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March 23, 2009

Economist's View - 9 new articles

"Which Plan is Best?" Follow-Up: Who Can At Least Tolerate the Geithner Plan?

James Surowiecki reacts to the post "Which Plan is Best?":

Who Can At Least Tolerate the Geithner Plan?, by James Surowiecki: Most of what's been written about Tim Geithner's plan ... has been, unsurprisingly, negative, since Geithner's plan does not involve the preferred solution of most bloggers and pundits: nationalizing the banks. But there are some interesting exceptions. The most useful post in terms of understanding the thinking behind the plan is Brad DeLong's FAQ. ... And Mark Thoma of Economist's View, who is actually an advocate of nationalization, has nonetheless written two excellent posts explaining why there are problems in the market for toxic assets and why the Geithner plan, while not ideal, could work in solving them.

Thoma's conclusion to his second post, which comes after his analysis of three options for dealing with the banking system (the original Paulson plan, nationalization, and now the Geithner plan) is especially interesting:

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none—to me—is so off the mark that I am filled with despair because we are following a particular course of action…

So I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid-course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

I'm biased in this regard, obviously, because I think the costs of nationalization likely outweigh the benefits, and that in any case it would be very difficult for Obama to get Congress to authorize the trillion dollars or more the government would need to take over America's biggest banks. And I agree with Thoma that the Geithner plan could work. But what I like best about his conclusion is something else: his implicit recognition that the people who came up with this plan — Geithner, Larry Summers, and Ben Bernanke — are well-versed in the problems of the banking system and serious about trying to solve them, rather than being either oblivious or corrupt. Much of the discourse around the Geithner plan, and around the nationalization debate more generally, seems to assume that Obama's economic policymakers don't understand the gravity of the situation or the virtues of nationalization, or else it assumes that they don't really care about improving the real economy. I'd be very surprised if either of those things was true. The Geithner plan may be a mistake. But if it turns out to be a mistake, it'll be one because Geithner and Bernanke made an incorrect evaluation on how much the banks' toxic assets are really worth, and/or because they overestimated how expensive and arduous nationalizing a big bank would be. It won't be because they didn't understand the problem.

"Which Plan is Best?" Follow-Up: Some Positive Comments on the Geithner Toxic Plan

Calculated Risk on "Which Plan is Best?":

Some Positive Comments on the Geithner Toxic Plan: From Mark Thoma at Economist's View: Which Bailout Plan is Best?

... I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear. ... I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

I tend to agree with Mark on this. The Geithner plan is suboptimal, but it is probably the best we can get in the current environment. I'd add a caveat: this plan is easy for the banks to game or arb - and if a bank is caught gaming this plan, the AIG bonus flap will seem like a light Summer breeze.

From Matt Padilla: Economists mostly bullish on $500 billion toxic asset plan

An excerpt:

"My gut reaction is that this is an excellent plan. This plan will go a long way toward getting banks in better position to lend more aggressively and break the deleveraging feedback loop that is now in place." Scott Anderson, senior economist, Wells Fargo

I think this is a myth that banks will lend "more aggressively" once the toxic assets are off their balance sheets. To whom? Perhaps Anderson is making the moral hazard argument here - maybe he is saying since the banks (and their investors) are being bailed out with above market prices for toxic assets that they will once again engage in risky lending. I hope that isn't his argument. The key problem with the Geithner plan is that it incentivizes investors to pay more than market value for toxic assets by providing a non-recourse loan and with below market interest rates. (See Krugman on the price impact of a non-recourse loan). The investors do not receive this incentive, the banks do. And the taxpayers pay it, so this is a transfer of wealth from taxpayers to the shareholders of the banks. This can be thought of as a European style put option - it can only be exercised at expiration. The taxpayers will pay the price of the option in the future, the investors receive any future benefit, and the banks receive the current value of the option in cash. Geithner apparently believes the future value will be zero, and that is a possibility. If so, this is a great plan - if not, the taxpayers will pay that future value (and it could be significant). Still I agree with Mark Thoma:

[T]his is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

Oh well, Paul Kedrosky quotes T. Boone Pickens today:

My dad said a fool with a plan can beat a genius with no plan.

