Indirectly related, I'm sure you'll recall the recent reports of Treasury intending to use SPVs to distribute TARP cash in order to evade executive compensation limits. You know, money laundering of sorts. This after all of the kabuki outrage expressed by Geithner and his boss over extravagant compensation.

Brazen indeed. It's difficult to see how this sort of behavior won't occur with the PPIP. They're giving us the finger.

Isnt the whole point to shift money to the banks so that there isnt another Great Depression or something. Do people want to keep their taxes and have no job or what?

Missing the point, of course, points out the obvious. Say what you will about Hank Paulson's original intention with TARP I, it was light years more honest than anything we have witnessed since.

Here's a lone dissenter:

http://blogs.ft.com/economistsforum/
2009/04/the-geithner-plan-criticisms-are-off-the-mark/

First, in all of your cases PE gets nothing -- I don't see this happening in aggregate. But that's not what I was going to say.

Your view of the 'consolidated financial sector' makes sense -- except in the case where a bank is nationalized. In that case the government directly assumes banks' losses and the picture is more 'private equity and banks' versus 'the consolidated government plus nationalized banks' sector.

That is likely to happen if the losses in aggregate are large.

In that case private equity is going to lose in aggregate (because they will have overbid, like everyone) and the consolidated govt + nationalized bank sector will be a net winner. Essentially PE will have eaten a chunk of the losses otherwise assumed by the govt.

babar — that's only true to the degree that the financial sector winners are the same as the ones nationalized, and to the degree that nationalized firms are certain not to haircut creditors. "consolidated financial sector" is a simplified first pass, which i hope i unsimplified adequately in the second paragraph.

you can come up with scenarios under which PPIP is gamed, but the profits all go to insolvent banks who remain insolvent despite the program, so that the subsidy is recaptured in a nationalization while some private actors have been goaded into absorb a bit of the loss. that strikes me as unlikely, but it is possible. i think it is more likely that some already viable banks receive subsidy, and some banks that are a priori insolvent receive sufficient subsidy to leave them viable and then some, in which cases substantial net subsidy remains with the private sector even relative to scenarios where all bank bondholders are guaranteed. i have a hard time evaluating the probability of various scenarios, but i think the net small private loss scenario is particularly unlikely.

(i think there's a significant chance that PPIP will fail to move many assets at all, and a significant chance that it will move a whole lot of assets at exaggerated prices. it depends on perceptions of legal and political risk by financial sector assets, and the degree to which FDIC/Fed/Treasury genuinely work to prevent gaming or give it winks of encouragement. these things are hard to know and weigh.)

the fine print says that the FDIC-insured debt is tradeable. i assume the paper will be issued by the PPIV's themselves. it's a non-recourse default swap market!

SRW,

I've had trouble analyzing this PPIP all along, particularly getting stuck on the correct meaning of recourse and non-recourse in the context of PPIP collateralized lending, versus, say, FDIC insurance. I'm still not there. But here is some rough thinking on PPIP in general using a somewhat different intuitive process. I'm assuming actual outcomes and counterfactuals for insolvency here that don't necessarily include haircuts for bondholders, and where the government is at risk for losses beyond equity holders – the “no more Lehmans” resolution mode, I guess. That comparison may not be right, depending on your point of view. If so, the analysis could be adjusted further to allow for the effective reduction of government subsidies via debt haircuts in insolvency.

This analysis is separate from the issue of gaming and self-dealing per se. A lot has been written on that. Obviously this is a potentially huge risk, but separate from the question of analyzing the economics of PPIP as intended. In fact, I think the analysis of gaming possibilities is somewhat simpler than gauging the full effect of PPIP as intended without gaming. I think you may allude to this in your 5:05 comment above.

So, first split the deals between those on which PPIP private equity makes money and those on which it loses.

Assume the measure of whether private equity makes or loses money is a function of whether or not the maturity value of assets purchased exceeds or falls short of the purchase price.

