The “Geithner Put”, part 2

(If you are curious about the term “Geithner Put”, it is a reference to the Greenspan Put.  Although it is more literal, since non-recourse loans place a floor on an investor’s potential losses, just like a put option does.)

In Part 1, I gave an example of how a private investor could buy some loans for $8400, ultimately realize $5000 on them, and still earn a 16.7% profit.  Milo Minderbinder would be proud.  The loser would be the FDIC, which is interesting because the FDIC is financed not by the taxpayer but by the banking industry — or at least, it has been so far.  So even if the FDIC needs to tap their new $500 billion credit line to make good on tons of bad loans, in theory they will eventually repay the Treasury by exacting higher insurance premia from the banking industry.

Thus Part 1 could be read as a transfer of wealth from good banks to bad banks and private equity.  Assuming Treasury actually demands repayment on the credit line and does not just write it off…

Part 2 of the Geithner Put is called the Legacy Securities Program.  Here again, the Treasury provides an example:

Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.

Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.

Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.

Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.

Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.

Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

This may sound similar to Part 1, with the Treasury providing the leverage instead of the FDIC…  But it is actually completely different.  The key concept is the non-recourse loan.  If Treasury wants to hire a handful of money managers, ask them to raise private capital, match the capital raised, and then let them lever up 3:2 or 2:1, that is not a subsidy in the same way as Part 1.  In this case, the loans are full recourse with respect to all of the assets run by that manager.  So it is not trivial to construct an offensive example, and this structure by itself is not so bad.

No, the bad part is this bit which appears a few paragraphs earlier:

Expanding TALF to Legacy Securities to Bring Private Investors Back into the Market

… stuff elided …

  • 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.

Whoops, there are those “non-recourse loans” again.  The TALF is the Fed’s new $1 trillion program to provide non-recourse loans against new asset-backed securities.  Part 2 of the Geithner Put extends this program to existing securities.  (Note the phrasing “originally rated AAA”.  We are definitely talking about toxic assets here.)

So the Treasury provides equity investment and loans for fund managers to purchase assets, and then the Fed provides the subsidy via non-recourse loans against those assets.  The degree of leverage here is determined by the “haircut” applied to the assets; a 10% haircut corresponds to 9:1 leverage, for instance.  Search for “collateral haircuts” in the TALF FAQ to get an idea of the numbers.  Although bear in mind those are for the current TALF, and we will have to wait to see the haircuts for the Geithner Put extension.

Apparently, we are left with private equity firms and bankers being able to fleece the FDIC and the Fed via abusing the non-recourse loans, with the Treasury/taxpayer participating in the upside of the fleecing.  Which is fine, I guess, if you believe the FDIC and Fed are themselves good for the losses; i.e., that the losses will not ultimately be placed on the taxpayer.  Color me skeptical, especially with regard to the Fed.

But I do give them points for creativity.

22 comments to The “Geithner Put”, part 2

  • vvvviking

    About those haircuts. Harkens me back to other entities that took MBS with “appropriate” haircuts: the FHLBs. They took a lot of Option ARM AAAs from WaMu and Countrywide at pretty generous haircuts, and still have losses on them.

    Put it another way: when these Option ARMs were originated, the AAA loss coverages were in the 10% range (at most, many were single digits: 7-8%).

    Two significant Option ARM portfolio purchases have happened in the past 6 months: JPM buying WaMu, and WFC buying WB.

    In both cases, the buyer wrote down the Option ARM portfolios by 25 – 30%, or about 3X the AAA LC that the rating agencies were assigning.

    Since the Fed is really supposed to be taking a “super senior” position, the haircut on AAA 2006-2007 vintage securities should be in the 40% range.

    Wanna bet the haircuts will be nowhere near that level?

  • knowtheory

    Apparently, we are left with private equity firms and bankers being able to fleece the FDIC and the Fed via abusing the non-recourse loans, with the Treasury/taxpayer participating in the upside of the fleecing. Which is fine, I guess, if you believe the FDIC and Fed are themselves good for the losses; i.e., that the losses will not ultimately be placed on the taxpayer. Color me skeptical, especially with regard to the Fed.

