Geithner's Plan: Loopholes Galore

[Beet]

So basically, the banks can take the bail out money they received from the government last fall, and use that money to purchase their own assets and have them overwhelmingly guaranteed by the FDIC. I don't care what you call it-- at the end of the day it's the same thing. Heads need to roll on Wall Street and executives and traders fired and prosecuted. The people who profited from the bubble should not be benefitting from the PPIP.

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Here are five ways hedge funds and investment banks may exploit Treasury's toxic-assets plan
By Theo Francis and Mara Der Hovanesian

It has been a little less than two weeks since Treasury Secretary Timothy F. Geithner unveiled the details of his project to restore banks to financial health. But analysts say hedge funds and investment banks are already looking for ways to exploit the complex web of auctions, public-private partnerships, and government guarantees proposed by Treasury to cleanse banks' books of toxic assets. "It's a highly gameable system," says H. Peyton Young, an Oxford University economist and a senior fellow at the Brookings Institution in Washington. "It's very difficult to write rules that are going to prevent self-dealing behavior."

Geithner's goal: entice investors to buy up the billions of dollars' worth of subprime mortgages, underwater commercial property loans, and other shaky securities that weigh down the banks' books. The partnerships will bid at auction for the dodgy parts of the banks' portfolios, hoping to get a big enough bargain that they can resell the assets later at a profit.

With their balance sheets restored to health, goes the theory, the banks will lend again. Investors who team up with Uncle Sam get a chance to make a fortune with very little risk: The government will provide half the equity, and the partnerships can juice returns by borrowing more funds on attractive terms from the Federal Reserve or by securing private-sector loans whose repayment is guaranteed by the Federal Deposit Insurance Corp.

Besides the generous terms, the partnerships have loopholes big enough for an investment banker to drive his Ferrari through. The basic problem: Everyone gets to play. Banks selling dubious assets can finance their sale to the partnerships, investors can buy debt from banks in which they own shares, and on and on. Strictly speaking, there's nothing wrong with much of this. But many of the strategies to exploit the partnerships increase the chance that the feds will overpay for the debt, sticking taxpayers with the bill.

Government officials say they plan to head off abuses as they iron out the program's final rules and argue that competition will also play an important part. "When programs are competitive, it becomes more difficult to game, because the outcomes are more uncertain," says Jim Wigand, the FDIC's deputy director of resolutions and receiverships. But with so many twists, gaming the system may prove hard to block completely. Here are five possible tricks:

SELLER FINANCING
Banks may be able to finance the sale of their own troubled loans, lending money to the public-private partnerships that buy the assets. A bank's loan to the partnership would be buttressed by an FDIC guarantee. Administration officials confirm that the Treasury may allow such seller financing. The move essentially replaces junky mortgages on the bank's books with an FDIC-guaranteed loan. With its risks so limited, the bank has every reason to pass off its weakest assets as better than they are, argues Fuqua School of Business finance professor Campbell R. Harvey. "They will want to unload the worst possible things at the highest possible price," he says. "And if they're doing the financing, it's even more likely that they will be able to do that." Government officials say they will charge more for loans used to buy the riskiest assets.

PUMP AND DUMP
Say a private investor in one of the partnerships owns big stockholdings in a bank putting assets out to auction. By overbidding for the bank's sludge loans, the investor could help drive up the banks' shares and make a tidy profit. His stake in the partnership might take a hit if the assets eventually aren't worth what the auction price suggests. But the government would shoulder most of any big losses. As long as the private investor's stock market gains exceed his loss in the partnership, the deal's a winner.

Government officials see this ploy as too risky for most investors to try. But the Treasury would be hard-pressed to prevent such maneuvers, short of barring a slew of hedge funds and other big bank investors from bidding in the auctions at all. Besides, it's impossible to disentangle all the connections between banks and money managers. "How do you find a private money manager that doesn't have a relationship with a bank?" asks Albert "Pete" Kyle, a University of Maryland finance professor.

PASSING OFF THE LOSS
In the public-private partnerships, the private partners are supposed to figure out how much to bid for assets, keeping the government well away from the business of pricing deals. But the way the deals are structured, the FDIC and Treasury will absorb as much as 93% of any losses, while getting to keep just half of any profits. "The government's going to be on the hook for the [deals] that are bad," says Brookings' Young. With their own downside so limited, the private partners are likely to be drawn to the riskiest deals, which offer the highest potential payoffs—and the government the biggest potential losses. One option under consideration is including multiple private partners in each partnership as a check on one another's excesses.

PORTFOLIO SWAPPING
For all the talk of toxic assets, some banks may want to hold on to their suspect loans in the belief that they will eventually pay off. The Treasury and the Fed, however, are breathing down the banks' necks to unload problem debts.

