Self-Dealing - Why Didn't Geithner Think Of That?

Ezra Klein, who would rather rail against the Geithner plan than do his homework, recycles a scenario in which an unscrupulous bank sells its own assets at an inflated price to a new private-public investment partnership in which the bank is the levered equity investor.

Self-dealing - why didn't Geithner's team think of that? Oh, wait - they did:

Private Investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF.

If a regulated bank can slide a controlling equity investment into a PPIF and then sell its own assets to that PPIF without the regulators noticing, we deserve the fate that befalls us.

His second example is more interesting:

Or imagine a hedge fund buys a pool of assets for 50 cents on the dollar. They also buy a credit default swap against the pool proving worthless. If the pool jumps in value, they make money. If the pool busts, they walk away from the original loan and collect money on the CDS contract.

I assume his notion is that the hedge fund buys the CDS on behalf of a separate account with the same owners (with the same level of participation) which is not part of the PPIF.  And who is selling the CDS,  anyway?  The seller wants to bear the price risk of toxic waste by means of a CDS rather than through these "subsidized" PPIFs - why?  If they are financially credible, they ought to be able to participate in these PPIFs; if they are not credible, why buy a CDS from them?  Puzzling.

In any case this strategy only pays off when the non-recourse feature of the FDIC loan support is activated, so *if* the FDIC does a good job (or is lucky) on the initial leverage this problem is moot.

And in the application to become approved as an asset manager, I see that:

In addition, the Applicant must describe proposed covenants relating to allocation of investment opportunities, competing funds and investments away from the Fund.

I don't imagine the Treasury can forbid investors in a fund from being aware of what they own and hedging it as they choose outside of the fund but I also think the asset manager could be contractually obliged not to promote and encourage those strategies.

FWIW, taking the trouble to read the tedious details can be helpful.  Lots of links helpfully provided by the Treasury at the bottom of this summary sheet.

Klein's broader point, that Wall Street will be better at gaming this than the Treasury will be at defending themselves, is a truism which applies to nationalizing banks as well.

MORE:  This example is just as unworkable but gets more points for cooler graphics.  The short version - bank bribes asset manager with a "transaction fee" paid to the asset manager rather than the PPIF but no one notices.  In a variation, the bank qualifies as an asset manager and sells its own assets to the PPIF, again without anyone noticing.  Uh huh.

Comments

[Charlie (Colorado)]

Here's a comment that could be put on a macro key about this whole thing:

who would rather rail against ${topicname} than do his homework

Here's another one:

FWIW, taking the trouble to read the tedious details can be helpful.

It's a little frightening how painful most people apparently find actual thinking.

[Fresh Air]

Or imagine a hedge fund buys a pool of assets for 50 cents on the dollar. They also buy a credit default swap against the pool proving worthless. If the pool jumps in value, they make money. If the pool busts, they walk away from the original loan and collect money on the CDS contract.

(a) Who will sell them this CDS?
(b) The cost of a CDS like this, even if it were available, would probably be so high as to make the investment barely profitable.

[GMax]

My guess the cost of the insurance will only ensure that no profit can be had on this transaction. Thus no one will buy such CDS like insurance.

[memomachine]

Hmmmm.

"(a) Who will sell them this CDS?"

AIG

"(b) The cost of a CDS like this, even if it were available, would probably be so high as to make the investment barely profitable."

See above.

[Jack is Back!]

When Berkshire Hathaway announces it will participate, then and only then, will I give it a 50/50 chance. This will mean that there is "value" there and Buffet will pull in the others. Blackstone (Pete Peterson) has already announced it is interested in PPIF. The only risk here is (as Reagan noted) "when you go to bed with the Federal government, you get more than a good night's sleep".

[Charlie (Colorado)]

My guess the cost of the insurance will only ensure that no profit can be had on this transaction. Thus no one will buy such CDS like insurance.