    But I do give them points for creativity.

    Okay, genuinely have no idea whether this is a sane suggestion or not, but why can’t the FDIC turn around and impose a progressively graded insurance rates on large complicated financial institutions? That’d have two effects, 1) recoup the insurance fund/risk from whatever the banks were making via this plan, over a longer more gradual time span, and 2) provide a disincentive to being large and complicated (aka a systemic risk).

    I’m guessing this is kind of a dream world fantasy, since my understanding is that the FDIC doesn’t have the authority to collect from investment banks (is that right?) or the shadow banking system that orgs like AIG were running.

    I’m just trying to figure out if this is genuinely just a give away, or if there is a world, some world out there in which this makes sense, and we aren’t screwing the little guy some how (whether it’s the tax payers, or small banks which didn’t do anything wrong).

  • jpm

    Nemo,
    Your example (and others) are assuming that the buyer and seller’s interest are not related. This is not the situation at hand.

    For example: Citi will invest $1B with a fund that bids on the assets. The gov’t will provide another (say) $9B to match Citi’s $1B as a nonrecourse loan.

    Citi will then provide personal incentives for the fund managers to bid 100 cents on the dollar for an BBB MBS tranche that is currently trading for 1 cent on the dollar. Naturally, the market is valuing this tranche at 1 cent because there is no hope of being paid back, and the tranche will eventually be a total loss.

    But when that total loss occurs, Citi now only loses 10 cents on the dollar because the gov’t just put up the other 90 cents.

    (above stolen from here: http://tinyurl.com/cl5kdv )

  • DTM

    First, the Summary of Terms for the Securities portion states: “Each Fund Manager will have the option to obtain for each Fund secured non-recourse loans from Treasury (“Treasury Debt Financing”) in an aggregate amount of up to 50% of a Fund’s total equity capital.”

    http://www.treas.gov/press/releases/reports/legacy_securities_terms.pdf

    So I think those are in fact non-recourse loans coming from the Treasury.

    Second, I noted in a comment to Part One that you appeared to be omitting the Guarantee Fees from your analysis. I’ll just note here that you appear to be omitting any default risk premium that the Treasury would include in the interest rate for its non-recourse loans. The point is essentially the same: it is possible there would be no net subsidy provided by these non-recourse loans, if the Treasury did in fact charge a sufficient risk premium to cover its losses on the loans which go into default.

  • snoopy

    Wow, Nemo, you’re getting a lot of comments.

    Anyone have an idea of how big the toxic pool is? What is the 10’s of trillions number that I’ve seen tossed around? To get a handle around those kinds of losses is going to take years. So at least they are getting started. We are definitely not anywhere close to the end of the handouts. They are gonna keep coming back for more. They came when the Dow was at 10000, they came when the Dow was at 7000, they will come again when the Dow is at 5000. :-)

  • Why would anyone assume a legitimate auction? A bank that bought its own asset for its current carrying value would offload at least 85% of the downside risk of the asset, thanks to the beauty of the non-recourse loan. Perhaps – perhaps – the Treasury wouldn’t stand for it, but a more complex special purpose vehicle would almost certainly get by them. Indeed, depending on the payoffs a fund with a highly levered position in a bank’s equity (say, far out of the money options) could bid a high price just so the bank could announce a successful sale and consider the ultimate capital loss on the asset to be a minor marketing expense.

    More here: http://tauntermedia.com/2009/03/23/gaming-the-system/

  • DTM —

    Thank you for your responses, both here and in Part 1.

    Yes, I have ignored the fees there and also the “risk premia” here since I suspect they will be immaterial. For one thing, if the fees and/or premia were going to be enough to cover the losses, private money could already offer a similar deal for profit, and there is no evidence anybody is doing so. In addition, it is my belief that the entire purpose of this plan is to help to recapitalize the banking system, and fees and/or premia sufficient to cover the losses would undermine that goal.

    I freely admit I could be wrong, and I look forward to seeing the actual numbers emerge.