"Toxic Car" Follow-Up: The Role of Regulatory Capture and Incentives

Sachi Mukherjee follows up on the toxic car analogy:

On toxic cars, by The Compulsive Theorist: Mark Thoma comes up with a terrific analogy for the issues around "toxic" assets held by financial institutions. Among other things, he gives a particularly clear explanation of the Paulson, Geithner and "Swedish" plans for dealing with these assets. Thoma concludes with the important point that even if a government intervention loses the taxpayer money on the toxic assets themselves, it may still in a broader sense be a good strategy, once we account in our risk function for the high probability of very severe economic disruption absent any intervention. Suppose we agree, on these grounds, that some intervention is better than no intervention, even if it loses the taxpayer money in the narrow sense of a book loss on the toxic assets. The question then shifts to which of the plans on offer is best (or least bad)?

In terms of the short-term book loss to the taxpayer, I doubt there will be a huge difference between the plans. As a Deutsche Bank economist memorably put it: "Ultimately, the taxpayer will pay one way or another". This is surely true. I don't want to trivialize such differences as there may be - this may still add up to a huge amount, which could literally have been spent saving lives - but only to emphasize that this is unlikely to be large relative to the costs of inaction for the broader economy.

Why then should we care about precisely how taxpayers end up picking up the tab? To my mind it is crucial here to recognize two things about the present crisis. First, the very fact that so many of the assets held by banks are toxic in the first place has much to do with the behaviour of agents within the financial sector and the regulatory environment and business and cultural norms within which they operate. Second, the entire game is iterated: whatever we do now will provide the backdrop for further rounds of play. Going back to the beginning of the Thoma analogy:

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine.

Now imagine something further (and I realize I'm stretching the analogy a little): what if the engine troubles that some of the cars will experience were caused by employees in the dealership swapping out good engine parts for bad ones? Or if all the while they had been currying favour with the local authorities and pushing for a relaxation of the town's laws prohibiting such activities? Or even that they were using op-ed pieces in the local newspaper to argue that this new way of selling cars was fundamentally better, and that the old-fashioned car dealer in the next town who suggested otherwise was an old fogey? And that the local dealer whose firm is now in such trouble that it is threatening the very social and economic fabric of the town continues to live in the biggest mansion and drive the fanciest car in town (and opines in the local paper that everything's fine)? If this were the broader context within which the townspeople had to decide on a rescue plan for the dealership, I suspect many would lean towards some version of the "Saab" plan (i.e. Swedish plan or variant thereof) so as to mitigate the chance of another batch of exploding cars appearing on the streets of the town in the near future. The key point I want to emphasize is this. Once we recognize the role of incentives and regulatory capture in the crisis, and the fact that once the immediate problems are dealt with the game will start again, this gives us another element to include in the objective function through which we evaluate competing policy proposals. What do such proposals do to incentives going forward? What do they say to players preparing to take part in the next round of the game? The magnitude of the economic fallout from inaction would almost certainly dwarf book losses taxpayers suffer on toxic assets. So it's vital we take action. But the magnitude of future losses from the wrong action, might dwarf even the current crisis. So it's also important we get intervention right.

"Toxic Car" Follow-Up: Pricing Toxic Assets

Sandro Brusco at noiseFromAmeriKa, a blog with other Italian economists Alberto Bisin, Michele Boldrin, Gianluca Clementi, Andrea Moro and Giorgio Topa, sent this to me in response to the post on toxic cars. One of the key problems in the example, and in the toxic asset problem more generally, is finding the right price for the assets when there is no market for them. Sandro uses an example similar to the "toxic car" example to show how mechanism design theory can be applied to the problem of evaluating toxic assets:

Mechanism Desing and the Bailout: Introduction Since the explosion of the banking crisis we have seen many analyses and many proposals for solution; hardly a day seems to pass by without the appearance of a new plan to save the banks. So, you may ask, why do we need plan n+1? Well, I am not going to propose a full-fledged plan. Rather, I would like to make a partial proposal related to one aspect of the problem, the evaluation of the so-called ''toxic assets''. The theoretical underpinnings of many of the existing proposals are often quite opaque: I would like to do the opposite, so I will try to explain in some detail the theoretical basis of my proposal.

To clarify, there seem to be two big and somewhat separate problems we have to deal with. The first is what we can call ''the mispricing problem'', or maybe more accurately ''the lack of pricing'' problem. It refers to the fact that an hefty amount of the assets currently in the portfolios of the banks is, at the moment, very difficult to price. The second is what we can call the ''how to deal with bankrupt banks'' problem or, to be more technical, ''how to avoid deadweight losses from bankruptcies in the banking sector'' problem. In many proposals the two aspects have been conflated, but I believe that they should be considered separately. More than that, there is a hierarchical order in which we should proceed. The ''mispricing problem'' has to be taken care of before we start reasoning about the efficient way to reorganize bankrupt banks, for the somewhat trivial reason that unless we put a sensible and credible value on the banks' assets it is impossible to say who is actually insolvent and who is not. The point has been made very well by Larry Ausubel and Pete Cramton, so it doesn't need to be repeated here.

