Geithner plan arithmetic

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

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

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

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

Notice that the government equity stake doesn’t matter — the calculation is the same whether private investors put up all or only part of the equity. It’s the loan that provides the subsidy.

And in this example it’s a large subsidy — 30 percent.

The only way to argue that the subsidy is small is to claim that there’s very little chance that assets purchased under the scheme will lose as much as 15 percent of their purchase price. Given what’s happened over the past 2 years, is that a reasonable assertion?

Update: Another way to say this is that by financing a large part of the purchase with a non-recourse loan, the government is in effect giving investors a put option to sweeten the deal.

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Michael Kogan March 23, 2009 · 10:18 am

yes it is because the assets have fallen so far over the last 2 years that it is hard to imagine that they are not underpriced at this point

David Lentini March 23, 2009 · 10:27 am

Has anyone put your points to Roemer, Geithner or even Obama? We have to stop playing softball with the people given the huge stakes here. I’m very worried that this plan is being sold with the same cavalier attitude towards the facts and implications (i.e., risks) that happened in the rush to invade Iraq back in 2003.

If the people pushing this idea can’t explain why the plan is still a good deal in spite of these risks, then it’s time to move to Plan B: Nationalization.

Lloyd Little March 23, 2009 · 10:33 am

Wow, thanks to the individual(s) that moderated the comments to your column today, not!

They left long winded dribble by undoubtedly glassy eyed Obama supporters, and pretty much then stopped allowing other posts. Actually, the arguments posted their contradicted themselves, and grossly. Simply put, they didn’t at all note that Geithner’s plan is the same as Paulsons’!

Wow!

Note to that individuat(s): Times readers aren’t stupid…we see through your fear of a truly progressive agenda…plus, don’t worry, don’t panic so much that in your attempt to cover yourself, as oppossed to the Bankers!, you forget we believe in a free press…wow!

Thanks!

jck March 23, 2009 · 10:35 am

I would underpay, say 70, with the non-recourse, I risk 10.5 with upside to 150-70=80
better than your coin-flip

Mo March 23, 2009 · 10:37 am

Hoorah! The great American ponzi scheme continues!

Robert Harris March 23, 2009 · 10:42 am

The punch-line of this post:

“Notice that the government equity stake doesn’t matter — the calculation is the same whether private investors put up all or only part of the equity. It’s the loan that provides the subsidy.

And in this example it’s a large subsidy — 30 percent
”

Is vague and and has numbers provided without explanation… rendering this post meaningless for any layman looking for logical reasoning.

It’s pretty unnerving when a well known educator tries to make his case with such a flawed presentation of his argument… This is serious stuff and if Dr. K has a valid point then he should take the time to be clear.

Max Kennerly March 23, 2009 · 10:44 am

Under any scenario — loss, gain, or default — this inflated price results in an instant subsidy to the seller of the “legacy” assets.

Treasury will have no trouble at auction, given the opaqueness of the process and Wall Street’s ease in creating new vehicles: it’s like giving me an 85% subsidy to buy at my own garage sale.

All I have to do is create “Toxic LLC,” bid everything up as high as possible, then buy the junk and throw it in the garbage. Viola! The garage sale revenue easily trumps the losses of Toxic LLC, which I declare bankrupt and then walk away.

Kym Lamb March 23, 2009 · 10:47 am

Professor Krugman,

Is there an up side to this politically or otherwise?

Is this plan somewhat of a bipartisan compromise or an experimental step? And if it doesn’t work, perhaps then, the administration is then free and clear to sell nationalization to the public? “We tried xyz and it wasn’t enough, so now we must nationalize.”

When will we know the plan is working? A few months? Six months? What is the measure? A thawing out of the credit markets? If this is a halfway step (the last chance effort to avoid nationalization), what does the extended time cost us?

MCA March 23, 2009 · 10:55 am

This point has been made a few weeks ago:
//www.interfluidity.com/posts/1235210036.shtml

Bundling the assets with a put option contradicts the stated goal of transparancy and price discovery for the assets, as the options are quite valuable themselves. (Otherwise there is no reason to make the loans non-recourse.)

Steve Zorowitz March 23, 2009 · 10:58 am

That’s a disingenuous example. Try it this way:

There’s an equal chance the asset is worth 50, 100, or 150. Same expected value of 100.

But if the HF pays 130 and puts up 19.5, it makes 20 1/3rd of the time, and loses 19.5 2/3rds of the time.

I’d rather assume a normal distribution of returns than yours.

S. Lubben March 23, 2009 · 10:59 am

Does the non-recourse issue even matter? Presumably the hedge funds would borrow through a limited liability entity anyway . . .