If you assume this, and I don't know why you wouldn't, then the maturity value of any assets sold to PPIP is the same maturity value experienced in the counterfactual, where the selling bank instead retains the assets.

So, maturity value in this sense is a yet unknown parameter that is nevertheless fixed in the case of both PPIP sales and the counterfactual of bank retention.

Next, if private equity makes money on individual deals, it is only because the assets sold were underpriced by the selling bank. Therefore, based on what turns out to be the true economic value for the assets, there is no government “subsidy” for the selling bank, solvent or insolvent. In fact, both private equity and the government alongside it have extracted value from the selling bank, because the selling bank would have realized greater value had it held the assets to maturity. This is the case whether the selling bank is solvent or insolvent. (Even more than that, it is the case whether or not solvency or insolvency is even being measured correctly or incorrectly at the time).

Next, if private equity loses money on individual deals, it means the assets bought were overpriced by PPIP at purchase. Then there is an immediate subsidy effect, since the bank sold assets for a greater price than it would have realized by holding them to maturity. Based on true economic value for the sold assets, there is both a private equity and a government equity subsidy for the selling bank. In addition, if the government “put” is in the money, there is an additional government subsidy. The total immediate subsidy is effective whether the selling bank is solvent or insolvent. The total size depends on the degree to which losses eat into PPIP equity and debt.

This is the immediate subsidy effect. The full effect depends on whether or not the selling bank is solvent or insolvent.

If the selling bank is solvent, the immediate subsidy effect is the full subsidy effect. It is a gift for the participating bank, due to poor risk judgement on the part of PPIP.

If the selling bank is insolvent, the immediate government subsidy via PPIP is only part of the full subsidy. It is a cost that would have been incurred via insolvency resolution, with or without the asset sale. Nevertheless, the full subsidy cost is reduced by what it might have been without PPIP by the amount of private equity losses incurred via PPIP. So the government in a sense gains on a relative basis due to private equity losses, compared to the case without PPIP.

The odd case is where the proceeds from a PPIP subsidy by overpricing assets make an insolvent bank solvent. Then the amount of government subsidization required to reach the solvency threshold is a cost that would have been borne without the PPIP sale (reduced by private equity losses) and the amount exceeding the threshold becomes the net subsidy.

The final result of PPIP is then the sum of the actual distribution of these various permutations of individual equity gains and losses, plus debt losses, compared to the counterfactual result without asset sales to PPIP.

Again, this leaves out self dealing risk, which has already been described extensively, and which is a potential horror show without some sort of specifically targeted restrictions in place.

I found Spence's article somewhat interesting because it assumed that the government would make judgements about different acceptable leverage ratios for different deals, based on different assessments of risk. I hadn't seen that idea figure much elsewhere, but have no idea how they would design and implement such an approach. Most people are focused more on the substantial self dealing risk at this point, which Spence mostly ignored.

JKH — I think that you're thinking this through basically correctly. If "no more lehmans" means all bank bonholders will be made whole, then subsidies (however defined) up to the point of solvency represent a financial cost taxpayers would have had to bear anyway. (This is John Hempton's argument.) BUT, that's much too simple an analysis. 1) Any subsidy above the point of barest viability is a taxpayer giveaway relative to the baseline of consolidating gov't and bank balance sheets; 2) even if the subsides aren't sufficient to bring the system as a whole to barest viability (i don't think they can be at the scale currently announced), some participating banks will be viable or near viable, and extract a fiscal subsidies that adds to the total taxpayer liability; 3) if gov't assumed bank balance sheets explicitly, taxpayers would have future upside in exchange for a by-assumption fixed cost of paying up creditors. if we assume bank liabilities by subterfuge, the restored "franchise value" is privatized, representing a subsidy relative to alternative no-haircut scenarios; 4) there's no need to assume no haircut scenarios. "no more lehmans" can be interpreted as a commitment carefully managed reorganizations rather than as a commitment to make all creditors whole.