I will concentrate my attention on the mispricing problem, but before I go there I want to make a point about the bankruptcy problem which is frequently overlooked. In every bankruptcy there are two issues: who gets the assets and how to avoid deadweight losses. There have been many calls to inject public funds in insolvent banks, through ''nationalization'' or whatever is the politically acceptable name of the process. Even if this implies reducing to zero the value for current shareholders (and it is not clear, in many proposals, that this would be the case), in many cases the idea is to help the creditors of the failing institutions (I'm referring to creditors other than depositors, who are covered by FDIC insurance). This is the way, for example, in which the billions given to AIG have been used. Helping the creditors of failing banks, or insurance companies, should not be per se a goal of public policy. If it is believed that some disastrous systemic effects would follow if such creditors end up losing their money then it is the duty of the policy maker to provide clear evidence of the existence of such effects. Not only that, creditors should be helped only to the minimum extent necessary to prevent such systemic effects. Policy proposals in this area should concentrate on eliminating deadweight losses, i.e. making sure that the assets of bankrupt banks are put back to work as soon as possible, not on saving the creditors.

Private vs. public information.

The mispricing problem originates in the many Mortgage Backed Assets that the banks have in their balance sheets and, at the moment, are very hard to price. What is creating problems is the uncertainty on the size of the losses these assets will face. It is important, however, to understand exactly what is the type of uncertainty that creates problems. At least from the theoretical point of view, uncertainty which is symmetric, meaning that there is no single party who has better information, does not create special problems. It is surely true, for example, that in the last year the expected payoffs of many mortgages have decreased. This reflects, on the one hand, the increased probability that borrowers will be unable to meet their obligations and, on the other hand, the decrease in value of collateral, due to the decrease in the price of houses. But, at least in the case of symmetric information, this merely implies that the price of the assets goes down. Risky assets will find their equilibrium price in the capital markets, prices which reflect their expected payments, their risk and the risk aversion of investors. Given the decrease of the expected payoffs, prices have to fall. It is also probably true that the payments on many mortgage backed assets have become riskier and that investors have become more risk averse. These two additional factors have contributed to the loss of value of the MBAs. But, again, these losses reflect true changes in fundamental factors, preferences and probability of repayment, and there is really no reason to believe that they cannot be properly priced in the capital markets.

Asymmetric information, however, is an entirely different matter. If the market starts to suspect that some of those MBAs are more toxic than others and that the managers of the banks know the ones that are more dangerous, then the markets can easily collapse. This is the standard ''market for lemons'' problem, which is by now well understood: investors don't want to buy MBAs at a price equal to their average value, because they are afraid that what they get is not the average but the worse, i.e. they suspect that the banks will first try to unload the most toxic securities. Lowering the price in this case does not work, since it only convinces even more the investors that the securities are truly toxic. The market essentially freezes. Investors will only buy at very low prices, the ones corresponding to the most pessimistic expectations on the assets. But this must mean that on average the MBAs are worth more than the market prices and therefore the sellers will be unwilling to sell.

Willem Buiter has called toxic the assets ''whose fair value cannot be determined with any degree of accuracy'', as opposed to clean assets, whose fair value can easily be determined. As pointed out by Buiter

Clean assets can be good assets (assets whose fair value equal their notional or face value) or bad assets (assets whose fair value is below their notional or face value).

In other words, clean assets are the ones subject to symmetric uncertainty, while toxic assets are the one subject to asymmetric information. This point seems to be quite clear from the theoretical point of view, but many observers seem to believe that the cause of the low prices lies not in the asymmetry of information but in some form of irrationality that is right now pervasive in the capital markets or in some form of uncertainty regarding the availability of capital on the part of the buyers. An important example of this kind of confused reasoning was provided in a recent interview by Treasury Secretary Tim Geithner.

While factors linked to forms of irrationality or financial constraints cannot be entirely ruled out, I find it difficult to believe that they are an important part of the story. The existence of asymmetric information is more than sufficient to explain the freezing of the markets for MBAs. To give an idea of how large the uncertainty may be, the Financial Times on Feb. 26 reported:

JPMorgan estimates that $102bn of CDOs has already been liquidated. The average recovery rate for super-senior tranches of debt – or the stuff that was supposed to be so ultra safe that it always carried a triple A tag – has been 32 per cent for the high grade CDOs. With mezzanine CDO's, though, recovery rates on those AAA assets have been a mere 5 per cent.