Exactly right, I think. This is much like buying a life insurance policy for a sickly 100 year old man. The premium will be very close to the face value of the insurance plus a carrying fee and profit.

[Fresh Air]

Jack--

Just because Blackstone said it's interested doesn't mean it will either (a) participate or (b) participate in a meaningful way. Preliminary indications of interest are a very far piece from a circled transaction.

[clarice]

Damn it all, Chaco, Mr PUK and I were seeing yachts dancing before our eyes.

[Charlie (Colorado)]

Damn it all, Chaco, Mr PUK and I were seeing yachts dancing before our eyes.

Might still be a worthwhile market in Obama credibility default swaps.

[steve sturm]

Figure this is as good as any of TM's posts to ask these questions:

Unless I'm missing something, presumably the offering price for these toxic securities will have to be higher than the current 'market' price, otherwise the bank could simply sell at the market price. In addition, the hundreds of billions of mostly taxpayer money flooding in would also put upwards pressure on the offering price. And finally, banks have pretty much weathered the storm, having written off billions and taking the hit to capital, so they would presumably be resistant to sell for less than they think these assets are ultimately going to be worth (or less than the present value of their expected cash flow).

So there will be upwards pressure on the 'market' price for these assets. But once that happens, wouldn't banks get to mark up the value of their portfolio to reflect the 'gain' they've just realized by virtue of the new higher price?

And wouldn't this gain further reduce pressure on the bank to sell what they have left, and it would also restore some amount of previously depleted capital and let the bank become even stingier in selling assets for less than they think they're ultimately going to be worth?

And wouldn't all of this result in these new pools chasing buyers and possibly paying far more than the assets are ultimately going to be worth, thus saddling the taxpayer with losses that we wouldn't otherwise have incurred?

(And sorry if this has been asked and answered elsewhere).

[Fresh Air]

Steve--

Presumably the price would be tempered by the "pros" involved, who will decide what the assets are worth, in effect. However there is an important wrinkle: If the Fed can dictate the amount of leverage, it will in effect be able to control the effective maximum and minimum returns to investors. This will give it extraordinary price-setting powers.

As far as the balance sheet values, many of the individual mortgages are worth dramatically more than their current book value. I'm guessing the book values carried currently are probably as low as the banks can allow to them to fall within the range of reasonableness. In other words, asset valuations always have two poles between which they can fall, and being at the low end is probably optimal here. It doesn't mean that's actually what the loans would fetch if put up for auction. More of a SWAG in most cases.

[bad]

Pardon my ignorance (again) but couldn't we have achieved the same thing more quickly and cheaply by suspending mark-to-market on these selected toxic assets?

[ben]

Why liberals hate the plan...

http://www.usnews.com/blogs/capital-commerce/2009/3/24/why-liberals-hate-the-geithner-bank-plan.html

Evidently liberals hate it because it's not outright nationalization. I guess that's the only good thing that can be said about it. None of the liberals, of course, care that it is a waste of taxpayer's money and a huge power grab by the government under the guise "of saving the banks". I think the liberals have won the day in a manner similar to how Reagan won the day by shifting the argument away from big government so much that the discussion was about "how small government should be". Now we are on liberal turf, everyone accepting bigger government, just arguing how big. It's an unfortunate and unwelcome shift.

[MayBee]

What got all these liberals and liberal blogs all hopped up on the idea of bank nationalization?

A year ago, we never heard about it. Now it's the only thing they long for. There must be one force pushing it. Does the SEIU want to unionize bank employees or something?

[bad]

Maybee, did you notice the lack of libs submitting questions at Tapper?

I thought surely some would question FISA and/or Bagram.

[GMax]

Look a lot of the announced 500 B will go for formerly AAA residential securities. And everything else will be current AAA rated CMBS. They are not going to take much of a bath here.

This program does not deal with anything toxic at all. They are still dealing with everything at the very tip of the debt stack.