Nathan Hellweg March 23, 2009 · 11:01 am

Another issue is that someone can buy calls on the bank and then overpay for the assets using treasury money, or the bank can overpay itself with treasury and FDIC money for its own assets through an intermediary. (There’s probably more opaque ways to do that sort of thing.)

Basically, all of these plans have been the same. Uncle Sam hands the banks a pile of money without getting much in return. There’s public outcry because it’s foolish, and fundamentally unfair to give money to these institutions just because they’ve made such huge losses, but some money gets put into the banks anyway.

Even if you give him a couple of inches of dental floss, the emperor is still naked.

Jim M March 23, 2009 · 11:06 am

I guess I don’t generally equate loans with subsidies, subsidies are usually money that is granted not loaned I think.

I wonder if the author has been keeping track of the recently proposed legislation to grant additional power to the FDIC to deal with bank holding companies. I have not seen him discuss it. That legislation suggests to me that taking the largest banks into receivership was more complicated than he has suggested and that the administration is preparing for that possible course of action.

As for the merits of the Geithner plan, I am still trying to understand it better.

Jeff Crook March 23, 2009 · 11:09 am

Another way of saying this is we can just replace his bad brain with a good brain, the monster will be as right as rain and we can all go back to our house flipping jobs.

Will O’Neil March 23, 2009 · 11:11 am

What’s the discounted NPV of these assets? Is there anything to the hold-to-maturity argument that we hear from some quarters? How optimistic about default rates does one have to be?

Hal March 23, 2009 · 11:16 am

You meant to say “share in the upside”, not “downside” did you not? That is the fib the administration is telling.

stacy clint March 23, 2009 · 11:17 am

Face it Prof, you were always gunning for Obama. I am no fan of either of you-but this is becoming foolish. Everytime I pick up the NYT I can assume automatically that you story would be Obama and how he’s making the wrong decisions. Face it, this is the U.S and not Sweden take your nationalization pipe dreams somewhere else. And did not offer to hear your thoughts. Just as they are stuck on their plan you are stuck on yours- so I don’t understand your rationale of saying they are bone-headed.I am sure this comment will be deleted before its even posted.

Nick Parker March 23, 2009 · 11:17 am

Re Michael/#1: Even with mortgage rates at their current lows, home prices are still being pressured downwards due to lack of consumer confidence, a surplus in supply, and a difficulty in obtaining credit. These factors lead me to think that we probably have some ways to go, especially in those areas that enjoyed rapid appreciation during the boom but haven’t yet seen a significant return to pre-boom or even early-boom territory.

puzzled March 23, 2009 · 11:17 am

I don’t get it. In the first example the private parties bid up to 100 for the asset (50% chance of -50, 50% chance of +50) in the second example the private parties bid up to 130.5 for the second asset (50% chance of -19.5, 50% chance of 19.5=(150-130.5) )

Isn’t it the case that so long as the privates bid competitively for the asset – they’ll bid against each other to dissipate any implied subsidy?

puzzled March 23, 2009 · 11:20 am

OK, maybe I get it. The private parties overpay for the legacy assets b/c so the subsidy goes to the bank….?

tew March 23, 2009 · 11:22 am

Paul,

You don’t even mention that the private investors will take long positions in the selling banks’ stocks (or other long positions in derivatives) and will then have an incentive to grossly overpay for the securities in this program. They’ll gladly take some losses in this program to boost their other positions outside the program.

Without strong prohibitions, audits, and enforcement this is nearly certain.

CathyG March 23, 2009 · 11:23 am

If there were any doubt that Geithner’s plan is heavily tilted toward benefitting private investors and banks at the cost of US taxpayers, today’s announcement that PIMCO has signed up to be an investor ought to settle it.

PIMCO has consistently been one of the most opportunistic investors out there.

cre March 23, 2009 · 11:33 am

Steve, just shift your normal distribution down a bit closer to zero and you’ve made the point. The problem is that nobody knows where the mean is.

BLD March 23, 2009 · 11:36 am

Is this not essentially a centralization of credit-default swaps? Private firms pay a 15% premium and in AIG fashion, the government takes over the risk of default. As the entire Obama Administration program has been, this is simply an extension of the status quo system that failed.

Art March 23, 2009 · 11:39 am

1. But the equity is the risky position. Have you heard of risk premia? Equity always works like that – higher expected value and higher variance.
2. There is no risk of ‘asset substitution’ as management of the asset does not control its risk here.
3. The odds that the asset will lose 15% of value should be based on the price, which is based on what investors with skin in are willing to risk, not on recent history.
4. The whole point is the extra boot to get savvy people sifting through these assets, but they do stand to lose if overbid, which is much better than the guarantee we give to TBTF banks.
5. I haven’t much liked Geithner’s past moves, but the more I look at this plan, the more it makes sense. It is a kick to motivate some action, but its not obscene handout.