fdic always has the right to price deals as it sees fit. the question is will. this is an organization that wrote the largest and most important put option in the world at no cost for a decade, because it and the government that manages it was largely captured by the parties benefiting from the option. if fdic is serious, tough, and sufficiently staffed, it absolutely could refuse to guarantee financing except on taxpayer advantageous terms. but that assumes that fdic is committed in fact, as it is by law, to a least-cost resolution. i don't believe that is the case — i think fdic has volunteered willingly and knowingly to be a conduit for a large deferred wealth transfer, on the false theory that what's good for incumbent banks is necessary for the broad economy. that's just an opinion, although I think a fairly considered one that I could support circumstantially. what do you think?

SRW:

No problem. The abundance of scams is actually the most striking thing about the PPIP. It was the first thing that came to mind for anyone with a background in hedge funds, private equity, or energy, and it had to be blindingly obvious to the folks at Treasury.

Since every scam would be defeated by making the loans fully recourse and ensuring capital adequacy at the parent, you have to assume that encouraging the scams is a feature, not a bug. And that is terribly depressing.

Needless to say, they are right back to the Doublespeak with the stress tests:

http://tauntermedia.com/2009/04/09/lake-wobegon/

SRW,

Your point about government assuming bank balance sheets and thereby capturing the restored franchise value for the benefit of the taxpayer is interesting. In part it recalls the MTM discussion. One of the advantages of government is that it has the staying power to be able to restructure a bank balance sheet without being subject to the MTM urgency of explicit recapitalization faced by banks on their own (an argument also supporting MTM relief). As discussed previously, this beneficial effect for the government in dealing with the existing book of assets and liabilities could account for at least some portion of the franchise value recapture. The rest could come almost as easily, given the profound skittishness of markets in capitalizing full franchise viability when that viability is close to the edge. That volatility and potential value recapture on behalf of the taxpayer would seem to immunize at least some of the standard moral hazard involved in the full process of a government “rescue”. Maybe one way of thinking about the interconnection between MTM, capital adequacy, and franchise value is that in the process of seizing the balance sheet, the government instantaneously extends the time horizon for the call option value of the franchise, thereby increasing its value per se. Whereas the bank operating on its own, subject to the urgency of MTM and knock-on capital adequacy and franchise value risk, is effectively offering call option value that is subject to potentially accelerating time decay.

I had a particular problem with Hempton's argument at an analytical level. Consider a given portfolio of assets funded either by a bank or by a PPIF (or a set of PPIF's). The bank's liabilities (assume deposits + other) are protected by an FDIC put. This is protection at the portfolio level. On the other hand, the PPIF(s)' liabilities are protected by a set of FDIC puts, based on asset collateralization. Non-recourse in the case of bank liabilities means non-recourse to the non-portfolio assets of the equity owners (equivalent to LLC non-recourse). But it means effective recourse to all portfolio assets. Non-recourse in the case of PPIP liabilities means non-recourse to the non-portfolio assets of the equity owners. But for each liability it also means non-recourse to portfolio assets other than those used as collateral for the specific liability in question. Therefore, the non-recourse provision for each PPIP liability is more restrictive than the non-recourse provision for each bank liability. That means the PPIP non-recourse put value in total is greater than the bank put value. The bank put is subject to the portfolio effect; the PPIP put is not. It was on this basis that I argued contra Hempton pro Krugman that it was not necessarily inconsistent to oppose PPIP while acknowledging “no more Lehmans”. Hempton produced four posts in a persistent effort to stamp Krugman as illogical. Granted, that seems to be a popular ambition among economic bloggers. Perhaps it should have its own Nobel Prize.

