Going around in circles on the toxic assets

Who would have thought there might come a day when we’d be asked to compete for our share in a pile of junk?!

Harvard’s Lucian Bebchuk suggests precisely that. His proposal for “jumpstarting the market for troubled assets” has been featured in various media sources, including the FT (here), Bebchuk himself (here) and, recently, by Mark Thoma (here).

Bebchuk’s basic idea is this: In order to encourage price discovery for the toxic assets lying in banks’ balance sheets, the government should allow multiple private funds to compete for them. In addition, to drive down its own participation, the government should make the private funds compete for the public funding made available for purchases of toxic assets under the Public Private Investment Fund plan (PPIF).

Interesting idea but, alas, I don’t think it does the job! I'm about to give a fairly lengthy argument why it doesn't, and what should be done. So if the term “discount rate” makes you yawn, I recommend scrolling down to the conclusion. Here we go:

The assumption driving PPIF is that the current “market” prices for toxic assets considerably understate their “fair” price due to the illiquidity of markets, a high cost of funding of potential buyers, etc. If only banks could sell their toxic stuff at prices closer to “fair”! Their health would by and large be restored and the government would need to pay far less for bank recapitalizations!

The PPIF, in theory, solves these problems (a) by providing partial government funding, thus lowering potential buyers’ cost of capital; and (b) by encouraging a simultaneous buying action on a massive scale, to address the current problem of (a lack of) collective action, whereby early, lone movers get burned.

In practice, however, nothing is solved unless market participants have a sense of what is “fair.” How can we find out? Bebchuk says by having multiple private funds compete for the toxics. Let’s see how/if that would work:

The problems with the theory: Think of a toxic asset—a mortgage backed security (MBS), say, backed by subprimes. And say I am an investor lured by the idea of teaming up with Geithner to buy a few millions worth of MBS junk of the above variety.

Now, suppose I expect subprime borrowers to default with probability p over the life of the mortgages. Very simplistically, this means that, if I held the MBS to maturity, I’d get its face value with probability (1-p) and a recovery value (given default) with probability p. The “fair” price of the MBS will then be the weighted sum of these two values discounted back to present.

So now with my estimate of a “fair” price I go out and make a bid. In principle, I would like to bid below this “fair” price, so that I can pocket the upside. But what Bebchuk’s competitive process does, in theory, is to drive participants’ bids up to “fair.” The idea being to incur the minimum losses possible for the seller banks.

Sounds great, no? Problem is… “fair” depends on my discount rate (my cost of funding these securities). In turn, this depends on how much Geithner is prepared to put in. So I go and knock on Treasury’s door. Geithner opens and (per Bebchuk) confesses that, “as much as I like you, Chevelle, my heart lies with the American taxpayer, so we’ll make you compete for our cheap cash. Show us your money!”

I’m now in a dilemma. I can’t bid too low, because I’ll be thrown out of the game. But then, how high? The only variable I have to guide me is the MBS’ current “market” price. This determines the maximum amount of capital I can put in without going underwater. In fact, that’s exactly what I do: I bid near that upper boundary, to ensure I win the game.

But that’s no help for Geithner: At that level of my own participation, I’ll bid for the “market” price, banks will incur large losses (or they won’t sell!) and more taxpayer money will be needed for recapitalization.

In other words, Bebchuk's idea of competing for public cash simply shifts the form of the government's participation: It reduces the subsidy to private investors; but it increases the amount needed to recapitalize banks.

More problems in practice: In practice, there are other complications. First, it’s questionable whether we can find enough private players with the size and expertise to generate the level of competition that Bebchuk envisages.

Toxic assets are very diverse and, with a few exceptions, participating private funds will likely have only niche areas of expertise. The resulting “market” will be very segmented, with the concomitant implications for competition and liquidity.

Secondly, different private funds have different costs of capital. This means that competition for the government’s cash will provide a clear advantage to the big guys with lower cost of capital—the Blackrocks and PIMCOs of this world. This raises issues of fairness.

Conclusion (The scrollers can start here): Ultimately, the government is in this either way. So rather than going around in circles, Geithner should just try to solve the problem with an end-game in mind. It’d go something like this:

My To-Do List, by T.G.

1. Calculate the hole in the banking system on a mark-to-market basis
2. Assess the probability that its size will prompt a popular revolt
3. If higher than 70%, prepare for the orderly liquidation of selected financial institutions. Emphasis on “prepare”, “orderly” and “not screwing up” (again).
Note to self: In the (unlikely, of course) scenario where “orderly” demands the exercise of the N(uclear) option, convene urgently a panel of linguists to find a politically-acceptable term for the policy move.

4. Re-calculate the hole in the banking system that remains.
5. Now choose between:
(a) Bailing out the banks via recapitalization
(b) Subsidizing private funds sufficiently to get them to bid the “fair” prices you need to cover the banks’ hole.

The pros of (a): Faster and “cleaner”, probably.

The cons of (a): Americans' loathing for higher government ownership of banks. Americans bigger loathing for a fresh fat bailout for the bankers. An 83% probability that I receive their collective wrath, eggs and tomatoes within 12 months.

Pros of (b): The word “private” features prominently in the PPIF acronym.

Problems with (b): The fairness and fragmentation issues above; implementation delays, due to complexities in designing the terms and conditions for participation etc. (a la (TALF)
(Second note to self: If we went for (b), avoid at all costs giving the impression that the government will be effectively setting the prices for the toxic assets.)

6. Oh, and before I forget… file my tax returns by April 15th!