Most of the consternation I’m still hearing about Geithner’s Plan revolves around the concern that the toxic assets are either worthless or are worth substantially less than whatever price they will be auctioned off for. You will read Krugman, for example, saying that Geithner is behaving as if there was no housing bubble. First of all, no one is talking about selling or buying these assets at their original value. They might be valued currently at .30/dollar. In the case of the First National Bank of Nevada, they sold off their toxic mortgages to PennyMac at .38/dollar. Under auction conditions, the toxic assets will hopefully sell for something closer to .70 or .80/dollar. Why the difference? Well, in part it has to do with this provision of Geithner’s Plan:
# Funding Purchase of Legacy Securities: Through this new program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency residential mortgage backed securities (RMBS) that were originally rated AAA and outstanding commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that are rated AAA.
We all know that the AAA rating wasn’t worth a damn. But the plan envisions restricting the program to AAA junk, which means that the worst junk is not in play. For that reason alone, we should expect the price to be higher than the .38/dollar PennyMac paid for First Bank of Nevada’s shitpile.
Now, I want you to consider the case of John Paulson. He is a member of a consortium that just bought up IndyMac. He got the money to invest in IndyMac by essentially shorting the housing bubble by buying up credit-default swaps on the BBB-rated shitpile. Here is how is described his strategy:
[Paulson] insists that his fruitful subprime trade, far from being stunningly clever, was a no-brainer for anyone who bothered to analyse the complex securities’ underlying collateral. “It was obvious that a lot of the stuff…was practically worthless at the time of issuance,” he says. He finds it “perplexing” that the banks holding the higher-rated tranches could not see this danger, and that so few others were prepared to believe that Wall Street’s finest could have miscalculated so badly.
Another motivating factor for Mr Paulson was the alluring asymmetry of shorting credit. The most you can lose is the spread over some benchmark rate. Yet if the bond defaults, the gains can be mouth-watering. He targeted BBB-rated tranches, the lowest in subprime securities. With credit spreads so low because of a liquidity glut, his possible upside as a buyer of protection using credit-default swaps (CDSs) was as much as hundred times the potential downside. One $22m trade is said to have netted him $1 billion when Lehman Brothers went bust.
Love him or hate him, this Paulson guy is one savvy investor. So, what does he think about the AAA-rated junk right now?
Just as markets used to hang on Mr Soros’s every move, they are now keen followers of Mr Paulson. He does not see the economy reaching bottom this year and is still a net short-seller of financial firms. More encouragingly, he has started buying up bombed-out mortgage securities. The number-crunching that told him subprime-linked paper was overvalued now suggests that some previously AAA-rated tranches are a bargain. He talks of distressed debt—mortgages, leveraged loans and the debt of bankrupt firms—as a $10 trillion opportunity.
So, you have Krugman and a lot of liberal bloggers on one side saying that all this AAA-rated junk is near worthless and that we are about to make a huge mistake in overpaying for it, and then you have the guy that got rich off shorting BBB-rated shitpile saying that the AAA-rated stuff is a $10 trillion opportunity.
It’s just something to think about. That’s all.
Hey. I made money shorting the housing market (not on MBS but still). Do I get to make policy now?
But I do agree that those that put money behind their analysis and that correctly realized we were in a massive and unsustainable credit bubble deserve to be listened to. Unfortunately, our “leaders”, including our Dear Leader, were telling us everything was o.k. when even this financial neophyte could see a bubble years ago. In fact, the DLC crew running economic policy has consistently made the opposite bet Mr. Paulson made. They bet on the system being fundamentally sound and I believe the Dear Leader is making the rounds yet again reinforce that propagandist message (Bush redux). So I don’t know how you can say we should listen to Mr. Paulson on this one issue but let the people that made massive losing bets on the other side of Mr. Paulson’s winning bets run the entire show.
In any event, I don’t trust traders and I wouldn’t make policy on the fact some trader with a book thinks we should do something. Just like listening to Peter Schiff or PIMCO would be foolish. That idea was as ridiculous last fall when you fell prey to the Wall Street terroristic threats; when you were threatening that the market would crash from 10,000 if we didn’t give the bankers money. It’s also ridiculous now when you’re trying to dangle the allure of a profit in front of us to sucker us into giving the bankers money. You’re trying to have it both ways; promising the government may “make money” (ha!) on purchasing toxic assets (but not promising) just as yesterday you implicitly argued that the markets will go up (and lift all our boats) when Obama gives money to bankers. You reveal the bankrupt strategy Obama is using; try his hardest to appease Wall Street and make markets go up. It will fail. Making policy based on the markets is foolish. It’s not good for the real economy; you know, the bottom 95% of Americans?
And anyway, as a firm believer in the free market, if this guy thinks he can make a buck I wish him well in his purchase of this asset and don’t think he needs government welfare to make this purchase. He can keep his profits but I don’t want to hear how we need to subsidize his counter party’s losses or that we need to subsidize his next profitable trade.
I didn’t say he’s necessarily right, but I think he has enough expertise to match or exceed Krugman in this particular area. I think we all benefit from knowing his take on this.
Interestingly, he’s been buying this stuff without the loan guarantees. I assume he will be pleased as punch to get in on the auctions which offer him a much, much sweeter deal.
Hey. Something I agree with you on. I certainly put more stock in Mr. Paulson’s opinion on this than other people but with one huge caveat: he may be talking his book. After all, he is not the first guy shorting the market to expect the government to eventually intervene to prop up prices. In fact, I bet most shorts expected this. How do you know he wasn’t simply ahead of the market (as he was before) and is buying in anticipation of government subsidies? Is the stuff he already bought all of a sudden worth more because of the imminent government subsidy? I covered a number of my short positions too early because I was worried about the government intervening to help its Wall Street masters (which has now come in spades; I just originally thought it would prop up the share prices of some of these stocks–it really didn’t work too well, see e.g. Citi).
