Image courtesy of AllPosters.com/J. Thompson
Each of the three programs announced by the Secretary of the Treasury today has the same theme: the private investor has a limited downside and a huge upside – the American taxpayer bears almost all the downside and gets shafted on the upside.
Read my preliminary analysis of the three programs.
I. Legacy Loan Program
The idea of this program is to combine a small amount of private equity with a small amount of government equity – and a large amount of government guaranteed debt to buy some troubled loans from banks.
Here is an example of the mechanics.
Private investors bid for $100 million for pool of loans that are deemed eligible by the FDIC.
Private investors contribute: $7.1 million in equity
Government contributes: $7.1 million in equity
Government guarantees: debt of $85.8 million
Maximum possible loss: Private investor $7.1 million; Government $92.9 million
Profit: shared equally.
Example, suppose a pool of mortgage loans is purchased for $100 million. In one year, the value increases to $125 million and the portfolio is liquidated. Suppose the interest rate on the debt is 4.7%. Hence, the debt holders get 4.7% x $85.8 = $4 million plus their principal, $85.8 million. What’s left over is approximately $35.2 million. The private share is $17.6 million. The rate of return ($7.1 grows to $17.6 million) is 148%. Now it is true that the government gets the same rate of return on their equity investment – but this ignores a crucial difference. The private investor has unlimited upside and the most they can lose is their initial investment. The government has the same upside but they are guaranteeing the bonds. Hence, we suffer almost all of the downside.
Does this sound familiar? This is exactly how we got in this mess. Private investors taking risky levered bets knowing that the government would bail them out.
Here we go again.
If we are going to take all the downside, then it is only fair that we get all the upside. Why should we share half the profits with somebody putting up only 7% of the capital? The American taxpayer is putting up approximately 93% of the capital (counting guarantees) but only getting half the profits.
I reject the idea that this is the best way (or the least worst way) to handle this problem.
There are three simple alternatives.
- The RTC model. Relegate the insolvent banks to a Resolution Trust Corporation-like entity (modeled after the solution to the S&L crisis in the 1980s) and unwind their troubled assets over a period of 5-7 years. If there is any upside, the American taxpayer gets it all.
- LLP minus the private equity. Farm the management to professional firms and pay them a modest fee. This way the American taxpayer bears 100% of the downside and gets 100% of the upside (minus a fee). It is safe to assume that the fee would be less than 50% of all profits!
- Distressed fund with the government as an equity investor. This fund could be levered but without government guarantees. This is a model that I proposed in September 2008 before the TARP was introduced.
II. TALF for Legacy Securities
The details are still vague on this initiative. Essentially, the government will lend money to investors to buy legacy securities that were at some point AAA rated – but could have any rating today. It is an expansion of the TALF (Term Asset-Backed Securities Lending Program). The original TALF focused only on today’s AAA securities. The government would lend money for participants to buy these securities – thus providing much needed liquidity in important markets like credit cards and student loans. Critically, these were low risk loans that the Federal Reserve is making because they focus on securities that are rated AAA today.
The new program expands this to potentially very risky securities.
The details are vague: “Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not yet been determined. These and other terms of the program will be informed by discussions with market participants.”
This simply means that the government has not determined how much leverage the private investors get to use.
In the end, this program might be worse than the first initiative. The private investor maximum downside is simply their investment. The government bears all the downside. Profits go 100% to the private investor.
In the Legacy Loan Program, profits were shared. Not in this one. The American taxpayer gets stuck with the downside and gets jack on the upside.
III. Legacy Securities in PPIF
Government farms out investment management to about five professional firms. Here is an example of the mechanics.
Invest $100 million in RMBS, CMBS, that were originally rated AAA (but could have any rating today)
Private investors contribute: $25 million in equity
Government contributes: $25 million in equity
Government contributes: $50 million in debt
Maximum possible loss: Private investors $25 million; Government $75 million
Profits: shared equally. Professional manager also collects management (and presumably a performance fee).
Sound familiar. All of these programs have similar themes. Let’s induce private investors to put a very modest amount of capital up. The inducements are: we will cover the downside and we will allow them to have potentially massive profits (essentially giving them an inordinate amount of the upside).
Final remarks
One of the reasons that the market for illiquid assets has remained so illiquid is that everyone expected the government to come in and do something out – to subsidize the private investors. Why buy today when you can get a much better deal from the government? We have expected this since the TARP was introduced last year. And now it comes to fruition.
Yes, the market is up. Why not? It is a good deal for private investors. Did you hear the laudatory comments from PIMCO, BlackRock, etc.? They stand to gain the most.
Yes, the programs will create new liquidity and drive prices of troubled assets upward. However, I believe that the stock and bond markets are putting undue weight on the short-term implications and not thinking through the long-term implications. These programs are not free. The size of the government debt will dramatically increase potentially crowding future debt. The Fed is printing money at will potentially at the cost of future inflation. Eventually, participants will ponder the long term costs of these actions. The hangover will not be worth the party.