But it will be a small but significant accomplishment if they do bring in $35 Billion of private money ( leverage 6 to 1 and then 50/50 on equity).

But dont be confused that this is the so called toxic assets. Not EVEN close.

[MayBee]

I did notice that, bad. I wonder what that means.

[Pofarmer]

But dont be confused that this is the so called toxic assets. Not EVEN close.

Then that means there's Trillions more hiding in the wings.

[GMax]

Quite frankly, this amounts to robbery of the American people," Columbia University's Nobel Prize-winning economist Joseph Stiglitz told Reuters.

Anybody know anything about Stiglitz? He does not seem to care much for Geithner plan now does he?

[Pofarmer]

Apparently, some other CEO and etc have taken pay cuts untill their companies are performing better.

From Google news
Ford CEO's compensation cut by more than a third in 2008

http://www.marketwatch.com/news/story/ford-ceos-compensation-cut-more/story.aspx?guid=%7B25AD0E18-7740-45AC-A2BE-A3B13BAF6D88%7D&dist=msr_2

[Pofarmer]

Then you have this

Goldman Sachs Said to Be in Talks to Repay TARP Funds (Update2)

I wonder, will that include the 20 billion they got as a counterparty payoff through AIG?????

LUN

[Fresh Air]

I saw Stiglitz give a speech once. He's as intellectually dishonest as the day is long. He tried to argue that cutting the capital gains rate increased market volatility. The man's a leftwing tool.

[MayBee]

http://www.marketwatch.com/news/story/ford-ceos-compensation-cut-more/story.aspx?guid=%7B25AD0E18-7740-45AC-A2BE-A3B13BAF6D88%7D&dist=msr_2

Imagine that.

[Charlie (Colorado)]

I wonder, will that include the 20 billion they got as a counterparty payoff through AIG?????

No, and it probably won't include what AIG paid Con Ed for electricity either.

What is so hard about this? The people AIG paid with the money are the ones AIG owed the money. A lot of those were people who were counterparties on financial transactions. Why? Because they were the counterparties on the financial transactions. Thus they were the ones AIG couldn't afford to pay. The fact that AIG couldn't pay the counterparties is why they needed a bailout. Once they got the bailout, they could pay the people who were owed money. Those would be the counterparties to the transactions. Who are the ones owed the money. That's why they're the counterparties.

For Gods' sakes, just think about it for a second. If you can't pay your power bill, and your Mom gives you $100 to pay the power bill, do you then keep the $100 and still not pay the power bill? No. Even though the power company is the counterparty to that financial transaction. because "counterparty" is a generalized word for "the other side of the transaction."

[GMax]

"We're doing a lot to brief Congress," Bair said. "We want to make sure Congress is completely comfortable with this program."

Boy if you were an investor about to sink some money into a partnership with the Govt, wouldn't FDIC Chairman Sheila Bair's words above just make you feel just warm all over!

[Pofarmer]

No, and it probably won't include what AIG paid Con Ed for electricity either.

What is so hard about this? The people AIG paid with the money are the ones AIG owed the money

Because GS also got bailout money DIRECTLY.

So, if AIG payed them with their bailout funds did they need how many other bailout funds they received? If they are now clamoring to give them back, I'd say probably not.

We were played, folks. Wink, Wink, nod, nod, shovel money.

[PeterUK]

More appreciation for your Dear Leader. At this rate you would be better swapping for Kim Il whatsisface.

[Ignatz Ratzkywatzky]

So, if AIG payed them with their bailout funds did they need how many other bailout funds they received? If they are now clamoring to give them back, I'd say probably not.

If I'm not mistaken Po, GS like WF and others didn't want the TARP money to begin with. They were compelled to take it, ostensibly and ridiculously as Treasury said, so they wouldn't be stigmatized, when of course it was the ones who did willingly take the funds who were quite properly stigmatized.