In other words, just because Mr. Paulson has a book of CDS or whatever toxic assets doesn’t mean he really believes in the fundamental valuation; he may just be playing us all for suckers (in fact, that’s my bet, where do I place it?).
that’s a very good point. But, even if it is true it still leaves us with a bunch of questions about how that plays out in the medium/long term for the value of these assets.
It cracks me up that the liberal business experts are claiming that the investors (purchasers) will make a huge subsidized killing although the feds who will share the proceeds will lose money and the banks will get overpaid.
Some people need either a better model explanation or lessons in arithmetic.
to be fair, most of the criticism has to do with differential risk. But I share your dismay at the repeatedly asserted angst about billionaires making money off this. Do you have millions to invest?
We need to find a lot of people with millions in disposable income to buy up this crap. And people are upset that they’ll profit from it. Well, why else would they invest their money?
The only legitimate criticism is over the terms under which they invest.
But take a normal hedge-fund. They will take 2% of money under management and 20% of profits. Do the math and you’ll see that it isn’t that different from what the Treasury is offering in this case. Or look at the case of IndyMac where the investors are on the hook for the first 20% of loan defaults and we’re on the hook for the remaining 80%. That is the deal offered under nationalization. Or consider the nationalization case of First National of Nevada. They sold off for .38/dollar, while we’re hoping to net .70 or .80/dollar through this program.
The real issue is false choices. Don’t complain about a choice you don’t have.
Well I keep getting told that the price paid for the assets will be too much (so the banks get a subsidy) and then the feds will lose money while the investors make money.
Since investors share profit if any with the Feds, this seems arithmetically impossible, but I don’t have a Nobel Prize in Economics.
on the FDIC versus TARP story you ran yesterday was a sad moment.
now, now…
I don’t think she’s being dishonest.
My take on it is that she is very angry about the crooks that created this mess being offered sweetheart deals to get rich off fixing the problem while we assume way too much of the risk.
I can’t find fault with her for being angry about that.
What I think is wrong is to blame the Treasury Secretary for a situation he has little control over. If Jane can find clean investors on a sufficient scale then she’s got magic powers that most mortals do not have.
What I think she was dishonest about is that the original article was clearly making the argument that the Timmy Plan was a ripoff compared to the FDIC takeover plan.
It’s interesting to me that the same people who predict this is gonna be a huge money loser are also pissed that they can’t get in directly with $1 or $10 or whatever. I don’t understand the logic of that.
that is kind of funny. I notice Yglesias repeating that complaint and I was a little disappointed in him. After all:
No one is excluded from participating if you can win the auction.
it’s: this is a horrible, terrible tax payer ripoff that won’t work. How can I buy in?
yeah. That’s a pretty tiresome argument.
On the other hand, it feels good.
that was clear to me, but based on her replies it appears that she honestly was focused on the ‘thieves benefiting’ aspect without self-consciously ignoring the fact that this is an unavoidable problem.
I share Jane’s ire, and suspect you’re probably right: the game is structured so that the bad guys will win at least the next round, no matter what.
The question is what comes next. If we let the banksters get away with making a few billion more, stabilize the economy, then enact comprehensive reform that prevents this sort of thing from happening again, it might be worth it. If we stabilize the economy and then start prosecuting the worst of them, so much the better.
Overall, given the history of past couple of decades and the limited clues offered by the White House, I’m moderately pessimistic.
Booman Tribune ~ The Worth of Crap
that’s exactly how i think obama’s reasoning, quite the quid pro quo, huh?
pity he can’t come right out and say it, (yet?) he’d get a lot of love for being so candid!
circumstances still permit soft-shoeing still.
slight problem with the “partnership” aspect of PPIF, 93% of the fund is from the taxpayers, 7% is from the “benevolent” private sector.
as usual, upside down regarding public/private. and I’m guessing the returns (if any) will be upside down as well; i.e. 90% to the wealthy investor class, 10% to the taxpayers. tell me why I should be in favor of this.
http://www.thenation.com/doc/20090406/greider?rel=hp_picks
The numbers don’t add up. I’d like to see a scenario in which someone could make money by overpaying – and not that stupid CDS scenario that involves felony fraud.
Not very sharp in your financial innovation skills, eh?
Even without a lose-lose, the main point is that the banks will be selling a security, but the investors will be buying an option on it, with the taxpayer putting up in the substantial difference in price:
krugman
But there are plenty of ways to make sure that they (almost) always win and the government (almost) always loses:
self-evident (server seems to be overloaded…)
me
So spell it out
Asset is purchased at $100
Investor puts up 7% = $7
Asset is actually worth $0
Investor loses $7
Where is the motive for the investor to overpay? I keep getting the same explanation that – look the government loses $93. Big deal. The investor walks off with LESS MONEY than he/she started with.
The only explanation I can come up with is that the 1/6 or 1/12 stake is considered peanuts. Investors scatter money at 100 assets, overpaying wildly, in the hope that one of them will win. But there are no 10x returns on this stuff – it consists of loans.
So is there a concrete scenario where the investor has an incentive to overpay?
Sorry, not going to give you a course on the basic concept of expected value in a blog comment. I hope you don’t work in the financial sector.
There’s no response from the “self-evident” server.
I’ll just note that although you have managed to insult me a bunch of times, you have not managed to provide a scenario in which an investor would profit from overpricing the asset in Geithner’s plan.
Business is ultimately very simple and all the wall street bullshit can’t obscure it: a profit requires returns greater than costs. If you cannot provide a scenario in which an investor has an incentive to overpay, I’m going to simply conclude that you are puffing a lot.
