Coincidence? I Wonder...

Paul Krugman:

I’m working at home today, waiting for the Fios guy. Which means that I’m probably going to drop off the face of the earth for much of today.

And the Dow is up 497 points:

Treasury Secretary Timothy Geithner – who hasn’t had many winning days in his short tenure on Pennsylvania Avenue – scored a big political victory Monday, as Wall Street traders breathed new life into his career with a stock market rally of nearly 500 points...

Fun's fun, and yes, maybe its time Paul spent quality time with a pool guy, or a lawn service technician, or a boiler serviceman, or the dentist, or all of the above.  But meanwhile the Fios guy is delaying Krugman's inevitable climbdown on the Geithner plan, which should make for the blogging equivalent of Must-See TV.

Paul Krugman spent the weekend denouncing the Geithner bailout plan, details of which were leaked to the NY Times.  His central objection - the leaked plan offered generous subsidized, highly leveraged non-recourse loans to investors, who would therefore have an economic incentive to overpay for the assets. For example:

Leave on one side the question of whether the Geither plan is a good idea or not. One thing is clearly false in the way it’s being presented: administration officials keep saying that there’s no subsidy involved, that investors would share in the downside. That’s just wrong. Why? Because of the non-recourse loans, which reportedly will finance 85 percent of the asset purchases.

Or here:

Brad gives it the old college try [in defending Geithner's plan].  But he shies away, I think, from the central issue: the non-recourse loans financing 85 percent of the purchases.

Well, as they nearly said in Animal House, he messed up - he trusted 'em.  The details of the plan have been released and the Times was, hmm, ahead of the curve with their 85% solution.

The plan has two parts of immediate concern.  The Legacy Securities program will attempt to revive the market for securities backed by residential and commercial mortgages, which is now famous as toxic waste.  The allowed leverage?  No, not 85%; actually, its 33% but the Treasury will make exceptions and sometimes go all the way up to 50%.

The related Legacy Loans plan tackles bank loans that have not been securitized.  Here, the maximum allowable leverage will be 85%, subject to asset type and quality:

Leverage will be determined on a pool-by-pool basis at the FDIC’s sole discretion, with input from the Third Party Valuation Firm. It is anticipated that the debt to equity ratio will not exceed 6 to 1 for each PPIF.

It is not clear just what a "legacy loan" is, other than it is "troubled and illiquid".  They provide an example based on residential mortgages and do say this when explaining the genesis of the banking problem in the introduction:

One major reason is the problem of "legacy assets" – both real estate loans held directly on the books of banks ("legacy loans") and securities backed by loan portfolios ("legacy securities").

OK - some non-securitized real estate related loans may be levered up to 6-1 at the discretion of the FDIC.  Here's hoping they know what they are doing.

LEARN FROM EXAMPLE:  Krugman provided a helpful example illustrating the value of the non-recourse subsidy but we will want to rework it armed with new information about the plan:

Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100.

But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset?

The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.

Fine, but suppose that the initial leverage is 33%, as with Legacy Securities, and the investor has to put up 67% of the purchase price.  The "correct" initial price is now $100.  The investor borrows $33 and puts up $67 of equity.  If the security plunges to $50, the investor loses $50, retains $17, and pays off the loan.  Conversely, if the assets soars to $150 the investor pays of the $33 loan and retains $127, for a profit of $50 above the initial $67 investment.

In fact, if the initial leverage is 50% the "correct" bid is still $100. 

That is a helpful example from Krugman illustrating that if the lender makes a sensible allowance for asset volatility the non-recourse feature is relatively valueless.  Krugman also lauds a similar example in which a "pool" of residential mortgages can be worth either zero or par.  Uh, zero?  No recovery on the real estate whatsoever?  What happened - was every house in the pool located over a literal toxic waste dump?  Or did the land burn down with the house?  And yet (by assumption) the FDIC cannot make these assessments in advance?  Not a helpful example in the context of real estate and limited leverage.

IF HE'S LOST THE JOURNOLIST: Paul Krugman has been pounding the table in favor of nationalizing problem banks as per the Swedish model. Since Sweden, population 9 million, successfully nationalized two banks on the periphery of global finance of whom no one has ever heard, Krugman is confident that the same US Congress which has shown such subtlety and restraint in overseeing AIG is ready to run Citigroup, Bank of America, and a few troubled regional banks as well.

Ezra Klein has some pushback.  My fave bit could be subtitled "Live Free or Die Hard" - Admin officials wonder what might happen if a zombie bank refused to go gentle into that good night:

Ben Bernanke does not appear to think the administration has the legal authority to forcibly take investment banks into receivership. What happens if a legal challenge disrupts the process?

Virtually no one thinks that Congress is willing to quickly offer either the legislation authorizing such an action nor the massive upfront money that receivership would require. Will Ben nelson and George Voinovich vote to take control of the banks? And what happens to the market while Congress is debating? And to Congress if the market dives?

No one knows if the Treasury Department has the technical capacity or simple competence to swiftly assume control of much of the United States banking sector. If Treasury seems unable to simply build out a banking plan and claw back bonuses, what makes anyone think they can run the banking sector?

No one knows how bad the downside is if you botch receivership, or if receivership doesn't work. It is easier to abstractly argue the virtues of successful nationalization than contemplate the consequences of unsuccessful nationalization. As such, it should be the absolute last resort.

Maybe we can apply a "Heal Thyself" rule - Treasury can hold off nationalizing and re-staffing anyone until they demonstrate an ability to staff their own senior positions.  Two weeks ago Obama and Geithner had not filled any of seventeen top spots.  However, three names were announced today, still pending Senate confirmation.

Comments

[Toby Petzold]

Who came up with this "legacy assets" term, anyway? It sounds like a euphemism intended to remind people that Obamachrist is just this terribly put-upon soul who inherited all these problems from Bushitler.

But his man Geithner is not new to this stuff. In fact, Mr. Indispensability was the head of the NY Federal Reserve when they gave AIG its first giant infusion of cash last year.

Why do any of these clown-asses have jobs today?

[MayBee]

Summers unloads on Krugman.

[mockmook]

I hope they don't know what they're doing--at least then there is only a 50% chance what they do hurts the economy.

[torabora]

The latest is Sen Dodd's wife was a director of an AIG subsidiary company.

These people are dirty.

All of 'em.

They make the Bushco folks look tame.

[bad]

torabora, do you have a link?

[Stephanie]

Got your LUN... it's even worse than advertised. It's an offshore (demspeak: tax evading) division of AIG...

LUN

[TCO]

You RINO maggots make me sick. Let the zombies die. You jerks have taken a finance based correction and infected the entire economy now. Hope you like taking red state money to pay for millionaire Democrat voting Manhattenites. Fuckers. Communists. Idiots.

[bad]

Thanks Stephanie.

TCO, take your meds.

[Jack Yerkes]

I got a question? How will they value the assets in question with a real estate appraisal or some model of cash flow?