The Treasury's Plan to Buy Bank Assets-Becker

One good aspect of the Treasury's plan to enlist the private sector in buying mortgage-backed and other bank assets is that it reduces the uncertainty-if it is implemented! - about what the government plans to do further in aiding banks. Starting with the vacillations of Henry Paulson, the former Treasury Secretary, the federal government's efforts to help banks have lacked a clear direction, and have wasted a lot of taxpayers money. Especially during a serious recession (I will call this a recession, not a depression, until the cumulative fall in GDP equals or exceeds 8-10 percent-so far the fall in US GDP has been about 2%, and world GDP has hardly fallen), consumers and businesses can cope much better if they know what the government plans to do. They can adjust much more easily to known government policies, even if they are not good policies, than to changing policies that lack any direction. A major criticism of early plans for the government to buy bank assets through an asset auction was that the government would overpay for the assets since they did not know the worth of the assets offered to them. Although that difficulty might be overcome, the Geithner proposal uses government money to encourage hedge funds, pension plans, and other financial institutions to buy bank assets in order to use private competition to determine the worth of these assets. Hedge funds and other financial institutions do not want to overbid since that would reduce their profits from any future appreciation in the value of the assets bought. Competition among different financial intermediaries for these assets would prevent them from underbidding since they would then not be able to buy the assets. To encourage private participation, the Treasury Secretary is offering bidders very generous terms. If say a hedge fund bids $100 for an asset, the fund would have to risk only about 7%, or $7. Another 7% would be risked by the Treasury (i.e., from taxpayers), and the rest would be a loan guaranteed by the Federal Deposit Insurance Corp. (FDIC). If the asset rises in value over time, the Treasury and the hedge fund would share the profits equally, while the hedge fund's losses if the price goes below $100 is limited to the $7 it puts up, no matter how low the price goes. Therefore, the downside loss to private companies in this example would be sharply limited by the equity they put in, while the upside gain could far exceed their initial equity. This means that hedge funds and other funds would find riskier assets very attractive, and they would bid more for them than for less risky assets with the same expected return. For example, suppose one asset had a 100% chance of being worth $100 in the future. The expected value of the asset is obviously $100, but a private fund would bid $107 because the Treasury would pay $7 of this bid. Suppose, on the other hand, there is another asset that has a 10% chance of appreciating to $1000, but it has a 90% chance of becoming worthless. The expected value of this asset is also $100, like the safe asset, but in my example it is worth much more to bidders under the Treasury's terms since the FDIC would pay the successful bidder 86% of its bid price if the asset became worthless. It can be directly shown that private funds bidding their expected value would then bid about $242 for this asset, which far exceeds the asset's overall expected value of $100 because the FDIC is guaranteeing most of the loss, and the fund would collect half the appreciation. Even if it were desirable to subsidize private funds to bid for bank assets, is it wise to structure the subsidy in this way so that the bidding is skewed toward more risky assets? One reason for doing so is that assets with greater variability in their future worth are presumably harder to value. Hence banks holding these assets might value them more than other financial institutions would. These would then be the type of assets that banks would be reluctant to sell in an unsubsidized market since market bids would be below bank estimates of their value. The Treasury's approach raises the willingness to pay by hedge funds and other financial institutions for precisely such risky assets. Posner's proposal is to do more of what the government did earlier; namely, lend to banks in return for preferred stock in the borrowing banks. This has the advantage of being simpler than the Treasury's convoluted proposal, and Posner gives some other advantages. However, I would worry a lot that the government when they hold greater amounts of stock would try to micromanage banks even in greater detail than they are already doing. Congress and the president have complained loudly about bonuses, pay levels, golf outings, and other business activities, and legislation was introduced to limit pay and perquisites. Under Geithner's plan, Congress might have less incentive to micromanage the decisions of hedge funds and others who buy bank assets since the government would have an equity interest in particular assets rather than an equity interest in the overall profits of these funds. However, Congress would also complain a lot if hedge funds and others made a large profit from the assets they bought with government guarantees. Perhaps this is why the Treasury's proposal gives such a huge subsidy to the funds that would bid for bank assets. In the absence of large subsidies, leaders of these funds would be reluctant to expose themselves to the torrent of criticism and interference from Congress and perhaps also the President. Nevertheless, it is highly worrisome that taxpayers would become committed to such potentially large additional subsidies to the financial sector.

Comments

[Robert Miller]

Based on Geithner's plan it seems each bank should bid as much as possible on its own toxic assets regardless of the assets value. For every dollar they spend buying their own toxic asset the government would provide them with an additional 14 dollars.

[David Heigham]

My guess is that, for once, the angel will be found to be in the small print of this plan.

The governemnt preserves discretion on such aspects as which securities it will accept in the plan and at what price. Once the market begins to work reasonbly smoothly, I expect to see these discretions exercised increasingly. I also expect that the tax issues which Posner points to will often be resolved in favour of the government, creating a very uesful additional Treaury revenue stream.

The buyers who get into this market first are going to make a killing; as people who choose the right moment to buy unpopular assets generally do. Those who come along behind are likely to find that they have to make do with surprisingly normal profit levels.

[David Heigham]

Isn't the angel, for once, in the details?

The plan preserves government discetion in what securities to accept in the plan and at what price. It would not be surprising if, once the market is working reasonably smoothly, we were to find these discretions being exercised in a far from generous way. Nor would it surprise me if the unresolved tax points that Posner refers to turn out to provide a very nice extra revenue flow for the Treasury.

The people who get in first under this plan are going to make a killing, as people who choose the right moment to buy unpopular assets generally do. Those who come along later may well have to content themselves with surprisingly normal profits.

[Eric R Weinstein]

Sorry Gary, but I don't get it. Something that "reduces the uncertainty" to "encourage hedge funds" with "generous terms" would seem to be an out and out anti-market subsidy or wealth transfer that you now seem to be promoting.

Can you explain why Chicago economists don't recommend simply valuing the assets assuming the illiquidity into the valuation. For example type "valuation of illiquid assets" on Google and grab the first result:

Valuation Bias for Illiquid Assets (2002)

Otherwise, this feels like "pick and choose" to save reputations after the fact. What you are endorsing is of course a massive subsidization of failed speculators by functioning agents in the economy. Am I getting this wrong or are you now reconsidering your life's work in light of current events?

Bewildered,

Eric Weinstein

[Gary]

Dr. Becker,

Apologies to query your arithmetic, or perhaps I misunderstand the rules:

Ex. 1 - you suggest a bid of 107 this assumes that investors' "equity" is senior to the Treasury's "equity". I believe the rules suggest that in fact they rank pari passu.

Ex. 2 - I believe the equation is: Let E=total equity. Leverage is approx. 6 times E. So E=10% x (1000-6xE). Solving for E = 62.5. So investor puts up 31.25; Treasury 31.25; debt of 375; for a total bid of 437.5.

Or have I erred?

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