[Fresh Air]

GS didn't GET bailout money. They borrowed TARP funds they didn't want or need. If what I've read is correct, they are about to give it back.

[mel]

FA-

No, they took money under the TARP when they converted to a bank holding company. Sold some of them purty preferred shares, not the one's Warren bought with the 10% coupon. They are negotiating the terms to repay the TARP money, because it comes with a holding period attached to it. The Government must accede to accepting the money back early. This is known in Chicago circles as, you are now my, at will, punching bag for the next three years. Sign here.

Oh and they needed the cash without a doubt.

[bad]

Mel, what do you know about Frank Brosens, currently at Fannie Mae and the proposed new head of TARP?

[bad]

OH CARP!! Frank Brosens is withdrawing his name and Herb Allison of Fannie Mae is taking his place to be head of TARP.

[mel]

bad-

under ordinary circumstances, when you go to the hardware store and buy a tarp, what would you use it for?

[bad]

To cover up something. LOL

[mel]

and in a financial sense, what would you use one for?

[Jim Ryan]

to abscond with your booty with it slung over your back.

[jimmyk]

couldn't we have achieved the same thing more cheaply and quickly by suspending mark-to-market

That was my thinking too, though it depends on whether banks are not selling because they would have to mark down other assets, or because they actually think the stuff is worth more than the market price.

[bad]

To protect something from undesirable yuck, like weather, paint, dirt, etc.

[Stephanie]

They are not selling because the SAD officers are not willing to part with perfectly good investments. Many bank's REO and SAD divisions are quietly racking up a pretty impressive portfolio of holdings that they plan on... holding. If you could acquire an asset with a LTV of 30% - after BASEL markdowns, what would you do???

[RichatUF]

jimmyk-

The "mark-to-market" regime is in a holding pattern because of the change from Basal 1 to Basal 2 of holding company reporting of Tier 1 capital. The european banks used AIG to skirt the international treaty. Instead of having capital reserves on their book of business they had a pile of AIG credit default swaps for the reference entities which cost consideribly less than reserves. My reading of "mark to market" is that the OCC has to have a comment period under Basal 2, then FASB, then the SEC.

I only caught a bit of Obama's presser on the radio and hard to believe that his radio delievery is worse.

I didn't get his comment that the dollar was "extraordinarily strong" (not that he'd trash the dollar, but the dollar has been in a bear market for years and no where near its previous strength during the 1990's).

Also, what's his thing with homeless veterans (homeless at a greater rate than the population as a whole?) and some recently released study finding that "2% of children" are homeless (that would be something like 1.5 million kids-it must be science). Ridiculous.

[mel]

bad-

prying eyes.

Stephanie-

The contre-temps to that is that when you have to mark your assets to market NOW, and establish proper capital to remain a BHC (bank holding Co.), what does it matter what you think WILL happen down the road when all your cash has gone towards defending your capital requirements, under Basel II (it was named after the city they negotiated them in, the 2nd time). The forced participation in TARP I & II shielded the weak institutions under the dilution of the "non-players" participation. It brought the weak and strong under scrutiny, some fairly, some not so much. The hedge funds had lost a major asset class that paid double digits (alt-ABS') they needed to recoup the loss of capital due to the mark down, and head of the coming redemption wave. So they sold the other holders of this stuff short, and rode each other's valuations to the basement.

So here we sit, waiting for anybody to put a bid up because, unless it's government backed, the hedge funds with cash left, and no scruples, are going to hit that bid hard, and run it through them, looking for another quick free money trade.

That's why nothing's trading in this stuff, the institutions can't compete, without a gov't prop, against the speedy cash of the hedge funds. They KNOW they'll get smeared by these guys and just cement down losses they are trying desperately to avoid marking down.

Just my 2 cents.

[bad]

prying eyes.

Geez Mel, I didn't know there'd be math...

[RichatUF]

GMax-

Anybody know anything about Stiglitz?