I dare say this might be an extreme case. The subprime loans extended in 2006 and 2007 have suffered particularly high default rates and the CDOs that have already been liquidated are presumably the very worst of the pack.

Clearly, with such numbers there is no need of irrationality to stay away from these assets. Even if the standard deviation surrounding this sample estimates is small (and chances that it is instead big), the distance between 100 (face value), 32 and 5 is large enough to scare anyone. And, again, while we may all be convinced that the actual average value is higher, how can we know that the seller is not trying to unload on us ''the very worst of the pack''? Even with perfectly rational agents, in these circumstances the markets collapse.

Since toxic assets are an important component of many banks' balance sheets, the uncertainty on their value implies uncertainty on the value of the banks, in particular bank equity. Hall and Woodward, in discussing a mechanism for efficient bankruptcy attributed to Jeremy Bulow, report a stylized balance sheet for Citicorp in which toxic assets account for $610 bn out of $1935 bn of assets. Given that the value of equity is just $11 bn, it is easy to see how even marginal changes in the value of the toxic assets may lead to bankruptcy (or, if you prefer to be an optimist, to a large increase in the value of equity). Buiter has performed similar calculations looking at the balance sheet of the Royal Bank of Scotland, and he credibly claims that the situation is similar for many big banks.

Thus, pricing toxic assets is crucial to determine properly which institutions are bankrupt and which are not. Notice that the existence of asymmetric information implies that the arguments claiming that the toxic assets are currently underpriced do have some merit. Presumably, absent asymmetric information, a careful analysis of the cash flows likely to be generated by these assets would produce higher values than what we would observe in the market. The question therefore becomes: how can we eliminate or at least alleviate the asymmetry of information, so that the capital markets will be able to price properly these assets?

The market vs. the government

Markets tend to underperform in situations of asymmetric information, but there are things that can be done. Remedies fall under two broad categories. First, direct action can be taken to reduce the asymmetric information, e.g. when you buy a used car you may ask a mechanic you trust to inspect the car before the purchase. Second, the seller can try to credibly signal the information. Of course every seller will claim that the car he is trying to sell is in perfect conditions. But only the seller of a car which is truly good may be willing to offer a warranty on the car, covering all mechanical problems that will appear in the next two years. This kind of ''signaling mechanism'' have been widely studied in the literature and we can apply the same insights to the pricing of toxic assets.

In principle these are remedies which do not require any government intervention, as rational agents should be willing to implement them in their self interest. But this has not happened, and the markets for toxic assets have remained frozen. Why?

The most sensible explanation I can come up with is that the management of the banks seems to lack the incentives to get the assets properly priced. Their strategy, although rarely spelled out in detail in the official debate, [has been on this site] and seems well described in this post by John Hempton: sit tight on your assets, wait for extra revenue to cover the losses, and then go back to normal. In the meantime, pretend you are solvent by claiming unverifiable values for your assets (Tyler Cowen in the New York Times also has an interesting post on the matter and the matter has been discussed by Michele Boldrin in this blog) and avoid taking new risks, i.e. avod doing the things that banks are supposed to do. This, it should be made clear, is a terrifying scenario. We really can't afford many years (three? five? ten?) without a functioning banking system.

Exactly why the managers are so reluctant to get the assets priced is hard to tell. Regulatory uncertainty, in particular the hope of getting additional bailout funds, is surely part of the problem. More in general I believe it is by now uncontroversial that bank managers have been earning huge rents in the past few years. They clearly hope to maintain at least part of these rents, and keeping their jobs is a crucial part of the strategy. Be it as it may be, at the end of the day what really matters is the empirical observation that markets are not self-correcting. Thus, it makes sense to look at what the government can do.

Differently from markets, governments can make offers that cannot be refused. Or, to put it more technically, governments can violate the individual rationality constraint of the parties involved in the transaction. Given the overwhelming public interest in having a well capitalized and well functioning banking sector, I think that the time is ripe for government intervention. But it is important to get the details right. Direct intervention to reduce asymmetry of information is being tried, partially and awkwardly, with the ''stress test'', but the potential for gains of financial assets is not something as easily checkable as the engine of a car. Providing incentives to managers to get them to disclose their private information therefore becomes important. Providing incentives may be costly for the market, but much less so for the government which can use the stick as well as the carrot. What we need to do is to set up a mechanism which elicits the information while avoiding paying excessive incentive rents to the bankers. In general the amount of incentive rents can be made small if we can violate the individual rationality constraints.

