Interest Rate Roundup

Friday, March 27, 2009

The truth behind the "public/private" asset plan

You have to love the way this public-private asset purchase plan is constructed. Ingenious how the administration has figured out a way to massively subsidize the banking industry and claim that's not what it's doing. This FT article makes clear what is really going on (I have read similar critiques at several other blogs). Here is an excerpt:

"The Geithner-Summers plan, officially called the public/private investment programme, is a thinly veiled attempt to transfer up to hundreds of billions of dollars of US taxpayer funds to the commercial banks, by buying toxic assets from the banks at far above their market value. It is dressed up as a market transaction but that is a fig-leaf, since the government will put in 90 per cent or more of the funds and the “price discovery” process is not genuine. It is no surprise that stock market capitalisation of the banks has risen about 50 per cent from the lows of two weeks ago. Taxpayers are the losers, even as they stand on the sidelines cheering the rise of the stock market. It is their money fuelling the rally, yet the banks are the beneficiaries."

How do the mechanics work? Have a look (and try not to let your eyes glaze over; this is important stuff because AIG bonuses are small beer compared to what's going on here) ...

"Consider a simple example: a toxic asset with face value of $1m pays off fully with probability of 20 per cent and pays off $200,000 with probability of 80 per cent. A risk-neutral investor would pay $360,000 for this asset.

"Along comes the government and says it will finance 90 per cent of the investor’s purchase and, moreover, do so as a non-recourse loan. Non-recourse means the government’s loan is backed only by the collateral value of the toxic asset itself. If the pay-out is low, the loan is defaulted and the government ends up with the low pay-out rather than full repayment of the loan.

"Now the investor is prepared to bid $714,000 (with rounding) for the same asset. The investor uses $71,000 of his/her own money and $643,000 of the government loan. If the asset pays off in full, the investor repays the loan, with a profit of $357,000. This happens 20 per cent of the time, so brings an expected profit of $71,000. The other 80 per cent of the time the investor defaults on the loan, and the government ends up with $200,000. The investor just breaks even by bidding $714,000, as we would expect in a competitive auction.

"Of course, the investor has systematically overpaid by $354,000 (the bid price of $714,000 minus the market value of $360,000), reflecting the investor’s right to default on the loan in the event of a poor pay-out of the toxic asset. The overpayment equals the expected loss of the government loan. After all, 80 per cent of the time (in this example) the government loses $443,000 (the $643,000 loan minus the $200,000 repayment). The expected loss is 80 per cent of $443,000, equal to $354,000.

"The idea of “private sector price discovery” is therefore flim-flam. There would be price discovery if the government’s loan had to be repaid whether or not the asset paid off in full. In that case, the investor would bid $360,000. But under the Geithner-Summers plan the loan is precisely designed to be a one-way bet, for the purpose of overpricing the toxic asset in order to bail out the bank’s shareholders at hidden cost to the taxpayers."


  • Please understand: talk to structured product quants on the Street, they will explain that bonds held on bank balance sheets were marked UP eggregiously when they were first issued. Senior management wanted the PnL, they wanted to get PAID off those insane marks.

    Fast-forward to today. Now we see bonds only slightly marked down. What's happened? Banks have only marked down that initial bogus PnL mark when the bonds were first issued. This does not apply to all bonds, of course, but to a substantial portion of bad debt out there it does.

    THAT'S THE DIRTY SECRET. That's why Crittenden is moving to London. All the big insiders at banks know this, the quants will tell you. Subpenea the quants and they will talk. Geithner HAS to know what's going on, it happened on his watch at NY FED.

    Christ, I feel like I'm talking to Bob Woodward in a basement parking garage in Washington, D.C., circa 1973.

    Somebody's gotta get this info to the right people. Ask the right questions and Cuomo might see what a scam this is. Geithner's plan is the biggest scam. FOLLOW THE MONEY, GIVE THE QUANTS IMMUNITY, THEY'LL EXPLAIN IT ALL.

    By Anonymous Anonymous, at March 27, 2009 at 10:24 AM  

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