What to do? A bank could effectively swap its existing portfolio of junky loans for another one very similar—only this time limiting the downside by using government loans and guarantees. The bank would auction off its loans to a public-private partnership. Then, using a portion of the auction proceeds, it would set up a different public-private partnership that would of course have access to government loan guarantees and matching funds. The bank would use the new partnership to buy a portfolio of similar problem assets twice the size of its old portfolio. The bank would then split any gains from the new portfolio 50-50 with the feds—but risk no more than the sliver of equity it contributed to the deal. The Administration may seek to block such maneuvers.

LAYERS OF LEVERAGE
Perhaps the most intricate maneuvers will likely stem from "layering" the government's many programs of the last six months. Starting with some of the capital infusion received last fall from the Treasury, a bank could invest in a private partnership that buys toxic assets using a loan guaranteed by the FDIC. Those assets could then be chopped up and sold as securities to other investors—who put together the financing for the deal by availing themselves of another program of low-risk loans from the Federal Reserve. Thus the original bank's capital at risk in this web of deals would be almost nil. "[This] is going right back to the practices that got us into this problem—except using government leverage," Young says. "It might lead to an even wilder party than we saw before."

How much leverage could investors or banks pile up? "As much as you can get away with, of course," says the bank analyst at one investment management firm. He thinks the recent outcry over bonuses at American International Group (AIG) may promote some self-restraint. "You're going to get caned in public these days, rather than getting caned in private," the analyst says. "There's not much appetite for that."

One government planner counters that if each program's safeguards are good, layering "shouldn't be a problem." Final rules are expected in the next several weeks. Banks and investors, meanwhile, will keep trying to get the most out of Washington.

http://www.businessweek.com/magazine/content/09_15/b4126020226641_page_2.htm

[Torie]

A very sobering article, and excellent in its detail. Thanks Beet. Why do I get this feeling the government is over its head on this?

[Sam Spade]

There's two words for Geithner's plan - it's called "money laundering".

[Bunwahaha [still dunno why, but well, so be it]]

Is it possible to have an idea of when will we know whether this plan can actually work or not to save banks? That would be a question of weeks, months, years to know it?

Just to know, if this plan can't save banks, when we will have to face a big problem...

[Sam Spade]

Is it possible to have an idea of when will we know whether this plan can actually work or not to save banks? That would be a question of weeks, months, years to know it?

It won't work.  Willing to bet my life savings on it.

You must be logged in to read this quote.

We're already facing a "big problem".  If I had to bet, next leg down probably begins in Europe and within this year.

[Torie]

Is it possible to have an idea of when will we know whether this plan can actually work or not to save banks? That would be a question of weeks, months, years to know it?

It won't work.  Willing to bet my life savings on it.

You must be logged in to read this quote.

We're already facing a "big problem".  If I had to bet, next leg down probably begins in Europe and within this year.

Sam, it is all going to hell exactly how and why now?  Is it something to do with a gathering lack of confidence in the US as a credit risk? No doubt you have explained this before, but I have not kept up with your economic musings of the coming gotterdamerung in detail. Thanks.

[Beet]

Is it possible to have an idea of when will we know whether this plan can actually work or not to save banks? That would be a question of weeks, months, years to know it?

It won't work.  Willing to bet my life savings on it.

You must be logged in to read this quote.

We're already facing a "big problem".  If I had to bet, next leg down probably begins in Europe and within this year.

Sam, it is all going to hell exactly how and why now?  Is it something to do with a gathering lack of confidence in the US as a credit risk? No doubt you have explained this before, but I have not kept up with your economic musings of the coming gotterdamerung in detail. Thanks.

He has never really fully explained the step by step mechanics of a potential event horizon. But from reading him with an open mind to the best of my ability and interacting with him over the last several months, my understanding is that he is predicting some sort of currency crisis in the primary capital account surplus/housing bubble countries.

The crisis would likely begin in fringe Europe (Russia, Ireland, Ukraine, Spain) or Eastern/Central Europe, due to massive asset depreciation, which exceeds the enhanced resourcecs of the IMF and generates overwhelming political need to default. This would trigger a second round of Lehman-style crisis focused in Europe that undermines European banks and the euro. The euro and/or the pound come under speculative attack, and massively depreciate, causing those countries to be unable to repay debt obligations held in foreign currencies. They then default.

Investors then change their behavior towards the United States. All throughout the downturn thus far, investors have treated the United States as a safe haven. Thus you have the perversion of the dollar rising in value on news of a drop in U.S. industrial production; normally, bad news in country X would cause country X's currency to drop, but since U.S. industrial production is now one proxy traders use for global risk, and the U.S. is the least risky haven, the dollar rises on the rise in global risk. This is what George Soros means when he calls the strong dollar a 'perversion' of the global financial system. But after EU sovereign defaults, the risk is that investors' behavior to the US will shift more towards what their behavior was toward Indonesia in 1998.