  • DTM

    Nemo,

    Private partners could not offer the same terms with an expected profit if they had a substantially higher cost of capital than the government, which is very likely the case these days. In other words, the hypothetical non-subsidy explanation for these deals would be that through these partnerships the government is sharing access to its lower cost of capital with its private partners, and in return getting help pricing the assets.

    Anyway, my primary purpose was just to point out that the structure of these deals does not necessarily imply a subsidy. Rather, to conclude there is a subsidy you must add additional assumptions–assumptions which may well be warranted. But in these discussions I think it is worth making those assumptions explicit and then explaining the basis for them.

  • DTM

    By the way, I should note that we probably won’t know for sure whether or not the government has charged profitable fees and default risk premiums in exchange for its guarantees and non-recourse loans respectively for quite a while, basically not until it is fairly clear exactly what losses on those guarantees and loans the government is actually going to realize. In that sense the “actual numbers” needed to confirm or disconfirm various possible assumptions won’t be emerging for quite some time.

  • billyblog

    Notice who is being left out of all of this – and bulldozed over in the process.

    The poor stiffs who took out those mortgages in the first place. Sure, some will play jingle mail, and others will be greedy operators who got caught attempting one flip too many. But most will be decent folks who really will bend every effort to scrape through and save the house, even if it has negative equity for a while.

    What happens to them once the Geithner Put is rolled out?

    Well, there was a time when there might have been some hope for them to go into bankruptcy and get their loans renegotiated. (Oh yeah, I forgot, banks around the country are doing this every day — voluntarily. Why there was actually a reported sighting of a mortgage renegotiation last Thursday in Roswell. Or was that a flying saucer?) In other words, there used to be some hope, however faint, that we might get the lenders, at whatever generational level, also to take a haircut, and this time in relation to the consumers and not just in relation to other lenders.

    But once we go to Geithner’s Put, that ain’t gonna happen.

    “Harumph, Harumph, Mr. Small Guy, on this Medusa, yeah, some of us bankers and hedge fund managers will end up cannibalizing one another. But that’s OK, you won’t have to watch it. Because we will have long since thrown you overboard. Indeed, we may be able to churn this musical chairs asset swapping long enough so that some of us actually come out big winners. But that will be after Sheriff Tim has put your and the Missus’ furniture out on the lawn, and we get somebody into your old house who can finally make the payments, albeit at a lower level that you, you sap, contracted for. Remember, those contracts are sacred – except when you’re too big, or too dear to the hearts of Tim and Ben, to fail.”

    And trust me, though Timmy won’t be the physical Sheriff, he will be cutting so many side deals to insulate these lenders from any risk in relation to a shared burden with the mortgage holders, that he will be the hammer that makes sure that the home-no-longer-owner is left even more out in the cold than he is now.

    And pick a number between 1 and 10 for how transparent those back room deals will be, with 10 being most transparent? Would you believe minus 4, à la twisting Chris Dodd’s arm – but apparently not that hard – to expunge any so-called “populist” elements from the Stimulus Bill? Or à la AIG finally being forced to cough up the information that for all these months it has been laundering our tax dollars to Goldman Sachs and many of its “deserving” friends both here and abroad the great “haircut” rate of dollar for dollar?

    Yup, the Treasury Department will be the new owners’ muscle, making sure that the full force of the Government ensures that the bankers optimize, even at a discount. And to hell with the people trying to hold on to those homes. Don’t they realize that this is all about swapping assets in the pit, not about having a roof over your head?

    Remember when Hank Paulson was badgered by Congress to use some of the TARP funds to help out the mortgage holders? Remember when Hank’s answer to that plea was to flip the bird to Congress? Timmy was at his side then, and Timmy’s new program is simply a wonky way of obfuscating the social reality that that this whole thing is ultimately about real people, real people who are about to get really squashed so that the financiers can go back to playing their games – in the baleful sense in which Jon Stewart recently excoriated them.

    And watch how quickly the secondary market develops for these assets. Why, how long before we have credit default swaps – or their functional equivalents – for these asset purchases effectively guaranteed on the down side by the taxpayer?