Here is the link to the Treasury proposal.
Professor Harvey,
Those are good points; I would note that the government will probably collect taxes on the private investors returns and will charge some financing rate on the debt so the government does get more than half of the upside. Even with this tax/finance-charge adjustment, it looks like the reward/risk is asymmetrically favoring private investors. It would seem preferable to have private investors in the first loss position for the first 20% or 30% of losses– the drawback is that this might make it less attractive for private buyers and the government would have less upside.
It seems like the big challenge will be that sellers (like Citi) won’t sell at distressed prices since it would result in further writedowns. Perhaps this program is a prelude to forced liquidations of institutions receiving government money?
There is no alternative. Of course the pot has to be sweetened for private investors. Otherwise they would have already bought the assets. This plan at least gives the taxpayer some upside and also means investors will share any loss. It is not equal but much better than previous plans when all the upside went to private investor and all the downside went to the Government. At least now it is shared to some extent.
To David,
Good points on the tax recovery. However, I am not sure how much the government will recover. I am not a tax expert but even the performanc fees of hedge funds are taxed at very low rate, the capital gains rate.
To Dan,
Why do you say there is no alternative? I spelled out three simple alternatives? I am not sure what you mean by “sharing the loss” when investor can lose $7 and we (the people) can lose $93. I agree with you that in the previous model it was 100% of upside to private investor and 100% of the downside to the government (too big to fail). So you are right, this is an improvement. However, it is not good enough (in my opinion).
Will the small investor be allowed to participate in this racket? With the cash that I have taken out of the market because I no longer trust it, is there any way I can invest somehow? After all, I like 148% returns as well. And as a taxpayer along for the involuntary ride, I’d rather have opportunities to participate more directly in the upside. Seems like an opp’y to create a fund open to the individual investor. (Not that I know how to do that, but might be more inclined to invest in such over my poor, supposedly “safe” market-tracking index fund).
It’s such a fleecing I am (almost) speechless. TANSTAAFL!!! When are the holders of bank debt going to take a loss? When are our political leaders going to admit the truth? The truth is this: we cannot borrow our way out of financial depression. The debt load is too high as is. Sticking the losses on the taxpayer is perverse.
Great post, Cam, thanks.
Update: a guy at slate.com is thinking the same thing. https://www.slate.com/id/2214509/
Gid,
I think small investors are out of luck. My original proposal was to form a giant distressed fund (think of this as a mutual fund that specializes in buying distressed assets at fire sale prices). The government would seed the fund with some equity, say $100-200 billion. The fund would then be open to other investors — worldwide. Further, there should not be a restriction on investment size, so anyone could invest in the fund no matter how small the amount. The fund would be able to raise debt – but no government guarantee. If the government’s share was 20%, they would get 20% of the upside and bear 20% of the downside. That seemed fair to me — and still does.
Here is a similar perspective:
https://krugman.blogs.nytimes.com/2009/03/23/geithner-plan-arithmetic/
Campbell,
You’ve put the proposals in a nutshell: This is the way we all got into this mess. As I understand them, these proposals have other negative aspects for the US taxpayer:
1. Asset sales to these new funds will be voluntary and hence we can expect a fair degree of adverse selection. I fail to see (in the light of all the theory and evidence on banks, etc.) how an outsider can value these toxic assets better than the banks themselves. So buyers must expect to overpay since banks will only sell them if their hidden valuation is less than the bid price.
2. From a private investor perspective, their modest investment has all the hallmarks of a call option on the portfolio. This option-like quality and being long volatility will lead to risk-seeking behavior by the funds.
The above are not a good outcome for taxpayers. This looks like a good deal for Wall Street and a bad one for Main Street. I wonder about the financial savy of lawmakers in Washington. It is, as you rightly say, doing a deal in the short-term which has a huge negative impact over the longer-term. Is it a case of back to the drawing board?
Cam : thanks for your response. Why do you think people are not following your advice? I am getting an MBA from Duke so I think I know something.
Professor Harvey,
In addition to generating negative long run consequences as you eloquently pointed out in your blog, this public-private investment voodoo wouldn’t even fix the pressing problems in the short term either.
As John Taylor eloquently pointed out, the fundamental problem here is about counterparty risk.
Counterparty risk is a problem that emanates from the REAL side of the economy.
The initiative being proposed does nothing to address the real side. All it does is pumping more money into the FINANCIAL side, which would obviously temporarily inflate asset prices as the result of demand imbalance. Without improvement in the real side, there is nothing to sustain the inflated market value of the assets and they will soon fall back to earth. This is precisely the same reason why the Fed rate cuts and the TARF fund haven’t worked either.
This is akin to giving repeated electric shocks to a patient whose internal organs are failing. Sure the electric discharges will temporarily stimulate the patient’s external organs (limbs), but the stimuli will quickly wear out and leave no permanent impact.
Heck, even cadavers react to electric shocks! Still, does anyone believe that we can bring the dead back to life this way ?( in the real world that is, not the Frankenstein universe).