What is to be done

I simply propose that, when it comes to evaluating toxic assets, bank managers be forced to put their money where their mouth is. The initial idea of using TARP money to buy toxic assets failed over disagreement about the proper price to pay. Ausubel and Cramton have proposed using a reverse auction for finding the prices, while Lucian Bebchuk is now proposing setting up competing buying funds with on a mix of public and private captal (here is a synthesis of his proposal).

Whatever buying mechanism for toxic assets is used, I propose to supplement it with a collateral to be provided by the bank managers. The mechanism should work as follows.

First, the government decides how much money it wants to spend buying toxic assets. Auctions (or some other mechanism) are held, and the prices at which the government buys the toxic assets are determined. Once the prices are determined, we can assess the solvency of the banks. If, at the equilibrium price, the bank is not solvent then the transaction does not take place. At that point we should proceed to liquidate bankrupt banks in the most efficient way. As previously said, what to do with bankrupt banks is not the topic of this post.

If the bank is in fact solvent, at the prices determined by the auctions, then the Treasury pays the price. The toxic assets are removed from the bank's balance sheet in exchange of hard cash and put into a government-owned investment fund. On top of this, the managers of the bank selling the toxic assets are required to put some of their money as collateral or, which is the same, put some of their own money in the capital of the investment fund owning the toxic assets.

I will illustrate with an example; the numbers are very tentative, and should be carefully analyzed before implementing the plan.

Suppose that the Treasury buys from Bank A assets for a total value of $100 million. The assets are held by a government-run fund. The bank managers are required to pay a certain amount of their wealth (for example, a total of $5 million) and then to deposit into the fund all their earnings in excess of a certain amount, say $200K. The money is deposited in an escrow account and is remunerated at the risk free interest rate. The fund lasts ten years and the Treasury requires a return of 7% per year. This means that after 10 years the Treasury should get 100×(1.07)10=196.72 million dollars. In the meantime let's say that the money in the escrow account is remunerated at 4% and that the manager deposit an additional 300K every year. After 10 years the amount is 5(1.04)10+0.3(∑i=19(1.04)i)=10.70. Let X be the value of the fund at the end of the 10 years. We can distinguish 3 cases: 1.The rate of returns has been more than 7%, i.e. X≥196.72. In this case the Treasury receives X and the bank managers get $10.70 million.

2.The rate of return has been less than 7%, but adding the money paid by the bank managers we get more than 7%, i.e. 196.72≥X≥186.02. In this case the Treasury receives 196.72. This is obtained from X plus 196.72-X from the escrow account. What remains in the escrow account (i.e. X-186.02) is given back to the bank managers.

3.The rate of return has been less than 7%, even when adding the money paid by the bank's manager, i.e. X<186.02.>

This is the basic structure of the proposal. The central idea is to provide the bank managers with incentives to price realistically the toxic assets. Such incentives are best provided when the managers' wealth (rather than the wealth of the banks' shareholders) is at stake. In all the schemes provided up to now these incentives were absent, so the bank managers always had an incentive to overstate the true value of the toxic assets. In order to counter this incentive the mechanism asks the bank manager to put their money where their mouth is. If the price claimed by the bank manager is unreasonably high then the risk of losing the deposit and all the extra compensations becomes very real.

One potential problem with the scheme is that now the bank managers may have an incentive to understate the true value of the assets, in order to make it easier to earn the annual rate of 7%. In order to counter this incentive, the mechanism stipulates that the toxic assets are purchased only if, at the resulting price, the bank is solvent. Thus, bank managers will be reluctant to lower too much the prices because that would mean losing their jobs and the rents that go with them.

In the ideal mechanism the incentives to understate the value of the assets are exactly matched by the incentives to overstate the value, resulting in truthful disclosure. The strength of the incentives in one direction or the other depend on the exact parameters of the mechanism: what is the required rate of returm, how much the managers are asked to put in the escrow account, and so on. But, I believe, even an imperfect mechanism would do much better than the current situation in which bank managers can claim wild values for their assets without having to pay any consequence.

Improving the mechanism

The basic mechanism described above can be enriched and modified in a number of ways. I will describe a few.