The Fed, Treasury, and the FDIC have all expanded their normal functions. The Fed has undertaken credit easing, Treasury has made equity investments, and the FDIC has expanded liability guarantees. One can argue against the exact partitioning of various pieces among the different entities and question the related notion of the independence of the Fed. But the partitioning is not a huge deal to the degree that everything puts the taxpayer at risk. All of it amounts to active taxpayer risk in the banking sector. They're all conduits for a risk transfer, which may result in a wealth transfer, size yet to be determined. Somebody who's actually executed the nationalization of a US bank is Bill Isaac, Chairman of the FDIC when it took over Continental Illinois. When interviewed recently, he basically said it was an operational hell. I think this in their minds still.

can someone explain this? seems the FDIC loans will take the form of secured debt issued by the PPIFs themselves, placed with the sellers and presumably paying interest. so they're tradeable IOUs. the participating bank, i gather, would sell them in order to monetize; the buyer, i assume, would receive a discount for this reason? no?

from the "legacy loans program summary":
"How will the PPIFs' debt be structured?
The PPIF will issue debt that is guaranteed by the FDIC. This debt will initially be placed at the
participant bank. The participant banks will be able to resell this debt into the market if they
choose."

jkh — i thought your comments re john hempton's posts were spot on. there are lots of ways that ppip can be more expensive than full assumption of large bank liabilities. your distinctions about what assets their is recourse to is ultimately a claim about the ability of banks under PPIP to have ex-post positive net worth not captured by the government, where as under a nationalization scenario, an positive net-worth of bank portfolios would be used to offset publicly provided subsidies. i think you used the concept of "granularity" in your hempton comments, which is right. incidentally, a similar point in a very different context is attributed to shiller here.

@taunter

I don't accept the idea that bonds of existing banks should be immune from impairment either, but I think it is a useful starting point for understanding the mindset of the PPIP.

I could be clearer on my points #3-#5 but not with my cloudy present mind.

@srw

No, in the full recourse state the treasury needs to move quickly and foreclose as fast as it can to preserve its interest if values are falling. In my example above, if the value falls slowly from $7B to $3B, the treasury needs to liquidate the portfolio by the time the value reaches $5B. Also as I have read several times on this site, financial institutions which are highly liquid but highly insolvent are quite hazardous as they are prone to extreme bets -- so the T will not want to create them.

@srw

You're right, the treasury could abandon prudence and not enforce any sort of margining or mark to market. The courts would enforce mark to market after the fact through fraudulent conveyance statutes. (Did I mention I send my kid to an expensive private school run by my brother?)

Less sarcastically: what you are suggesting has very different goals than the PPIP. When you say 'you don't need transfers of all the assets to make a market' you are invalidating one of the key premises of the PPIP -- one of its primary purposes is to remove these assets from bank balance sheets. In my posting I am specifically not addressing larger issues. I am just trying to describe why, given the assumptions and goals the treasury started with, non-recourse funding is reasonable. (So I am resorting to non-recourse logic here.)

My arguments are also non-recourse in that I will not stand behind them personally. I am just trying to figure out how they got from their goals to this program. I would do something very different, which you would probably like even less.

Steve --

You are talking about a single non-recourse loan to each individual, right? Or can I, as an individual, take out multiple non-recourse loans, each one collateralized by a different asset I purchase?

The phrase "non-recourse" is vague enough that it can result in extremely fuzzy thinking and ridiculous arguments (cf. Hempton). The real question is, with recourse to what?

FDIC bank insurance is with recourse to all of the assets of the bank. The PPIF insurance is with recourse to each pool of assets. This simple observation is what makes Hempton's argument nonsense. (Well, that, and the "all bank bonds are now full faith and credit of the U.S." premise.)

Your proposal, if I understand it correctly, is to make the loans full recourse with respect to the individual's other assets. But when you say "non-recourse", it implies that the individual can surrender the collateral and thus discharge the loan. I am pretty sure that is not what you mean, since you mentioned "bankruptcy", but I suggest you take care to be more clear.

...

Steve and Taunter have already responded to babar. "Margin calls" are optional in any event; "make all bondholders whole" is absurd policy; etc.