    And then, of course, we’ll need a bailout to bailout the bailout of the bailout, and so on ad indefinitum.

    This wouldn’t have happened if the banks had been nationalized, because that would have put the whole matter into a political context, where there would have had to have been give and take from both sides and, well, just a smidgen of acknowledgement that we have government and other institutions ultimately for the sake of the general social welfare, not for the sake of securing Vikram Pandit’s right to do a $10m makeover of Citibank’s executive offices.

    But not in Tim’s universe, where only bankers and hedge fund managers, and other varieties of really “creative” people exist.

    And is there anything more risible than the suggestion that the banks will end up footing this bill through premiums paid to the FDIC, even though, alas, so many good people will have to be thrown under the bus along the way to maintain the sanctity of these “public/private” contracts that Tim is about to enable? Really, how can anyone make that suggestion with a straight face?

  • diek

    You know what? This whole thing is getting surreal. Notice that *everyone* has an opinion on what the best solution is, and they are all getting more vocal about them, and they are all different. In other words, nobody has a clue. The only right thing to do is set a strategy with flexibility, quick feedback, and make adaptations as the feedback comes in. Nothing else has a chance. Geithner’s plan has a lot of avenues of getting capital into banks and other institutions. I hope he has consulted with bank managers, Congress, etc., so that this plan will be acceptable to them, as it does no good to have a perfect plan if nobody follows it. The right solution is going to take many strange detours and will look pretty messy before it’s done. Guaranteed.

  • chris

    My Question:

    Given that billions of dollars are involved, I’d imagine that the government would release
    their complicated mathematical analysis of all this. Have they?
    ——————————————————————————————————-

    Answer to my own question.
    (I haven’t seen any government analysis, so let me do one.)

    I’m an applied mathematician. But my area is not economics.
    Let me see what I can come up with.
    Let’s make it simple and take a look at the simplest example.

    Simple Example ***************************************************
    No loan/no leverage. 50-50 private/government split. Face value = $100.
    $84 winning bid. Private investor holds assets to maturity.

    The holder of the original asset, e.g. a bank, loses $100 – $84 = $16 (compared to the face value).

    The private investor and the government each put up $42.

    If the assets pay $84 + x then
    the government and the private bid winner each gain or lose (except processing costs, etc.)
    x/2 dollars, with the maximum value of x = $16 = bank loss, and the minimum value of x = -$84 = negative winning bid.

    In this example, we see that one effect of the plan is to force the government to purchase assets at
    a price determined by the auction’s winning bid (whether the winning bid is rational or not.)

    The risk/reward is equally shared by the government and
    the private investor.

    In some sense, this simple example is like the government putting in a buy order (capped at face value) for 1/2 of what ever is being sold.
    This will have the effect of increasing the winning bid (as the government is buying 1/2 of the assets, and price increases as demand increases).
    Moreover, since

    x = [the dollars that asset pays out] – [winning bid]

    the effect is that x decreases as the winning bid increases.
    This benefits the bank, as

    x = bank loss,

    at the expense of the government and the private investor.

    ******** Next lets factor in leverage and non recourse government backed loans.

    Once we factor in non-recourse loans providing leverage, the model is complicated. However, it is clear
    that the amount of the winning bid will increase further as private investors will reap benefits even if they sometimes
    bid a little bit high, since the government is taking the big downside gamble, but only a 50-50 upside.
    In this case, the benefits to the private investor and the original asset holder (the bank) will come at the expense of
    the government.

    The one model in which this is a good plan, from the government’s perspective is if the plan
    itself has a feed back loop effect, which makes the [amount that the assets pay out] increase,
    which will offset the decrease in x, which is caused by the increase in the winning bid.

    Summery.
    The banks are getting a nice bailout, as compared to what they would otherwise
    get for their toxic assets, especially as they can choose not to sell their assets if they don’t like the price.

    The private investors, since they get to decide how much they will pay, and since they will be
    bidding with non recourse leveraged dollars, they should also get a nice deal.

    It is bad to say, but the government is not getting a good deal in all this. If the government
    was a private business everybody who made this deal would get fired I think.