A) Flexible horizon. The investment funds holding the toxic assets should have a limited duration, say 10 years. However, the goal should be to close them down as soon as possible, with the constraint that the investment yields the required return over the period of life of the fund. For example, suppose that after one year the assets bought by the Treasury for $100 million can be sold at $107 million. In this case the assets are sold, the Treasury gets the money and the bank manager receives back 5(1.04)=5.2; from this point on the manager is free from the obligation to deposit the excess salary in the escrow account. The government is out of the picture and the (formerly) toxic assets are now less toxic and freely exchanged in the capital markets.

Similarly, suppose that after one year some of the assets appreciate more than 7%, while others do not. For the sake of the example, let's say that assets which have been paid $50 million are now worth $55 million. The assets can be sold and 50(1.07)=53.5 should be paid back to the Treasury. The remaining 1.5 million goes back into the fund. The new goal is to make sure that the remaining 50 million earn 7% over the 10 years, with the extra gain coming from the sale of the assets going toward that objective. In general the assets can be sold at any time at which they can produce a return of 7%. The bank manager will have the money back and will be able to stop depositing the excess salary only when the fund is liquidated.

B) Managing the escrow account. I have assumed that the money deposited by the bank managers is remunerated with a fixed rate. This is really not necessary. There would be no problem in, for example, letting the bank managers actively manage their account. In fact, if they have provided truthful values for the toxic assets they should attach a high probability to getting their money back. It should therefore be in their interest to maximize the value of such funds. Of course, some provisions against fraud (e.g. using the money to give loans to family members) would be necessary if active management is allowed.

C) Reducing the risks for the government. Realistically, the amount of money that bank managers can put in the escrow account will be only a tiny fraction of the value of the toxic assets. The role of those deposits is to provide managers with a strong incentive to tell the truth about the value of the toxic assets, rather than to provide valuable collateral. The scheme however can be supplemented by using the bank assets as collateral. For example, it can be stipulated that banks are not allowed to distribute dividends as long as the fund exists, and that in case the return on the toxic assets is inferior to the required return the banks have to make up for at least part of the difference putting money in the fund. The detail may vary, but this would give an additional incentive for bank managers to provide realistic valuations for the assets. The sooner the fund is liquidated, the sooner the managers will be freed by constraints in the management of the banks.


The main point that I tried to make is that the mechanisms proposed up to now for pricing toxic assets ignore one important way in which asymmetric information problems may be dealt with, namely making the prices of the transactions contingent on the future values of the assets. No information can remain private forever. The value of the toxic assets will be revealed over time and we can set up mechanisms making payments contingent on the future values. My proposal is equivalent to making the wealth and future incomes of bank managers, the ones having the private information on the assets, contingent on the future values of the toxic assets. If, as it is often claimed, a strategy of ''buy and hold'' for these assets can produce very high returns at the current prices then the managers should have no problem accepting the scheme here proposed. On the other hand, if the managers oppose the proposal we will have obtained valuable information anyway: that their claims on the high value of the toxic assets are not to be trusted.

"Toxic Car" Follow-Up: The Free Insurance in TALF

The post on toxic cars prompts an explanation of the free insurance that is part of the Geithner plan:

The Geithner CDS, by Cheap Talk: This post from Mark Thoma is useful in spelling out some of the accounting behind the Geithner plan and its old incarnation due to Paulson and co. But we cannot assess the policy unless we come to grips with the Treasury's motives for intervening in the first place. When we do the picture changes a lot and it becomes clear that this amounts to a blanket insurance policy for the banks.

Suppose that a bank has a stockpile of toxic assets, and suppose that this bank is solvent only if those assets value at least $X. When TALF comes to negotiate the purchase of these assets, we know that the bank will not accept anything less than $X for them. Accepting less than $X turns a concern which is potentially solvent (under rosy assumptions about a recovery in the market for the assets) into one which is certainly insolvent. The balance sheet woud now be transparent and the bank will be shut down.

So TALF either results in no sale, or a sale above $X. A sale at $X or higher ensures that the bank is solvent and therefore amounts to guarantee of the bank's liabilities.

I am not expert enough to know whether guaranteeing the bank's liabilities is a good idea (I suspect it is not the best), but I can say this. If free insurance is what the Treasury wants out of TALF, then TALF is a bad way to do it. A simpler and far better way is to simply declare that the bank's liabilities are backed by the government. It amounts to the same thing if TALF were to work properly. But there are many ways TALF could go wrong.