God I love this stuff. The famous concept of expected value. First the artists striving to attain immortality through uncomfortable living (see diary) and now this: the concept of expected value, properly understood only by finance professionals. I think I’ll sit on a wire for a while and chirp.
Even broken clocks are right twice a day.
It could be that Mr. Paulson actually understands the whole affair and not just the small portion of it wherein he did well before. I certainly hope that’s the case. But there just isn’t enough track record here to be confident of that conclusion.
The reason I’m feeling uncomfortable about the whole situation is that it’s not at all clear to me that the people in charge of fixing it fully understand the extent to which the market is and has been a scam disguised as a perpetual motion machine.
I just don’t understand this argument:
The issue isn’t that they’re worthless, the issue is that they aren’t worth nearly as much as the financial institutions are pretending they’re worth. Sellers have a huge incentive to not sell at lower prices because lower prices will potentially reveal that they’re insolvent/essentially bankrupt.
So the bankers have a lot of assets that they will not sell at a reasonable price. Too bad for them and who cares – unless the Geithner plan causes overpayments.
As for this comment (crap, heading into Someone On The Internet Is Wrong territory), the reason that the big players can make money while the gov’t loses money is because of the no recourse loans, and the asymmetric upside/downside of the Geithner plan.
They’re buying shitpile mostly with gov’t loans, and if there’s money to be made they and the gov’t benefit. But if the asset is shit, they don’t have to pay back the loan, just hand over the asset.
AND THE FUCKING HAIRCUT which is at least 1/6 of price. So if the asset is bad, as far as I can tell, the investor loses actual money and it doesn’t help the investor that the government loses more because we’re talking about actual money not expected return.
Check the price of a put option about 15% out-of-the-money on a security with very high volatility. You’ll be shocked. That’s the economic value of the subsidy that taxpayer is in for, for no good reason. A simple back-of-envelope calculation like Krugman’s will allow you to understand why the value is so high (or run Black-Scholes if you need to in order to be convinced…)
Black-Scholes is irrelevant here. As long as the price of a put option is non-zero, the investor still loses money if she/he overpays. There only escape from this is if the investor places multiple bets and the payout is big enough on a win so that it makes up for the loss. But I don’t see any possibility of how that happens here. Instead all this complex stuff about asymmetry and black-scholes that I’m too stupid to understand, surely you can give me a scenario-example where investors make money by overpaying.? Can you?
And what the defenders of the Krugman argument keep evading is that Krugman’s back-of-the-envelope calculation shows the investor losing money. Where is the incentive for the investor in that? If someone gives me a 0% no recourse loan for 99% of the cost of real-estate, I do not have a motive to lose my share by purchasing title to the Brooklyn Bridge.
If you don’t understand the simplest idea of a risk-neutral expected value calculation, there’s not much point in continuing this discussion into things like risk premiums, option value, hedging strategies available to investors to make it a lose-lose for the government, etc.
So the answer is you cannot come up with a winning scenario?
I must assume you didn’t follow my link to self-evident.
Not that the scenario is needed to make this an expected-value fleecing of the taxpayer. Again, I hope you don’t work in the financial sector.
Actually I don’t – I run a profitable business.
Glad to hear.
Self-evident now links. That scenario is at least better than the CDS conspiracy theory, but it depends on some silly assumptions. You don’t need a lot of math to understand Self-evidents thesis it’s a simple amortization strategy.
You bet on N pools using the leverage so that 100% losses on some of them don’t wipe out your gains on the other. The scenario in self-evident depends on both a peculiar distribution (some assets worth 120% of bid price and some worth 0%) and also depends on the kind of idiot probability theory that got the banks into trouble in the first place. Geithner is betting investors will want to actually look at the underlying asset. Self-Evident is describing an investor betting that some probability distribution is reliable over a large set of pools for which the investor will have winning bets at a certain range. If Treasury cannot manage AAA rated assets mid crash to get back a reasonable percentage of purchase price that investors are willing to bet on, it is not capable of running a liquidation anyways.
You have a point in that it’s necessary that there be sufficiently uncorrelated assets available for a hedging strategy to work. A low correlation is not very likely, since they all depend on the state of the economy and on the housing market. But some of the uncertainty is specific to each pool of assets, in particular how crappy the underwriting standards were for each combination of originator/geographic area/time period, so the correlation will not be that high either.
You also have a point that the other possible schemes being described are either of dubious legality or plain illegal. This doesn’t mean they won’t happen, some almost certainly will — the structure of the program almost ensures it.
But you’re still missing the point that the taxpayer is giving away for free put options with an economic value in the hundreds of billions. If you think put options don’t have much economic value, I’d like to buy some from you…
So your objection is that the puts are too sweet. But the original objection was that the structure inflated the values obtained by the banks. The strategy postulated by Self-Evident is weak evidence that such inflation will occur because it seems like an incredibly dangerous bet. If you play with the numbers, the 100s just have to drop to 92 to give the investor a loss. As you note, to determine low correlation one would have to do a detailed analysis of the loan books anyways – which is the point of the process and then if you had that information it would be stupid to overprice the low value assets so you’d drop this hedging strategy, robbing the banks of the supposed inflation of assets.
The argument that the puts are too sweet is very different from the ostensible argument being made by Krugman/Atrios that the valuations will be too high.
If the real objection is that the puts are too sweet, the answer is: i don’t care. The administration buys the consent of the market by allowing them to play vulture with the good assets of the banks at minimal taxpayer expense. Fine by me. Given the alternative of total market panic and higher costs for the government in FDIC forced auction, I don’t see a problem.
The banks will be getting the fair price of the asset plus the price of the puts, minus a risk-premium.
