Sunday, September 21, 2008

I Changed My Mind

By definition, the fair price of a risky asset is one that allows a high return. Therefore, if the Treasury intends to buy distressed assets at a fair price, it must intend to get a high return, which is to say, it must intend not only for the taxpayers to make a profit, but for them to make a large profit. If the Treasury doesn’t intend to pay a fair price, then it is intending to recapitalize banks by giving away money without receiving any equity participation, which is merely a program of welfare for the rich. Thus, either the Treasury intends for taxpayers to make a large profit, or it intends to engage in a program of welfare for the rich. Which is it?

I just looked at the Congressional map, and it turns out that Barney Frank is not my Congressman. He is from my state’s Congressional delegation, though, and I think he represents the district in which my vacation condo is located. Anyhow, here’s the question I would like him to ask Hank Paulson:
Do you intend for this plan to be highly profitable for taxpayers? Mind you, Mr. Secretary, I don’t mean that your intentions will necessarily be realized. I know there is a lot of risk, and even if you intend for taxpayers to make a large profit, they may end up losing nearly the whole $700 billion. But I’ll repeat my question: Do you intend for this plan to be highly profitable for taxpayers?
Unfortunately, when I do this thought experiment and consider the possible outcomes, my estimate of the expected value of the Secretary’s answer contains only about 10 basis points of “yes.” There are 90 basis points of “no,” and the remaining 99% consists of not really answering the question. Of course one can press him if he gives a weasely answer, but most successful people in the District of Columbia are very good at continuing not to really answer a question when they are pressed for an answer.

So we have to guess why he doesn’t want to answer the question. Is it because he doesn’t want to get people’s hopes up by admitting that this Plan is intended to make a large profit when he knows that outcome is subject to risk? Or is it because he intends to overpay for the distressed securities with taxpayers’ money? In my estimation, most of the weight of probability goes to latter motive.

I should also say that I’m becoming increasingly skeptical about the proposed mechanism for setting prices. In principle, if the mechanism results in the Treasury repeatedly taking losses on the securities, it should be replaced with a better one, but I worry that it will not be. The problem with a reverse auction is that bankers who have taken inadequate write-downs on their distressed assets, and who are already undercapitalized on their books, may have little incentive to make fair bids.

This is essentially the usual moral hazard problem for corporations. Bankers facing a potential endgame have no incentive to protect their creditors (or depositors, who are mostly FDIC-insured anyhow). If they run out of capital, even if they just barely run out of capital, that’s the worst case outcome. If they run out of capital and end up deeply in the red, that outcome is equivalent from the banker’s point of view.

From a creditor’s point of view (or from the FDIC’s point of view, in the case of most commercial banks), the optimal action is to take a fair price for the security even if that uses up all your capital. From the banker’s point of view, the optimal action is to gamble on the possibility that the fair value of the security will later rise to its book value or higher. That way you have at least a chance of coming out ahead. But you’re gambling with creditors’ money (or with the FDIC’s money). If the gamble doesn’t pay off, the value of the asset goes down, you end up in the red, and your creditors (or the FDIC) are stuck with the bill. Thus the banker has no incentive to bid fair value: instead she will bid book value, or possibly even more. If the bid wins, she gets a windfall. If the bid loses, she gets to gamble with creditors' money. But if she bids fair value, she is assured of losing.

Accordingly, while I stand behind the logic of my "Bailouts for Fund and Profit" post, and I continue to bristle at the suggestion that liquidity is not really an issue, I have concluded that the actual primary purpose of The Plan is recapitalization at taxpayer expense. Accordingly, until such time as my vacation condo’s Congressional representative should actually ask my question and get the “yes” answer or something roughly equivalent, I am herewith withdrawing my support for The Plan. As per my "Recapitalization" post, it is the wrong plan.


Anonymous Anonymous said...

Glad you came around amigo.

Regardless of political leanings, this thing is way too opaque and therefore badly fails the olfactory test.

Mon Sep 22, 06:56:00 AM EDT  
Anonymous Anonymous said...

Re Bankers who have taken inadequate write-downs:

Some banks will have taken conservative or even overly conservative write-downs. These banks will have a competitive advantage. Provided there are enough of these banks, and they hold enough of the bad assets, the reverse auction mechanism should work.

I can offer no substantive proof by my gut is that Paulson, Bernanke, and their advisors believe that the last condition (i.e. enough conservative banks holding enough assets) holds true (or true enough so that with some clever structuring they can "outgame" the bad banks).

Clearly the structure has to be carefully calibrated. If treasury seeks to buy at prices that are too low, banks may prefer to sit on the assets, and cut back on the other assets (working capital and receivable facilities) that are the lifeblood of the economy. So if the Treasury tries to make "too much" money, it will largely defeat the purpose of the facility.

On the other hand, if it prices too high, there will be political fallout. But the economic consequences of too high pricing are not as severe. Obviously, inefficient or dishonest institutions will not be as heavily penalized. But higher pricing from the Treasury may also permit institutions to sell to private sector buyers at lower prices (using the profit from the treasury to subsidize sale at a loss to the private sector).

In summary, if you believe the facility is aimed at liquidity (as I do), then qualms about Treasury not getting the best pricing should not cause you to reverse your support.

Thu Sep 25, 10:03:00 PM EDT  
Blogger knzn said...