    To be honest, I am in over my head here and I am sure a better analysis using standard models is possible.

    But this extra simplified example I think is sufficient understand how the program is structured and it avoids
    having to model the expected number of dollars the assets will pay out, etc. Which in turn avoids arguments
    over any distribution used.

    Given that billions of dollars are involved, I’d imagine that the government would release
    their complicated mathematical analysis of all this. Have they?

    If not, going along with the plan is like buying a pig in the poke.

  • chris

    Correction:
    I wrote: This benefits the bank, as

    x = bank loss,

    Actually, I meant to write, this benefits the bank (asset holder),
    as

    [bank loss] = $100 – [winning bid].

  • snowman

    Put aside the problem I have with a tax payer bail out of illiquid assets, I have doubts this program will work (per Geithner’s def: get banks to lend cheap money again): there isn’t enough investor money out there to make it work.

    1) the big investors will shy away because they’ve already been burned. Pension funds, endowments etc will not put their money into this. Pension assets, for instance, make up about 60% of all assets invested. They are never going to get involved in this scheme, no matter the haircut. Several huge players have recently changed their charters to ensure not one penny sits with a hedge fund, for instance.
    Anything that smells, tastes, or looks like MBS won’t go with their constituents. So from the get go, a huge portion of the investor base needed to make a market work and create liquidity is already a no-go.

    2) The hedgies/Pe guys aren’t sitting on top of a ton of cash either, their traditional sources of money (see point 1) has dried up. Many of the biggest (it’s the 80/20 rule) have started to diversify into either long term value, or trying (with little success) with quant stratgies. It is no surprise over 110 funds have imploded in the past 18 months. Add to this the Uncle Same quid pro quo to the PE/hedgies: “we’ll pay you to invest, but now you have to open your kimono”…don’t expect a rush to line up for the program.

    3) There is huge uncertainty on what exactly are in these portfolios, ie the physical assets, and the abiltiy to re-pay. Are they empty 200-unit condos in Naples? Are they 3 bedroom houses in Teaneck NJ? What do the cash flows look like? If I were an investor I wouldn’t trust any figure I got from the bank’s book. I would have to grab my valuator, see the sites, talk to the owners etc etc. In other words, there is a big disconnect between what the banks think they have and what they really have. It’s similar to the commercial real estate disaster in the early 90’s; the investor had to go to the office buildings, see what kind of plumbing it had, interview the tenants etc; because the banks had no real clue. Given the huge swath of real estate we are talking about, the task is almost impossible, and I doubt investors (those with real money) will buy and hold without significant due diligence.

    4) Investors won’t attract much retail investment on this stuff. For one, it’s got radioactive labels printed all over it, two: the man on the street won’t get hosed once again unless he really understands what this is (see point above), and three, disposable income isn’t exactly flourishing these days. There simply isn’t enough money around, and anything there is goes to paying down debt and general savings.

    The list goes on. Geithner has to do something, but I expect a weak fizzle.

  • doug

    Nemo, Are you posting to yourself? Just kidding.
    I have never seen so many that could predict the future with so little uncertainty….
    Diek, Right on the money. I agree.

  • inthecheapseats

    Nemo, thanks for the good posts.

    In the context of billyblog and diek, who I sympathize with completely, the thing that is bothering me the most about the Geitner plan is this: I don’t see the criteria by which an outcome could be judged a success for the taxpayer. The plan is so complex that for the intelligent interested lay citizen, NO conceivable outcome will demonstrably convince him/her that the taxpayer didn’t get screwed again at the profit of the saved banks, even in the scenario in which everything goes as Geitner and Obama would wish. Therefore Main Street will continue, with just cause IMHO, to be very cynical about Wall Street and a sizeable chunck of confidence will be witheld from Wall Street for years. As much as I want to give Geitner the benefit of the doubt for the good of the country, I’m stuck with Krugman’s conclusion: despair that this is not going to be the fix the economy needs and runs a good chance of permanently derailing Obama’s agenda.