He wrote a book, widely quoted and circulated by the "antiwar" movement, "The Three Trillion Dollar War". He was ridiculous then too. FWIW.

And another thing about the Obama's presser. He is claiming that by changing the procurment system he'll save $40 billion and that by moving the Iraq War expenses to a Pentagon line item he is "showing the true cost" of the war.

Isn't the latter backwards? The true cost of the war can be seen if it is funded by supplementals and its hidden when it is line items in the Pentagon budget.

Anyway-I'm not sure how reducing "inefficiency and waste" in the procurement system (especially with politically engineered systems like the F22 or V22) is going to "save" $40 billion. Get ready for another round of defense cuts.

[mel]

Easy, Rich.

Close the Department.

[RichatUF]

mel-

I could see Obama trying. Maybe a Department of Peace with a hanger full of unicorns and rainbows.

One more thing, then I'll just look up a transcript and yell at the cats. He said that we have to "change the status quo" in the Israel-Palestinian issue and then went on to repeat the 2 state solution status quo. I'm not really stunned he would be sympathetic to Palestinian terrorists but I'm sure he knows what "status quo" means.

And I did misspell Basel-darn it.

[Charlie (Colorado)]

Because GS also got bailout money DIRECTLY.

If you and I both work for Con Ed, and I owe you $5, do I not have to pay the $5? After all, you're already getting paid by Con Ed.

C'mon, Po, explain it to me. What did you think AIG was going to do with the bailout money, if not pay it to their creditors?

[RichatUF]

And it seems I was on point: Drudge has it flagged up that the Pentagon is going to drop "Global War on Terror" and adopt "Overseas Contingency Operation".

I suppose changing it to "In Which Pooh Goes Visiting and Gets Into a Tight Place" and airdrops of honey would have been to great a change.

[Stephanie]

Mel, I'm knee deep in Basel II at work. But the $$ in the SAD and REO departments are up almost 500% since the summer in the attribute marked "Hold." Curious, no?

[Pofarmer]

and some recently released study finding that "2% of children" are homeless (that would be something like 1.5 million kids-it must be science). Ridiculous.

I think I saw something that said that people living with a parent or other relative were considered "homeless." This is the same way that they consider folks on medicare and medicaid "without insurance".

Because GS also got bailout money DIRECTLY.

If you and I both work for Con Ed, and I owe you $5, do I not have to pay the $5? After all, you're already getting paid by Con Ed.

C'mon, Po, explain it to me. What did you think AIG was going to do with the bailout money, if not pay it to their creditors?

No matter how they got paid it, it was still bailout money. I've been involved with a couple, uhmmm, actual bankruptcies, the lawyers will try to claw stuff like that waaayyyyy back. If they wanna pay it back, it should ALL go back.

[RichatUF]

Pofarmer-

Not with the cds contract-AIG FP had to disentangle those *which was not a material default*. If AIG defaulted on some, they would have defaulted on all of them, which is the "systemic risk" test that the Fed used to shovel money into the place before TARP. If they would have defaulted on them it would have caused a capital crisis at all of AIG's counterparties-the companies and states that have gotten money over the last 2 quarters.

[Pofarmer]

Can somebody help me out here?

With the amount of money currently proposed, what % of these "troubled assets" is this plain going to buy?

[Pofarmer]

Thanks Rich.

I guess the thing that concerns me, is that when you start shoveling money to the parties, and the counterparties of those parties, and the parties start paying counterparties you A) Don't know where the money is going to go and B) Can't quantify what the final number is going to be because you don't know when parties are going to be made "whole enough" to continue on.

[rhodeymark]

Charlie - your examples all concern legitimate counterparties, yet anyone could buy a swap without having an interest in the underlying asset, no? It's the only way the derivatives could have exploded exponentially.

[rhodeymark]

Re: Stiglitz, wasn't it the AEI who uncovered evidence that he was commissioned by the FMs to produce a favorable risk report in 2002?