This is the price that the market will discover. If the thing is well-run and the auctions were fully competitive, the investors would only get a fair risk premium over that, and not a penny more. They’ll pay for what they get: an asset and a put option on it.
The thing is attractive to them because the auction will almost certainly be less competitive than about any other market they have available, so they’ll get a nice premium. But this is the least of the problems.
It’s the banks that will be getting the value of the put for free when the sell the assets. That’s the whole point of the program: to give free money to the banks, period.
Paulson tried several times to do it directly, i.e. just give the banks the money and be done with it. Geithner tried to do it before with a minimal disguise. Now he just created a complicated way to confuse (some) people about what he’s doing. This additional layer adds some economic inefficiency relative to just giving the money to the banks (some money will go financial institutions that hold these assets but don’t need the money; and we do need to pay the investors their risk-premium). But the main problem is with the goal of the plan: to give free public money to the banks to prop them up, rather than doing what’s supposed to happen in a free market (insolvency, receivership, restructuring, re-privatization, …)
You take as given that there is a “market” for assets and some rational discoverable fair price. Since “markets” like those depend deeply on both government policy and availability of finance and both are in flux, I don’t see it.
btw – it’s kind of interesting to put self-evident’s assumption in a spread sheet and play with the parameters. If the split is 50/50 good/bad and the good assets drop all the way to 92/100 while the bad assets suffer a 32% drop in value down to 57/100 the Government wins and the investor loses.
You give a great deal of meaning to the term “being full of oneself”.
It’s Tautology Tuesday: The fair price of the asset + the price of the put – the risk premium = free money to the banks.
Comical.
odd to be told by “left” critics of Obama that they knew we are being ripped off because of their mastery of the obscure jargon of the fair market.
Why it is almost as if they were right wing economists.
You also get a chance to participate in the FPFMP (Free Puts For Mike Program): I put 100K on the SP500. If it drops by more than 15% you cover my losses. I’ll pay you $20 to participate. Want to participate? Hey, it’s a free twenty!
The irony of this conversation is that your kind of thinking is exactly what sank AIG and the rest of the financial industry: These CDS contracts have no value in our base scenario, so we can sell lots of them on the cheap and big profit… and big bonus!
I don’t understand your reasoning on this at all. There is no 15% reset.
You put your money down, the government matches it. The rest of the money is on loan and you pay interest on it as well as buying progressively more equity.
If the investment loses value you can’t sell it at a profit but unless it defaults to zero, you haven’t technically lost anything.
You can sell the product for what you paid for it, but if you if profit on the sale you have to share the profits based on relative equity. The government’s equity is based on their original equity investment plus the amount of the loan they own. You have to pay off the outstanding loan and then you share the equity portion of the profits.
There isn’t any situation where a loss of 15% of the value of the traded value results in some automatic loss.
The “left” is angry and, oddly, repeating exactly the same points made against the Democratic President at RedState.
I am not much left of center, but certainly angry. If everyone says you’re wrong (other than self-interested parties with ties to the financial industry and bizarro-world-loyal-bushie types) then you must be right!
No please… profound insights like this need to be formalized numerically.
What a clever and emotionally devastating put-down! I feel so small, you must be a really big, brilliant, and very macho man.
It’s the very simple idea of a non-recourse loan. If the asset is worth less than the amount borrowed, the borrower can just give the asset to the lender and walk away. Same as with mortgages and jingle mail.
First of all, my understanding is that when you put your money down the government multiplies it in the form of a non-recourse “loan.” The scare quotes are there because these aren’t loans in the ordinary sense. Anything that’s not recoverable unless the value of an asset goes up is an investment. A security, if you like. Not a loan though. So what we have is not only not a “matching” loan, but an asymmetrical investment, with the government assuming the greater portion of the risk. That’s the red flag.
Right. Only your profits are heavily leveraged, while the government’s profits are not. In exchange for that asymmetry the government will collect interest from you, for however long you continue to believe that the investment will appreciate. No longer than that. And because your risk is disproportionately low you have an incentive to pay more for the asset than what you actually calculate it to be worth.
Forget about the bailout for a minute and imagine a lottery where the tickets are auctioned off, and each ticket has an equal chance of paying out $0, $50, $100 or $250.
You realize that as long as you don’t pay more than $100 for a ticket, the odds are that you’ll make money in the long run, so you and a friend decide to start a business which bids on these tickets and split the gains based on equity. Because you’re busy and wealthy and your friend is unemployed and poor, your friend provides 7% of the cost of the tickets, and you provide 7%, plus the final 86% in the form of a non-recourse “loan” which your friend pays down until such time as the lottery results are announced. Your friend, being unemployed, is tasked with going to the auction and actually doing the work of placing the bids.
You and your friend deposit money with the auctioneer at a ratio of 93:7, and when the next auction day comes, your friend goes to the auction to buy tickets. Your friend will owe you $86 for every $100 worth of bids placed, but will also have a legitimate and rational incentive to bid above $100 for tickets rather than let them be purchased by other people. Any tickets your friend purchases at a price greater than $100 are a bad bet for the partnership, but a good bet for your friend individually.
Is it really not clear why this is a problem, or why the worth of crap depends on the exposure of the partner who’s doing the bidding rather than on the exposure of all the partners in aggregate?
That doesn’t matter. What matters is that if the asset depreciates, or even fails to appreciate at a rate which the investor requires in order to keep paying down the “loan,” then the investor can just walk away.
So, considering what we got with nationalization (huge cost, no upside) and the people that benefited off of it (hedge-fund managers and former Countrywide executives) how is this deal worse?
Different collateral. Mortgages involve real property, whereas PPIP involves derivatives. It’s the difference between loaning sombody money to buy a racehorse and loaning somebody money to bet on a racehorse. You don’t get the horse if the bet doesn’t pay what you thought it would.