    Does anyone know whether or not treasury, or anyone else, has constructed a scoreboard by which the taxpayer can objectively monitor who’s winning and who’s losing as the months roll by?

  • Xacto

    Perhaps the whole plan here is to find politically palatable and “sneaky” ways to allow the Fed to print money and get away with it. I.E. there are two “outs”:

    1) Inflation kicks in and the worst case scenarios don’t happen because the underlying asset values get rescued by inflation.

    2) The worst case scenario happens and the Fed allows its loans to the FDIC to go unpaid (or paid at a 0% rate over 100 years) — i.e. money was just printed to make this happen.

  • Bill Courtney

    It looks to me like this is a plan by Treasury to sell derivatives. (Ssshhh! Don’t say that too loudly. We were told that evil, fancy-pants financial instruments were what got us into this mess.)

    The subsidy looks like half of a call option with no expiration date. (So more like a warrant than an option, but let’s continue.) The investor gets half the option and Treasury gets the other half.

    The nominal value of the underlying asset is the auction price.

    The strike price is 85% of whatever price is set by the auction. Thus, the call is in-the-money by 15% of the auction price.

    The premium (price of the call option) is the 15% that is not covered by the no-recourse loan. Note that there is NO TIME PREMIUM. (That is, there’s no EXPLICIT time premium.)

    If the price of the underlying asset falls and stays below the strike price (by defaulting, perhaps, or being settled for a very few cents on the dollar) the investor walks away, just as with a call. Else, the investor can take the difference (half the difference, actually, since he’s partnered 50-50 with Treasury) between the selling price and the strike price. Just as with a call.

    Recognizing that there is no time premium being charged by Treasury means that the original investors could turn around and make a sale in a secondary market (if such is established) and MAKE A KILLING.

    Of course, in an efficient market, the initial auction will increase the price of the underlying asset by just the amount necessary to equal what the ‘correct’ asset price should be plus enough extra to account for the missing time premium. That is, the price will include an implicit time premium.

    Of course this will work, when has the commons (excuse me, I meant, “when has the market”) ever behaved tragically?

  • snowman

    To inthecheapseats: The Treasury will appoint asset managers who will issue monthly performance reports. Probably will fall to the usual suspects, Bank of New York, JPMChase and a couple others. Their reporting is prettty good so we’ll get to see.

    That is, if anyone shows up to the party……
    Acid test: would you invest in this (remember – the assets to be sold will be decided by the bank so don’t think you are getting any stuff they are sure about)?

  • What is to keep an investment manager from hedging some toxic asset portfolio with something that has a big upside when the bank selling the toxins is cleaned-up? The hedge could be a bunch of call options on the stock but can also be some of the bank debt that currently sells at very distressed levels. My point is that the investment manager can protect himself and make money even he overpays for the toxic portfolio that goes bust.

    In fact, if this was the trading strategy, the IM would want to pay as much as possible and get the worst junk off the bank’s balance sheet. On the other hand, the treasury does not hedge itself and can lose all its investment. Actually, in the case of Citibank, BoA and others, the Treasury holds preferred stock, equity shares or both. With Citi, the government owns 40% of equity and probably a good deal of preferreds (I have to check). Therefore, if Citi was cleaned up, the treasury too, would make a killing. Imagine the glory that Geithner would bask in for engineering such a brilliant plan that makes a profit for the government!

    So who would be the losers in this case? Well, FDIC and the Fed (with the non-recourse loans). The small banks would bear some of the burden through the higher FDIC insurance premiums. As far as the losses of the Fed, I have no idea if those would need to be paid or they would simply be written off. Maybe someone can shed some light in this matter. If the losses on the Fed balance sheet are written off, then it means that they are truly printing money and devaluing everyone that holds US currency.

    If this is what the Treasury was thinking it would be pretty devious but clever nevertheless.

  • What Nemo describes is the subsidy hidden in the Geithner plan announced on March 23, 2009. My paper, “The Put Problem with Buying Toxic Assets” at http://ssrn.com/abstract=1343625 argues that insolvent banks won’t sell their toxic assets without a big subsidy.

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