Sunday, October 12, 2008

$700 Billion? So What?

Guaranteeing an asset is equivalent to buying the asset while giving the seller an option to repurchase at the same price. Conversely, buying an asset is equivalent to guaranteeing the asset while retaining an option to purchase at the guarantee price. (The proof is left as an exercise for the reader.)

When Secretary Paulson first proposed the TARP, it was a plan to buy $700 billion worth of assets from banks. Some valid criticisms were made – for example, that the program would do nothing to help recapitalize banks unless the Treasury deliberately overpaid for the assets. But the criticism that seemed to resonate most with the general public was that taxpayers would be “spending” $700 billion (a huge amount even compared to the already historically large budget deficit) to “bail out” the banks.

Suppose instead that Secretary Paulson had proposed guaranteeing $700 billion dollars worth of bank assets – at some appraised value – in exchange for call options on those assets. That’s equivalent to what he actually proposed, but it might have been met with considerably less hostility.

The FDIC already guarantees several trillion dollars worth of deposits (depositors’ assets), at face value, in exchange for a small insurance premium. Guaranteeing a mere $700 billion worth of assets, at a more realistic appraised value that takes into account the probability of default (analogous to the probability of bank failure in the case of deposits), in exchange for a rather valuable call option that will pay off handsomely if the default rate is less than expected (an option which could presumably be sold on the open market, though it may be more valuable to the government, with its large capacity to absorb risks, than to private owners)? That hardly seems like a big deal, and it doesn’t seem to involve any “expense” of taxpayer money – at least not in the short run.

There is, of course, a risk to the taxpayers, just as there already was for the FDIC. The theoretical worst case scenario for the TARP – a loss of $700 billion – is not nearly as bad as the theoretical worst case scenario for the FDIC – an obligatory public bailout costing several trillion dollars.

One may, of course, have valid criticisms for this “equivalent TARP” (“Troubled Assets Guarantee Sytem” maybe – “TAGS”) – the same as the valid criticisms of the actual TARP. Again, the TAGS does nothing to recapitalize banks unless the appraisals are deliberately inflated.

But if the problem – as Secretary Paulson originally seemed to maintain – was just liquidity, then the TAGS would solve it. Assets guaranteed directly by the Treasury are almost as good collateral as direct liabilities of the Treasury, so banks – even suspect banks – would be able to borrow against the guaranteed assets at reasonable interest rates whenever they needed money. They might run out of collateral, but in that case, the bank must have been undercapitalized in the first place.

There are a lot of details to be worked out. For example, what would the TAGS guarantee? Resale value? Reovery value? And how much time has to pass before the guarantee applies? And if an asset is sold, does the call option attach to the asset, or is the original bank on the hook for the option? And so on and so forth. The whole exercise is academic, since Congress has now passed a different version of the TARP. I just wanted to make the point that the TARP was not (and is not) as big a deal as the $700 billion figure makes it sound.


Anonymous Anonymous said...

Troubled assets are, almost by definition, losing bets on certain types of economic activity. So there is no upside to these guarantees. It is all downside risk.

So basically any other type of investment by the government is more economically desirable. Simply not borrowing the money is a better macroeconomic investment than this. Because people in the general economy will have more "money" and can use to do something other than support condo prices in Florida.

Mon Oct 13, 09:45:00 AM EDT  
Anonymous Anonymous said...

The first anonymous is not completely correct. Troubled assets are almost always a losing bet for a bettor that has a short time horizon. Troubled assets, should they be solvent at all, are not a poor bet for the long haul. Rather, if the govt holds assets that cannot otherwise be sold or priced in the market now, but which stay solvent, they will almost surely pay a low price now and gain a benefit when they do sell these assets later. Of course, this is the govt we are talking about, so that's not a small order. Nonetheless, the issue is certainly about the solvency. While buying some of these assets would help solvency of the "non-troubled" portion of banks' balance sheets, I find it dubious that the buying of easily identified troubled assets would be the tipping point for those companies between solvency and insolvency. Rather, I think their debt ratios are so high already that this would still result in insolvencies nonetheless.

Mon Oct 13, 10:38:00 AM EDT  
Blogger knzn said...

Troubled assets are, almost by definition, losing bets on certain types of economic activity.

They are, by definition, bets that have already been recognized to have a substantial chance of losing. Any reasonable appraisal of such an asset would take into account what is already known about that chance of losing.

So there is no upside to these guarantees. It is all downside risk.

There is an upside in the call option that the government would get under my proposal. (Did you read that part?)

Say a mortgage has a face value of $100,000 a 50% chance of defaulting. To simplify the example, let's say this means it will sell for 50% of face value. (In reality it would be less than 50% of face value, because of risk aversion.) The government appraises it at $50,000, guarantees it at that price, and takes a call option with that price as the strike price. If the mortgage defaults, the guarantee kicks in, and the government is down $50,000. If it goes to maturity without defaulting, it's worth $100,000; the government exercises its call option and pockets the $50,000 difference.

In real life (assuming the appraisals are reasonable), the odds for the government are better than in my example, because investors are risk averse. The appraised value of the mortgage should be closer to, maybe, $40,000, to compensate the holder for the uncertainty. Then the government has a 50% chance of losing $40,000 and a 50% chance of making $60,000.

Mon Oct 13, 10:50:00 AM EDT  
Blogger knzn said...

I see the second anonymous has also made the point in my previous comment.

Regarding the solvency issue, as I said in the post, a legitimate criticism of either the TARP or the TAGS is that they do nothing to help with capitalization problems. (Actually, the TARP in its present form does help, but only because more recent revisions give the Treasury the opportunity to inject capital directly.) There has been dispute over whether the main problem was capital or liquidity. I think the consensus has come pretty strongly toward the former, but a few weeks ago it was still respectable to argue that it was mostly a liquidity problem.

Mon Oct 13, 10:56:00 AM EDT  
Anonymous Anonymous said...

Found a way to recover those 700 billion dollar:

Tue Oct 14, 05:56:00 PM EDT  
Anonymous Anonymous said...

"Guaranteeing an asset is equivalent to buying the asset while giving the seller an option to repurchase at the same price. Conversely, buying an asset is equivalent to guaranteeing the asset while retaining an option to purchase at the guarantee price."

Not quite. You've left out the risk free asset. You have to short it in the first and buy it in the second to get equivalence. I'll leave the proof to you.

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