Yeah, we agree that the “trick” being played is to reinflate a currently deflated asset bubble using public monies. Only I think that’s crazy and you apparently don’t. I understand that the point of the exercise is to reinflate the asset bubble, so that the banks — the current owners of the assets — don’t have to mark down the assets, and thereby have their current insolvency revealed. Understanding what Geithner et al are trying to doesn’t mean that I think it’s a good idea.
Well yeah, the nationalization option sucks really bad. But the upside of nationalization, which you seem to be disputing, is that in exchange for huge expenditures of public monies, the toxic derivatives can be cleanly separated from the loans which back them, and thrown away. The nationalized bank(s) can stop lying about the value of the value of their assets and start making semi-rational decisions about risk.
In the current model, the losses are absorbed by the government anyway, but the “toxics” remain in circulation, leaving the bubble — and the uncertainty — in place. Until such time as the valueless derivatives are thrown away/written off, the normal process of price discovery (i.e. the point at which the market clears, real estate prices stabilize, and credit starts flowing again) is delayed. Not accelerated.
derivatives are only part of the shitpile.
Here is what we’re dealing with the PPiP:
Your racehorse? Here it is:
So what? The “legacy loans” are only a problem if they’re genuinely worthless. The derivatives are where all of the uncertainty is! The risk associated with a shitty loan can be estimated by any halfway decent loan officer. If some loan holder — or anybody else who has access to the loan papers — wants to know what the expected value of some shitty loan is, then all they have do is recalulate the value of the loan in the old-fashioned way, using the current market value of the collateral (a known value!) and updated actuarial assumptions about the borrower (another known value!). If you have the papers then “stress testing” the loan is a piece of cake.
What’s not a piece of cake is when you don’t know what other encumbrances exist on some loan that you own a small chunk of, or how much of the revenue from that loan will reach your tranche between now and maturity, or whether the “insurance” policies that you took out against your package of loans will actually pay off if the loans default, or how many of the “insurance” policies tha you sold to other people (in the form of CDSs, backed by your own package of packaged loans) you’ll wind up having to pay out when other loans default, or…
See, I could go on and on with why pricing the derivatives has become hard, but the point is that the uncertainty is because of the derivatives. Not because of the underlying loans. It’s certainly true that a loan holder might not want to recalculate the value of its loans because marking them down to current expected value will cause the holder to be revealed as insolvent, but that’s not the problem right now.
The problem right now is supposedly that the finance sector is paralyzed by uncertainty. Subsidizing the exchange of credit-derived assets just so they’ll circulate may get people to trade those assets, but it doesn’t give people any reason to do anything else. The “market” value of the assets hasn’t been revealed just because they changed hands. The risk has not been examined by people who are motivated to estimate it as accurately as possible.
Both of the parties to each of these subsidized transactions has a structural interest in overvaluing the asset. That maximizes both participants’ shares of the money which is being pumped into the market as a whole.
This creates the illusion of progress but doesn’t actually solve the paralysis, because it doesn’t reduce the risk associated with unsubsidized transactions. Unsubsidized transactions still involve the same uncertainty about “normal” market price as they do now, so as long as banks can continue to engage in subsidized transaction they will do so. All we’re doing is trying to reinflate the bubble. And we may not even succeed in doing that.
Also, when Treasury says something like this:
your first thought should be “Hmm. I wonder whether they’re feeding me some sort of PR line?” Not “Excellent! Now I can argue from authority by quoting this in an online conversation.”
And this:
This part here is undiluted grade AAA bullshit. The reason we have markets in the first place is that in the absence of a normally functioning market you cannot possibly be sure what the normal market price would be! That entire sentence is nonsensically stupid. It’s “not even wrong” as the saying goes.
That last comment was before I ran across this little gem, via NC:
Only it’s not “puzzling” at all. It’s exactly what Geithner is aiming for. I’m not big on “sources say,” but this is exactly the behavior I was predicting above. The Geithner plan is all about subsidizing the mere act of trading these formerly-inflated assets, not about actually clearing the market. So anybody who wants to benefit from that subsidy is motivated to start buying or selling, but when the subsidy money runs out the assets will still be in circulation. We’re basically praying that if we keep the music playing for a while longer there will be enough chairs for everybody when the music finally does stop. But we’re not actually removing any players, or adding any chairs.
I’m deeply suspicious of anything in the post, but I don’t see why this is sinister. If BOA buys assets with face value 100 for 45 instead of 30, they may just be being smart.
It’s no more sinister or irrational than anything else banks do. It’s just that it’s not likely to accomplish the thing that it claims to be trying to accomplish (namely getting the consumer and commercial credit markets unstuck).
What I’m trying to tell you is that the goal of this project is very clearly not the discovery of “natural” market prices for currently distressed assets. You can’t pay people to trade something and expect them to do their buying and selling at the same prices they would if they weren’t getting paid. And if the face value of these securities were the least bit meaningful we wouldn’t have this problem in the first place.
Upthread, you asked for a concrete example of overpaying for distressed assets. Well now you have one from real life.
why is it overpaying? If you take a face value unsupportable $100 loan, but it for $40, cut the mortgage holders debt by 50%, you now have a great deal and the entire economy benefits.
Why is PennyMac making so much money doing this?
First of all, you’re talking about the actual loans, which are a total red herring. The things being overpriced are mortgage-backed securities. The difference is that not only can you not “cut the mortgage holder’s debt” when you purchase an MBS, but in practice you have no fucking idea who the mortgage holders actually are. You probably don’t even know who the loan servicer is.