If treasury seeks to buy at prices that are too low, banks may prefer to sit on the assets, and cut back on the other assets (working capital and receivable facilities) that are the lifeblood of the economy. So if the Treasury tries to make "too much" money, it will largely defeat the purpose of the facility.

Well, I don't imagine that the Treasury is going to sit on part of the $700 billion if the banks aren't taking the bids, so there is very little chance that the price will be "too low" in the sense of being so low that banks don't sell. In a later proposal, I suggest that banks should be compelled to sell at a conservative book value, but that's obviously not going to happen.

The reverse auctions present a difficult problem as far as defining the asset categories. And I'm convinced that capital is part of the problem, not just liquidity. The Paulson plan is better than nothing, better than the Democrats' revision, and much better than the House Republicans' alternative, but it still seems to me to be far from the best way to spend $700 billion.

I'm now convinced that buying preferred stock in financial institutions would be a much better idea, though it appears to be a non-starter in Washington. No need to hire thousands of investment bankers for months and months to figure out how to buy and sell things. Just one auction and you're done. (Well, not quite, because the government would probably want to sell off some of it.) And preferred stock is the perfect vehicle; it amounts to making a loan on very lenient terms. Like any loan, it solves the liquidity problem, and because there is no fixed maturity and the dividends are not compulsory unless the bank is profitable, it solves the capital problem as well.

Fri Sep 26, 12:23:00 AM EDT  
Anonymous Anonymous said...

Re Preferred Shares:

I'm not clear on how a preferred share infusion would work.

Would you wait for sick banks one by one to come to the treasury? If that's the approach, then it's not systematic and things just drag out.

If you do some sort of auction process, then how would that work? Presumably the banks that are in the worst shape would be most eager to bid for the preferreds. So the weakest banks would benefit first (although at higher prices).

At what price do you start the auction? How do you size the infusions per institution? Would the preferreds have an equity kicker? If so, bank CEOs, who have had their fill of dilution, may simply not participate. Would you coerce them? How?

Even if you believe the issue is one of capital, I would argue that private capital infusions are likely to resume or increase once the Paulson plan has been implemented (provided it works as intended). So the Treasury provides the liquidity as a precursor to private investors providing the capital.

I still think the Paulson plan is optimal in terms of balancing ease of implementation, institutional strenghts and weaknesses, effectiveness, and level of participation.


Fri Sep 26, 11:11:00 AM EDT  
Blogger knzn said...

If you do some sort of auction process, then how would that work?

Banks submit bids, each with a dividend rate and the number of shares the bank is willing to issue at that yield (possibly multiple bids per bank, if a bank is willing to sell a certain amount at one yield, and more at a lower yield, &c.). The highest bids are accepted until all the funds are used up. Details (open or sealed bids, whether banks have to pay their own bid or the cutoff bid, &c.) can be worked out.

Presumably the banks that are in the worst shape would be most eager to bid for the preferreds. So the weakest banks would benefit first (although at higher prices).

I think that's going to be true of any plan that uses auctions, as the TARP apparently plans to do.

At what price do you start the auction?

The long treasury yield, so that it's at least breakeven for the Treasury if the bank is profitable.

How do you size the infusions per institution?

According to the number of shares bid.

Would the preferreds have an equity kicker?

I'd say not. In the plan as described in my other post, there would be a tax on bank profits (after preferred dividends) implemented with a lag after the auction. That is vaguely like equity, but it doesn't discourage participation, since it isn't contingent on participation. It has the disadvantage that the good banks have to pay too, but they can afford it, and no plan is perfect. Also, there's a flipside to the usual moral hazard issue: we want to encourage banks to lend aggressively during a crisis, so the plan should favor illiquid banks to some extent. Once a crisis occurs, it becomes a good thing when banks expect a bailout, so the usual moral hazard argument reverses itself.

I would also make the preferreds callable, to encourage the ultimate unwinding of the government involvement (although many of the shares will have been sold off by the government).

Would you coerce them? How?

The tax is like a subtle form of coercion, in that they have to pay for part of the bailout whether or not they receive any benefit.

I still think the Paulson plan is optimal in terms of balancing ease of implementation, institutional strenghts and weaknesses, effectiveness, and level of participation.

As far as ease of implementation goes, the Paulson plan sounds like a disaster to me. The heterogeneity of the assets to be purchased and managed, as well as the difficulty in valuing them, will necessitate a huge number of person-hours and give a lot of opportunities for misbehavior by the bureaucrats and contractors involved.

As far as level of participation, my plan would use the whole $700 billion unless banks are willing to pass up issuing preferred at the long Treausry rate, which it seems to me would be a good deal even for a very well capitalized and liquid bank -- like a CD where they never have to pay back the principal and they can be late on the interest whenever they need to be.

I guess we can disagree about effectiveness, but the preferred stock plan would address both major issues. It won't liquefy the market for troubled mortgage assets, but the point is to bail out the banks, not to bail out their assets. I don't see anything wrong with just letting them hold the assets to maturity, and if their reserves have been conservative, they will most likely make a profit.

As for institutional strengths and weaknesses, I'm not sure what you mean. Either plan is going to favor weaker institutions. Or are you talking about the infrastructure for the plan's implementation? The preferred stock plan doesn't require much infrastructure.

Fri Sep 26, 12:25:00 PM EDT  
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更新日期:2009/08/25 17:19

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Fri Aug 28, 01:25:00 AM EDT  

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