In other words, a classic currency crisis (it used to be that developing countries would have currency crises without financial crises; starting with Argentina in the early 1980s this changed and developing countries started to have both financial and currency crises; thus far the United States, UK, Spain have had financial crises without currency crises).

The problem of course is why this would happen, since there are no other countries in the world that are less risky than the United States, not even China. The greatest risk to the world economy right now is political- the risk that some country will make a political decision that roils the markets, or in particular that powerful countries will make political decisions that will undermine the markets before a fully recovery can be underway. It is very difficult to predict the future, however. A great deal of it is really purely psychological.

[Torie]

Thanks Beet. I will ponder this. Something is missing here, but I need to collect my thoughts.

[Sam Spade]

I will ponder what Beet is saying also, mainly because it is somewhat incomplete in some places and inaccurate in others.  

But that's ok - it's not a bad layout of what I see, in a general sense.  After all, I've been a little coy with what I say and maybe a little more explanation is needed.  I do play the *Al* game quite often in this regard.

One of the reasons why I'm careful in what I say and making too many predictions is because even though I believe an inevitable bad ending is unavoidable (as with all debt-deflations - yes put me in that camp), outside actors, especially government, can change what that ending is, and, of course, its severity and length.

Another reason why I'm being careful is because the exact fact-scenario we face at present is similar but yet unlike any other seen in the past.  For example, unlike all the recent global debt-deflations in the past couple of hundred years, no currency is backed by gold.  True, the dollar is *supposed* to be backed by gold, but it isn't.  However, it is the overwhelming debt-denominated currency in the world (as pointed out by Beet), which gives it incredible power and which makes me think that it is likely the dollar will keep skyrocketing as debt keeps deflating. 

But yet at the same time, I would have to think that would logically put me in the camp that we will not see massive price deflation (as we saw in GD1 for example), except in those countries that are export-dependent to the US.

Anyway, I am digressing.  The key point is that I don't know what will exactly happen or any sequence of events.  But I can observe what is factual:
1) The US government is creating an enormous government finance bubble in an attempt to prop up the housing market, the lending market, the banks, state governments, social and military spending, ad infinitum... (including btw, the central banks of Europe/Japan, but I need not go there now)
2) Banks in Europe/UK are terribly overlevered, mainly in US loans denominated in dollars or in loans to developing EU countries denominated in Euros;
3) The Euro is a currency with two states in halfway decent financial condition (France & Germany) and a whole bunch of other states in varying financial conditions from bad to horrible and without any real financial controls should something blow up in that mess.
4) Japan is sinking into a massive depression because exports to the US and other countries have fallen off the cliff and they have no currency reserves or *special methods* like China.  China is using its currency reserves in an attempt to create another speculative bubble and, in addition, create more goods to export out to countries in the hope that these countries will, in fact, buy more, something which, btw, has never worked from the export-dependent country's perspective.  I am also kind of ignoring the massive oversupply China already has.
5) In general, in a tiny response to Beet, the politicians of nearly every country are making things worse by bailing out failing banks and running up massive government debts in the hope that stimulus (in the form of more debt) will solve a debt problem.  In the hope they can solve this global debt-deflation, I believe they are making things worse in the long run and the possibility of complete global collapse of the financial system is a reasonable one at this time.  In short, I believe global market > governments of the world, no matter how much unity we reach (and I doubt if things get worse, that unity will get better).

These are but a few of the more important facts in my mind. 

The supposition that all this leads to a "global currency crisis" of some import like Beet describes seems a logical one in my view.  It is merely a question of when, where and to what extent.  Will it be really bad, worse or catastrophic?  I do think that what has been done so far leads me to think that worse or catastrophic is the more likely result, but I am willing to hold out for bad.  In fact, I am probably even willing, somewhere in my brain, to hold out that none of this really means anything and we can reinflate.

Man, this post got long.

Anyway, I have been working a bit on a really long piece about it - but it'll probably not be completed anytime soon, if ever.

[Lunar]

NYC 2011



sorry everyone, the internet declaredeth thus so

[Torie]

Ah, debt deflation. Plus ca change, plus ca meme chose.

[Sam Spade]

NYC 2011



sorry everyone, the internet declaredeth thus so

yes, that really sums up what I think quite well (presuming, of course, that *I* am *the internets*...) 

[Torie]

In other news, William J. Bernstein (I inter alia did some editing work on a couple of his finance books), just told me on the telephone that this financial crises is similar to the one that occurred in 1907.  I didn't know there was a financial crises in 1907, but I do now. Every time I think I know everything, something pops up to remind me that I don't. It is so damn annoying! 