Let’s say that the maturity value of one of these things is $100, the current resale value is $30, and you pay $40. In real life you can’t possibly know the maturity value because you don’t know what the encumbrances are, but let’s just pretend.
The only rational reason to pay more than the resale value is if you have some private knowledge about the inherent value of the thing being purchased, and based on that knowledge you believe that it is undervalued by potential buyers who do not have the same knowledge or beliefs.
That last part is important. Do Citi and BA have such knowledge and beliefs? Maybe. Maybe they have some special knowledge about the value of the toxics because they’ve been doing their own “stress testing,” or maybe they believe that the US real estate market is on the verge of a startling recovery. Unfortunately both of those theories also predict that they would also increase their loaning activity. And they don’t seem to be doing that.
So maybe they just agree with my interpretation that the PPIP is basically a plan to pay people to trade mortgage-backed securities, and they are trading because they want to get paid.
See
http://www.fanniemae.com/mbs/pdf/hasp.pdf
I think one problem we have in this discussion is that “inherent value” and “natural price” don’t mean anything to me. How much of the current trading value is due to panic conditions on the marketplace and how much is due to actual probabilities of payout? If the market depended on banks providing credit, and the banks are not providing credit, does that mean that the lack of purchasers is due to no value or is it due to no credit?
The only rational reason to pay more than the resale value is if you have some private knowledge about the inherent value of the thing being purchased, and based on that knowledge you believe that it is undervalued by potential buyers who do not have the same knowledge or beliefs.
Or the same capital costs or access to capital?
And the Homeowner Stability and Affordability Plan is no different than the FDIC selling off mortgage debt to third parties who then clean up the book by maximizing the number of non-default loans they’ve just bought. It helps clean up the foreclosure crisis even as it enriches former Countrywide executives that created the problem in the first place. It’s extremely distasteful, but it lowers the default rate which lowers the default rate on MBS’s. That mitigates the free-fall and has the potential to reverse it.
And it isn’t like these things are being done in isolation. Even the Stimulus Plan is part of the effort to stop and reverse the rate of foreclosures.
Maybe they don’t mean anything, period. But I’m not the one who keeps insisting that the market is undervaluing the paper that the Treasury wants to pay people to trade. Saying it’s undervalued invites one to ask: “compared to what?”
No, I don’t think so. Capital costs matter, but modulo inflation (or demurrage 😉 cheap capital doesn’t make people buy assets at above the going rate unless they think the going rate will go up. Or they’re trying to game the market. Or of course when the capital belongs to somebody else.
You are ignoring that the securities are based on the underlying mortgages, no matter how convoluted the details may be.
We have no better indicator of the worth of bundled securities than the value of bundled mortgages.
So, if PennyMac is buying mortgages for .38 cents, lowering principle and/or interest rates on the loans, and making an absolute killing nonetheless, we can assume that the mortgages are worth more than .30/dollar. And if they are worth more, it is quite likely that the securities are worth more. I’d also add that this case involves a bank in Nevada and that is one of the hardest-hit housing markets in the country for foreclosures.
I’m not ignoring it. I’m saying that it’s not good enough and that the devil is in those very details.
We also have no better way of predicting large earthquakes than monitoring tremors. And yet, for some reason, we don’t seem able to predict large earthquakes. Just because there’s a theoretically knowable relationship, that doesn’t mean anybody actually knows it.
Again, this is why we have markets. If the value of the mortgages is a useful indicator then please explain why we are still in this situation. If it’s not uncertainty about the eventual market value of certain widely held assets then what exactly is preventing the banks from lending? Why, exactly, have the “secondary markets have become highly illiquid?”
On what basis? Owning a mortgage gives you an undiluted and probably unencumbered(*) revenue stream, access to the loan papers (unless they’ve got lost somehow, in which case you’d be well advised not to buy the thing), a physical asset for collateral, the option of selling securities and derivatives, and most importantly the ability to renegotiate the contract. Owning a non-derivative MBS gives you access to a (probably heavily) diluted revenue stream, the option of selling part of your revenue stream in the form of securities, and that’s all. Owning a derivative gives you a seat at a poker table with a bunch of people whose solvency is in doubt. Which of those things would you pay 38 cents on the dollar for?
The thing is, simultaneously claiming that some market is “highly illiquid” and also that the items traded in that market are systematically underpriced is basically in Glorious Five Year Plan territory. There are plenty of mysteries in economics, but one thing that we can say with a bit of confidence is that markets which are systematically underpriced will attract liquidity. You don’t have to pump money into them to get people interested. Ferfuckssake this is practically the definition of financial arbitrage. Capital flowing to where the best return is.
* Those loans that the geniuses of
CountrywideBlackRockPNMAC purchased all of three months ago are in fact heavily encumbered, but only by FDIC, and only temporarily. I suspect that the only loans changing hands without government intervention nowadays are those for which any downstream obligations have already been written off.I like your example of large earthquakes because I think it carries a kernel of truth about what happened to us.
But I also don’t like it because I think it doesn’t really follow logically.
What really matters is the state of mortgages and the rate of default. That is the true driver of value for the derivatives. A CDS might trade up on a downturn, the rest will trade up, and vice-versa.
So, we cannot disentangle the two. If you buy a package of mortgages for .40 cents and have money left over to renegotiate, and make a killing, then you can buy the same package for 50 cents or 60 cents, do nothing, and make a smaller killing. And if these mortgages are really worth 70 cents at break even, then there is no question that the securities are worth way over 30 cents.
The more we sell mortgages at a discount and allow them to be rehabilitated, the more rehabilitated the securities will be.
I think there is plenty of evidence that there is money to be made on buying securities at their current prices. And the actions we’re taking should help that situation to improve.
But, part of it depends on the overall housing situation despite all our efforts. If it continues to deteriorate, all these investments could be losers even though we’ve taken these actions to fix the problem.