For example, there is no assurance that under TALF the bank will actually use the $X cash from the sale to stay in business. No doubt Geithner will make sure that an AIG-style transfer to executives and shareholders will not happen but there are too many other possibilities to guard against in law. By contrast, a real insurance guarantee means that the money does not change hands until the creditors come calling and then it goes directly to the creditors without the bank ever touching it.

A second problem with TALF is that the government typically does not know the exact value of $X. To be sure that it actually covers $X, it would have to accept the high probability that it overpays. With a real insurance policy there is no need to guess at X because it will be revealed when the bank defaults.

BTW, I made a related, but somewhat different point about TALF's predecessor here (pretty technical.)

Which Bailout Plan is Best?

Which plan is best, the original Paulson plan where the government buys bad paper directly, the Geithner plan where the government gives investors loans and absorbs some of the downside risk in order to induce private sector participation, or straight up nationalization?

Last March, before Paulson had announced his plan, I said that I thought it was time for the government to begin aggressively purchasing toxic assets to solve this problem once and for all:

I'm starting to think that the Fed should drop the term part of the TSLF and instead trade permanently for risky assets (with the haircut sufficient to provide some compensation for the risk), bonds for MBS, money for MBS, or whatever, and don't limit trades to banks.

The Fed would act as "risk absorber of last resort." Why should it do this? There has been an unexpected earthquake of risk, a financial disaster on the scale of a natural disaster like Katrina, and the government can step in and sop some of it up by trading non-risky assets (money, bonds, etc.) for risky assets at an attractive risk-adjusted price. ...

I still think that this would have worked then, I called the government a "risk absorber of last resort," and the prices of the assets at that time were high enough to keep banks solvent. But it would have involved a massive transfer to the banks without giving taxpayers any share of the upside. In addition, as time has passed and prices have fallen, solvency issues have come to the forefront - the balance sheet problems are no longer hidden by overpriced assets - and the solvency problems must be addressed directly. That means that if there is no separate program to provide an infusion of capital, simply removing the toxic assets from the balance sheets through government purchases at current prices - prices so low that the banks are insolvent - won't be resolve the problem.

So if it was to work, the Paulson plan had to be amended, it needed to both get assets off the banks' books somehow, and it also needed to provide recapitalization in a way that is politically acceptable (which means no giveaways - the asset purchase plan I proposed above would have been a giveaway without some sort of redistributive mechanism attached to the plan).

So which plan is best? Any plan that does these two things, removes toxic assets from balance sheets and recapitalizes banks in a politically acceptable manner has a chance of working. The Paulson plan does this if the government overpays for the assets, but the politics of that are horrible (as they should be). The Geithner plan also has these two features, though it has a "lead the (private sector) horse to water and hope it will drink" element to it that infuses uncertainty into the plan. The plan for nationalization most certainly has these features, but it has political problems as well.

So I do not take a binary (or, I suppose, trinary), either/or approach to the proposals where I think one plan will work and the others will fail miserably. All three plans have their pluses and minuses. The politics of the Paulson plan make it a non-starter, I have no quarrel with the view that it constitutes a giveaway that is not justified, so the only way the Paulson plan will work is if we can convince people that equity stakes or some other mechanism makes the plan sufficiently equitable. I prefer nationalization because it provides a certainty in terms of what will happen that the other plans do not provide, the Geithner plan in particular, but it also appears to suffer from the political handicap of appearing (to some) to be "socialist," and there are arguments that the Geithner plan provides better economic incentives than nationalization (though not everyone agrees with this assertion). The Geithner plan also has its political problems, problems that will get much worse if the loans that are part of the proposal turn out to be bad as some, but not all, fear. So all three plans do the requisite things - get assets off the books and provide recapitalization - and each comes with its own set of political worries.

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none - to me - is so off the mark that I am filled with despair because we are following a particular course of action.

The post quoted above was from over a year ago, and we had been aware of growing problems in the financial sector for some time before that. There were programs in place, but nothing of sufficient scale to get the bad paper off the books, so we've been at this for a long time without any big, decisive, effective policy action. What's important to me is that we do something, that we adopt a reasonable plan that has a decent shot at working and that satisfies the political test it must pass (though the administration could certainly do more to sell the plan to the public and help with this part, so passing the test is partly a reflection of the effort that is put into selling it). We've been spinning our wheels for too long, and it's time to get this done. We can't wait any longer.

