless.
From comments on Krugman
Submitted by TheWesson on Mon Mar. 23, 2009 3:00 PM PDT.
From comments on Krugman's blog:
Joe D:
"The distribution is almost irrelevant for the sake of the example. The point is that the non-recourse loan means the most the investor can lose is 15% of the price. For any (reasonable) price distribution with mean of 100, the max price the investor is willing to pay is now 100+x (for some x > 0, dependent on the actual distribution; these “best and brightest” will certainly figure out x), so the subsidy wrapped in the loan is x%."
So the idea here is to get the bank an offer of x% above market value and if THAT still doesn't work, then I suppose the next step will be interesting.
By the way, when various MBS's have been wound up in the past (IndyMac insolvency?) the price discovery there was between "very low" and "extremely low".
Don't forget, leverage gets involved too, so it doesn't take a 75% mortgage default rate to take the MBS down to 25%.
Sorry no links.
Look there's a price. Hey, that's price discovery.
Submitted by MarkH on Mon Mar. 23, 2009 5:15 PM PDT.
By the way, when various MBS's have been wound up in the past (IndyMac insolvency?) the price discovery there was between "very low" and "extremely low".In those cases the bank is already insolvent. In our current situation it's pretty clear the government has made them solvent for the moment. Thus, they're not in the same kind of immediate squeeze as a bank already defunct.
And the alternative is...?
Submitted by MBunge (not verified) on Mon Mar. 23, 2009 5:46 PM PDT.
Maybe I've missed it, but have any of the critics of Geithner's plan spelled out the possible and likely downsides of their proposed solutions? And I don't might what will happen if it doesn't work, but what level of pain and suffering will result if it works at all or even works perfectly? Krugman, Atrios and company may be completely right economically, but I get the sense their answer to Big Shitpile would be massively, society-altering painful in the short term and they don't quite appreciate how big a risk that is to take.
Mike
Most likely outcome
Submitted by DCreader (not verified) on Mon Mar. 23, 2009 6:14 PM PDT.
I think the most likely outcome is that Geithner succeeds in helping the banks off-load their junk onto these "public-private partnerships." Then these assets really turn out to be just as bad as everyone feared and the "partnerships" go belly-up leaving the taxpayer holding the bag. The end result is still the same -- free money for Wall Street.
Deliberately biased price discovery.
Submitted by BigTom (not verified) on Mon Mar. 23, 2009 6:22 PM PDT.
As Mitch, Robert Waldman, and Detlef have tried to demonstrate, the no recourse loans introduce a very obvious asymmetry, bewteen the risk benefit exposure of the government, and the private players. Whatever part of the estimated price distribution for which the norecourse feature of the deal comes into play will be discounted by the private players. They will be willing to bid more than they would in a fair market situation. So basically, at the taxpayer price of a rich subsidy, Geithner is trying to game the markets into discovering an artificially high price. That way he hopes the banks can be declared healthy, and once the gloomy economic mood is broken then the economy (and he hopes) the value of the assets recovers.
Now, one way to somewhat mitigate the unfairness (that a choosen few fat cats get this subsidy) would be to open up the asset purchase to the public, through something resembling an exchange traded fund, -or simply let mutual funds bid for the assets. This is of course nearly as bad, as only a few percent of US citizens have the wherewithall to participate in such a scheme. Its only a marginally better than the current plan.
There is a real danger of a US Yeltsin plan
Submitted by Mitch on Mon Mar. 23, 2009 6:41 PM PDT.
MBunge,
Although I agree with you in completely principle about the downside of nationalization (as my many posts arguing against will attest), I believe that you are comparing apples to oranges. Which is to say that while I am in agreement with much of what you say, I take issue with that which is implicit in your argument, namely, that the Geithner plan is the only alternative to nationalization. I disagree.
First, if Krugman, Atrios and others are wrong that there is a “solvency” crisis (and Geithner is correct that there is merely a crisis of confidence) then, as I believed I showed in my two earlier comments, it is much easier and cheaper to achieve the same result by allowing the banks to value the “toxic assets” at roughly the price which the “private investors” would assign them. This is why I have argued that the Geithner plan is a deliberate giveaway to Wall Street.
Second, even if the Geithner plan (as opposed to the much superior Guthman plan of simply revaluing and guarantying deposits,etc.) is successful, there are going to be some pretty unpleasant, painful alterations in our society as a result of the largest transfer of public wealth to private hands in world history. This would be a massive gift for the “master of the universe” class and might easily send us down the path that Russia took (with some help from Larry Summers and friends) following the breakup of the USSR. If you want scary, spend a few minutes using Google to check out the nightmare that Boris Yeltsin spawned. It makes the worst excesses of the Bush years look tame by comparison.
Mitch Guthman
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