Well that’s clearly what everybody’s hoping will happen. And I agree that it would be a good thing if the MBS market started to clear.
What I don’t understand is how you think these securities are going to get “rehabilitated” without some people losing a giant fucking shitload of money, in the form of writedowns. We don’t know how much exactly, but we know that it’s a giant fucking shitload. A significant fraction of GDP, over and above what’s already been lost.
The loan writedowns are peanuts. Rounding errors. The current book value of the securities and derivatives is orders of magnitude larger than the loans underneath them, and were based on the assumption that the value of real estate could only ever go up. So we know, beyond a reasonable doubt, that the vast majority of the losses will be the result of security and derivative writedowns, not loan writedowns. There’s a lot of worthless paper outthere (you don’t dispute that, do you?) and whoever owns worthless paper at the time that it becomes clear that it’s worthless will have to eat the cost of the writedown, regardless of what they paid for the paper.
Right now, it’s mostly financial giants who own big shitpile. It is mostly through those giants that the pensions and endowments and sovereign funds are at risk. If the music stops, the giants fail for sure. And the party line is that if the giants fail (or if the government takes them over, or does anything other than keep them afloat in their current form), then the pension funds and endowments and sovereign funds will go down too. I dispute that claim, but that’s a different argument.
So what we’re going to do is pay people umpty billions to buy and sell MBS, and keep the game of musical chairs going, so that different people will be unable to find chairs when the music stops, and those people will have to take the losses. People we don’t care so much about saving.
This does not seem to me like a good plan.
It has merits, sure, particularly if you’re a bank. It might even have the desired effect, and reinflate the bubble long enough for another bubble to come along. I don’t doubt at all that it will get people to start buying and selling MBS. Things could be a whole hell of a lot worse, I know. But it’s based on lies, and I’m a bit fed up with plans that are based on lies. The two biggest lies are that the primary purpose of this plan is to revitalize the commercial and consumer credit markets, and that shitpile is undervalued.
I think you are making a lot of good points especially that the actual loans are a total red herring when it comes to these securities. Owning MBS doesn’t give the holder any power to deal directly with the underlying mortgages. This is a point that seems to be lost (understandibly so, it’s complicated) on many people.
PPIP is a plan to value the MBS – and the only way to do that is to create a market in which they are traded. I agree with you there. My first thought on why Citi and BofA could be buying is this:
Once the trading starts it will affect the balance sheet of every company that holds these because there will now be a market for them. So every bank in the country is now wondering how their balance sheet is going to be affected. Including Citi and BofA.
Banks can’t simply refuse to sell for prices that will destroy their balance sheets (whether or not those prices are actually too low) because there are too many banks for that kind of collusion to be practical and once one sale occurs the deed is done and the non-selling banks have to adjust their financials.
But banks could artificially drive up the price by buying at higher prices and thereby protect their balance sheets while simply continuing to hold worthless MBS. I’d have to think about that some more, but it’s a possibility.
PPIP is a plan to deal with both the securities and the underlying loans. If it weren’t, then these criticisms would have a lot more validity.
How does it deal with the underlying loans – it is only purchasing the securities?
I believe the purchase of actual loans is also subsidized. Which, as BooMan points out, is a good thing, and the only thing that seems vaguely sensible about the plan.
The problem is that even for the folks who buy the loans, buying a bundle of heavily encumbered loans is a profoundly different proposition than buying the same loans unencumbered. It’s much better than buying securities based on those loans (assuming you want to be in the mortgage business), but it’s the sort of thing that you would only want to do if the value of the underlying assets was going up, or if you were being subsidized (or leveraged) to do it, or if you could walk away from the downstream obligations without declaring bankruptcy in case things didn’t work out. The second and third options are, as I understand it, what PPIP is offering people.
Talk about being full of oneself… Tautology? In the immortal words of Inigo Montoya, I don’t think that word means what you think it means.
It’s not rocket science, despite your best effort to impersonate a dimwit. Let’s do the following: I put 100K on the SP500. If it drops by more than 15% you cover my losses. Want to give me that deal for a small fee?
The irony of the inanities your are saying is that it’s exactly that thinking that sank AIG and the rest of the financial industry: These puts (CDSs, etc.) have no value in our base scenario, we can sell lots of them on the cheap, and… Profit!
mihilo, I welcome your participation at this site. I have to make you aware of the commenting policy which is basically that you can’t act disrespectfully to other members. You can disagree and disagree forcefully, but you can’t just dis people or act like a prick.
So, please share your opinions and do so with as much vigor as you can muster, but try to avoid calling people dimwits even if that is your opinion.
Rereading what they first wrote and what I then wrote, and noting that given that you chose to direct this comment at me, I’ll take the clue and politely take my leave of the site.
relax.
I have to warn someone. I’m not picking on you, I’m just stepping in to get you and everyone else to chill out a bit.
I’m pretty relaxed (just doing several things at the same time…)
I was going to leave it at that, but it’s actually worse than I thought.
You recommended a comment that was thrown into the thread by someone who was not part of the discussion and that was more ‘insulting’ than my reply to it (besides being unintentionally comical: if you’re calling someone full of himself for mentioning econ 101 stuff, you probably shouldn’t use big words like tautology if you don’t know what they mean). And after recommending that comment you upbraided my reply to it.
Doesn’t make you look very good, as far as I’m concerned. But, hey, it’s your site. I’ll leave you to it.
All shin-kicking aside, the pertinent issues about the lack of applicability of financial formulas to the real world are raised by Bill Janeway in this interview. Rick Bookstaber is also always worth reading.
Don’t you realize that it is precisely your mindset, with its blind faith in numerical tautologies that lies at the root of the current market debacle?