So I am willing to get behind this plan and to try to make it work. It wasn't my first choice, I still think nationalization is better overall, but I am not one who believes the Geithner plan cannot possibly work. Trying to change it now would delay the plan for too long and more delay is absolutely the wrong step to take. There's still time for minor changes to improve the program as we go along, and it will be important to implement mid course corrections, but like it or not this is the plan we are going with and the important thing now is to do the best that we can to try and make it work.

Paul Krugman: Financial Policy Despair

We'll likely only get one attempt at rescuing the banking sector, and Paul Krugman prefers we use the "time-honored procedure for dealing with the aftermath of widespread financial failure" rather than the Geithner plan:

Financial Policy Despair, by Paul Krugman, Commentary, New York Times: Over the weekend The Times and other newspapers reported leaked details about the Obama administration's bank rescue plan... If the reports are correct, Tim Geithner ... has persuaded President Obama to recycle ... the "cash for trash" plan proposed, then abandoned, six months ago by ... Henry Paulson.

This is more than disappointing. In fact, it fills me with a sense of despair. ... It's as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street. ...

Right now, our economy is being dragged down by our dysfunctional financial system... As economic historians can tell you, this is an old story... And there's a time-honored procedure for dealing with the aftermath of widespread financial failure...: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.

That's what Sweden did in the early 1990s. It's also what we ourselves did after the savings and loan debacle of the Reagan years. And there's no reason we can't do the same thing now.

But the Obama administration, like the Bush administration, apparently wants an easier way out. The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks' books are really worth much, much more than anyone is currently willing to pay... In fact, their true value is so high that if they were properly priced, banks wouldn't be in trouble.

And so the plan is to use taxpayer funds to drive the prices of bad assets up to "fair" levels. Mr. Paulson proposed having the government buy the assets directly. Mr. Geithner instead proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The idea, says Mr. Obama's top economic adviser, is to use "the expertise of the market" to set the value of toxic assets.

But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn't really about letting markets work. It's just an indirect, disguised way to subsidize purchases of bad assets. ...

But the real problem with this plan is that it won't work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks ... that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.

You might say, why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.

Even more important, however, is the way Mr. Obama is squandering his credibility. If this plan fails — as it almost surely will — it's unlikely that he'll be able to persuade Congress to come up with more funds to do what he should have done in the first place.

All is not lost... But time is running out.

links for 2009-03-23

Geithner: My Plan for Bad Bank Assets

Timothy Geithner explains and defends his new plan to repair financial markets:

My Plan for Bad Bank Assets, by Timothy Geithner, Commentary WSJ: ...Over the past six weeks we have put in place a series of ... initiatives ... to help lay the financial foundation for economic recovery. ... Together, actions over the last several months by the Federal Reserve and ... initiatives by this administration are already starting to make a difference. ...

However, the financial system as a whole is still working against recovery. ... Today, we are announcing another critical piece of our plan to increase the flow of credit and expand liquidity.

Our new Public-Private Investment Program will ... purchase real-estate related loans from banks and securities from the broader markets. Banks will have the ability to sell pools of loans to dedicated funds, and investors will compete to have the ability to participate in those funds and take advantage of the financing provided by the government.

The funds established under this program will have three essential design features. First, they will use government resources in the form of capital from the Treasury, and financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the Public-Private Investment Program will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. ...

Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets.

The new Public-Private Investment Program will initially provide financing for $500 billion with the potential to expand up to $1 trillion over time, which is a substantial share of real-estate related assets originated before the recession that are now clogging our financial system. Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury.

This program ... is part of an overall strategy to resolve the crisis as quickly and effectively as possible at least cost to the taxpayer. The Public-Private Investment Program is better for the taxpayer than having the government alone directly purchase the assets from banks that are still operating and assume a larger share of the losses. Our approach shares risk with the private sector, efficiently leverages taxpayer dollars, and deploys private-sector competition to determine market prices for currently illiquid assets. ...

For all the challenges we face, we still have a diverse and resilient financial system. The process of repair will take time, and progress will be uneven, with periods of stress and fragility. But these policies will work. ...

But ... we must also start the process of ensuring a crisis like this never happens again. As President Obama has said, we can no longer sustain 21st century markets with 20th century regulations. ... The lack of an appropriate and modern regulatory regime and resolution authority helped cause this crisis, and it will continue to constrain our capacity to address future crises until we put in place fundamental reforms.

Our goal must be a stronger system that can provide the credit necessary for recovery, and that also ensures that we never find ourselves in this type of financial crisis again. ...

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