[Beet]

In a small response to SS's small reponse to me, I would say that if world governments allowed the debt-deflation/debt-destruction from the worldwide housing bubble to proceed forward, you would eventually see "complete global collapse of the financial system". I am worried about many things right now, but if the governments to stand by and do nothing would not have saved anything, including their own revenues or political stability.

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Another problem here is that for the US to repay its roughly $3 trillion and still growing government debt to foreign investors, the US must become a net exporter, and for the US to become a net exporter, the US dollar must devalue so that US exports will become competitive. But if the US dollar devalues, then the value of US investments of foreign investors declines relative to their own currencies. If foreign investors think that this is going to occur and decide to pre-emptively sell their US-denominated debt, this could trigger a panicked capital flight from the US dollar. Just the decision of one major foreign central bank which is a large dollar reserve holder, of which there are many, could trigger such a run.

The government would then be forced to choose between printing money, raising interest rates, and defaulting, and possibly parts of all three. The inflation rate in Indonesia, for example, was 58% in 1998, and this is a developing country that had virtually no history of inflation (unlike other developing countries) for decades. This is how every debt crisis in history has been resolved: expungement.

The good news is that after a couple years of armageddon, the US dollar will have massively devalued, the US savings rate will be high, and the debt will be somehow expunged. The US can begin to export and build up foreign reserves of whichever is the new reserve currency at that time, and the economy will begin to recover.

How can the government prevent this? First, they must stabilize the financial system. Then, they must defeat debt-deflation. Finally, they must take care of the debt problem. They must somehow convince the current account surplus countries to allow the market to devalue the dollar (or devalue through a Plaza-agreement style arrangement); a decisive, one-time move that does not involve a selling cascade by the foreign central banks that hold the bulk of these securities. Over time, the US would repay its foreign currency debt through net exports. This is not as far-fetched as it sounds: the US trade position was in balance as recently as the 1991 recession. Many developing countries swung from large deficits to large surpluses in the 1990s.

[Bunwahaha [still dunno why, but well, so be it]]

Thanks all of you for your analyses. What would be the signs that this plan doesn't work? Something happening suddenly or something happening step by step? If possible to answer of course.

Ah, debt deflation. Plus ca change, plus ca meme chose.

Unless you were purposely using bad French, that is: Plus ça change, plus c'est la même chose.

Giscard, him, turned it into: "Le changement dans la continuité" ("Change in continuity"), one of his political slogans, it remained a bit famous here.

[Torie]

Thanks all of you for your analyses. What would be the signs that this plan doesn't work? Something happening suddenly or something happening step by step? If possible to answer of course.

Ah, debt deflation. Plus ca change, plus ca meme chose.

Unless you were purposely using bad French, that is: Plus ça change, plus c'est la même chose.

Giscard, him, turned it into: "Le changement dans la continuité" ("Change in continuity"), one of his political slogans, it remained a bit famous here.

Ouch! My bad, and I have been doing it "bad" for about 4 decades without previous correction. Well, better late than never. Thanks!

[Sam Spade]

Thanks all of you for your analyses. What would be the signs that this plan doesn't work? Something happening suddenly or something happening step by step? If possible to answer of course.

All I can is *watch the valuations*.

Oh, and on the bank stress tests, I keep hearing strong rumors that they're set up so that actual loans that are bad receive more more weight than securities that are bad.

Naturally, think about who that benefits.  Definitely not regional banks.

[Torie]

Thanks all of you for your analyses. What would be the signs that this plan doesn't work? Something happening suddenly or something happening step by step? If possible to answer of course.

All I can is *watch the valuations*.

Oh, and on the bank stress tests, I keep hearing strong rumors that they're set up so that actual loans that are bad receive more more weight than securities that are bad.

Naturally, think about who that benefits.  Definitely not regional banks.

What do you think Sam about watering down mark to market accounting rules?  It seems insane to me. It seems to me everything should be marked to market.  Carrying on the books a value for an asset that is more than it is worth, strikes me as simply false and misleading. If we are going to indulge in false and misleading, then what is the point of audited financial statements which must be disclosed to the public?

[Sam Spade]

What do you think Sam about watering down mark to market accounting rules?  It seems insane to me. It seems to me everything should be marked to market.  Carrying on the books a value for an asset that is more than it is worth, strikes me as simply false and misleading. If we are going to indulge in false and misleading, then what is the point of audited financial statements which must be disclosed to the public?

I fully agree - I remember my arguments with jmfcst on this very point.

Here's the problem:  Long before the watering down, there were already a number of rule changes which have the same effect.  The placing of tons of Level 3 assets off-balance sheet is a major one.  Go examine the subject of 23A exemptions.

What the watering down of mark-to-market allows financial institutions to do is to hide the deterioration of Level 1 and Level 2 assets like they can presently address Level 3 assets.

[○∙◄☻¥tπ[╪AV┼cVê└]

Taxpayers want their $3 trillion back.