Well, that was a rhetorical question of course, since clearly you don’t.
great interview
Janeway: They were the pioneers in
China. In Hong Kong, they were kings. Sibley was the public face of Jardine
Fleming. He once said that giving liquidity to bankers is like giving a barrel
of beer to a drunk. You know exactly what is going to happen. You just don’t
know which wall he is going to choose.
I normally follow a strict policy of not criticizing Duncan but he weighed in on this, so…
What I’d like to see from Duncan is some analysis about the AAA-rating requirement and how he thinks that requirement changes things.
There’s no question that he’s right about perverse incentives and their ability to skew prices. What’s not clear is that these formerly AAA-rated products are as shitty as he assumes. And we know they’re better than the total pile.
“We all know that the AAA rating wasn’t worth a damn. But the plan envisions restricting the program to AAA junk, which means that the worst junk is not in play. For that reason alone, we should expect the price to be higher than the .38/dollar PennyMac paid for First Bank of Nevada’s shitpile.”
The worst crap has very low valuation uncertainty, people know it’s worth close to zero. Because of that it has very low option value. It would carry a very small premium under this scheme, and put even more into question the prices being paid for the others securities (which will be their expected value plus the option value throw in for free courtesy of the taxpayer — assuming there’s no other shenanigans going on boosting up the price further, and there likely will be).
Let’s assume that one of these banks is insolvent and is taken over by the FDIC. The FDIC then would then have the duty to sell these assets and get the highest possible prices for them.
I would assume that part what goes into the decision is when to sell them. Wouldn’t they hold them, hoping the economy rebounds? And if that’s the case, isn’t that what these troubled banks are arguing today: that their crap will be worth more in a healhty economy than a bad economy?
As I have repeatedly noted, IndyMac was nationalized last year and it has already been sold.
As part of the sale, the investors agreed to pay-off the first 20% of all new defaults on existing loans while the taxpayer pays off the remaining 80%.
In the case of First National Bank of Nevada which was also nationalized, the toxic assets were sold off at a price of .38/dollar. The people that bought it think it was about the sweetest deal ever and they are renegotiating the loans to keep as many of them as possible from defaulting.
So, those two cases give you a baseline for nationalizing and selling in the short-term. We lost 10.7 billion dollars on IndyMac. It is one/fiftieth the size of Bank of America. So, if we lost the same amount on Bank of America, that would come to $535,000,000,000,000.
” So, if we lost the same amount on Bank of America, that would come to $535,000,000,000,000. “
Are you just extrapolating out the overall sizes of the banks or the size of the holdings in the shitpiles?
I am just multiplying $10.7 billion by fifty.
Wouldn’t that be five hundred and thirty-five billion? Not trillion as you have. You just have three too many zeroes, I think.
if the CRAP is only worth .30 cents on the dollar, then why should WE pay one trillion for it??
AND, if the charlatans (bankers) are saying, “it might be worth more one day”, then WHY do they simply not keep their paper until the value rises?
WHY do they simply not keep their paper until the value rises?
i think they’d love to, but there’s a teeny problem with that, being the next wave of defaults will be a lot bigger, and if they have too many empty houses on their books they get hated even more, and the the whole farce of pretending you have a high market to mark to evaporates, and with it the worth of their mythic ‘assets’, house prices fall even further, (in search of some (equally mythic?) ‘fundamental’, and soon it gets impossible to pretend any more and everyone takes a bath, shave, sauna and haircut. except those who saw it coming and shorted here and put there, meanwhile they just need a leedle help to tide them over till the good times (maybe, some day, some computer models say) reroll…
n-o-o-o problemo.
Three problems:
1.) Not only is the next wave of defaults an issue, the zombie banks are lying about their debt. One can only wonder why The Three Stooges (Timmy, Larry and Bennie) running the Treasury don’t demand an independent audit of these banks so we the taxpayers know the truth.
2.) Because the next wave of defaults is coming, and because the banks are lying about their true debt, the PPIF fund is nothing but a desperate attempt to make these already insolvent banks whole. they will never be in a position to “start loaning again” as per the alleged intent of the PPIF according to Obama and team.
3.) Even if the banks “start loaning again”, now that they are conveniently risk aversive they will not loan to anyone with anything less than a stellar credit rating, and as far as loans to small businesses, interest rates will be so high as to lock
most people out of getting a loan.
so the INTENT of PPIF will end up being bogus; i.e. clearing the balance sheets of the zombies, allowing them to significantly increase their loaning power and get the economy moving. the operative word here being significant.
the only realistic answer is, in terms of getting the economy moving again, is to NATIONALIZE the zombie banks. form 4-5 regional federal banks. loan money to people with decent credit ratings and to small businesses, both at relaxed terms.
excellent summary, superpole.
Booman Tribune ~ Comments ~ The Worth of Crap
are they really going to try and sell us the idae again that they didn’t see it coming, that’s it’s just some random ill wind that’s blowing in from nowhere, and they are are just good folk who happened to get a tiny tad overstretched?
come on… even a brain made of hostess twinkies is going to have to gag on that.
economics seems to make its practitioners tunnel-visioned, to put it mildly. the three stooges’ decisions seem as out of touch with the reality of public perception as you can get.
and if their choices weren’t enough evidence, you have to wonder how they don’t seem aware how they’re gonna get crucified when the next wave hits, and maybe compromise all the good things O-man is trying to do.
and if he throws them under the bus, who are the next candidates for the awesome job of governing the treasury during the Great Depression 2.0?
I think we need to stop picking at Geithner. Presdent Obama has confidence in him, and so do I. I voted for President Obama, and I trust his decisions. I’m one of the people that gave him the right to make these decisions. If he has confidence in Geithner-so do I.