It is pretty clear (to me, at least) that the Treasury has intentionally designed this structure to transfer taxpayer wealth to the banking system without requiring a Congressional vote. In my view, not only does this exceed their statutory authority, but it is a fully conscious and deliberate effort to do precisely that.

Nemo's general point is exactly right:

“The phrase "non-recourse" is vague enough that it can result in extremely fuzzy thinking and ridiculous arguments (cf. Hempton). The real question is, with recourse to what?”

“Non-recourse” is an unfortunate and truly illogical term. There's no such thing as “non-recourse”, not really. There are only degrees of recourse, which must be specified in order to have an intelligent analysis.

PPIP recourse is more restrictive than FDIC recourse. That means the creditor put option in total is more out of the money under PPIP than under FDIC. That means the equity call option is worth more under PPIP than under FDIC. All of that means Hempton is wrong.

“Banks are non-recourse” gets the prize for most magnificent blur; awarded to John Hempton.

jkh has me pretty much right.

babar, in a mark-to-market world, you never know whether you are "lett[ing] the investor become insolvent but not call[ing] in the loan", or whether there is a market downspike unrelated to the actual cash flows that will be realized from the asset.

(even if markets were perfectly efficient, jkh's point would hold, not margining would leave a borrower with an out-of-the-money call upon redemption, and redemption is always possible due to unforseeable shocks. in a world with imperfect markets, it's quite possible that assets are bid below some "ideal" expectation of cash flow value. margin leverage leaves investors open to being right all along, but getting liquidated at a loss along the way. i think that banks should be subject to mark-to-market discipline, because no one can agree on a true, nonmarket expected asset value, and path-dependent margining requirements encourage caution and prudence. but there's nothing at all absurd or inconsistent about absorbing path risk for some investors willing to stand behind at-maturity valuations and of whom we wish to encourage risk-taking.)

i'm also with jkh on terminology. reading through this discussion, i think it's probably always a good idea to use the formulation "with recourse to", rather than non-recourse or full-recourse. all loans are with recourse to something, but for all loans that recourse is limited. "non-recourse" is with recourse to explicitly agreed collateral, loans to banks are with recourse to bank capital, "full recourse" loans to individuals are with recourse to all personal assets except for those that may be sheltered in a bankruptcy proceeding.

(that said, "with recourse to blah" is precise but longwinded, i'm sure i'll still end up using the lazy formulations a lot.)

nemo — i meant single <i>full</i> recourse loans to individuals. if i said non-recourse, that was my usual mental confusion. i think liquidity constraints and path risks should be removed from individual investors willing to price bank assets, and stand behind their valuations with full recourse to their nonbankruptcy shieldable assets if they are wrong. the scale of loans should be commensurate with the scale of the borrower's finances, so that the costs of bankruptcy are large relative to the gains that would be realized by investors who treat participation as a lottery. it ain't rocket science, though. people should be able to borrow against these assets on roughly the same terms and in roughly the same amounts that they would be able borrow against home or real-estate investment purchases during "ordinary" (not-credit-bubble) times, but with explicit recourse to noncollateral assets.

> “It's like a full-recourse home mortgage: the collateral is out there, but you don't margin, and in the end you go back to the borrower for satisfaction.”

Ok, I understand it now. My understanding was obscured by the fact that I was thinking in terms of a three year time frame -- which would make 'working it out over time' kind of silly. i am not even sure PPIP has a three year horizon -- that's built into TALF but probably not PPIP. in any case i get it.

but i still see two problems with it.

first, i think that the treasury wants to encourage participation, and i don't think people would lever themselves up to do this. maybe i'm wrong about this. (but i personally wouldn't. i have had the option to lever myself up to buy stocks and never have done it. i am in principle fine with the stocks i own going to zero -- but that's enough risk.)

second -- and this is another important point -- i think that another (unstated) goal of the program is to put a floor on the prices of some legacy assets in order to break a potential forced sale dynamic (intermediary insolvency causes delevering causes forced sales causes asset price drops causes intermediary insolvency etc) if other large institutions fail or if deleveraging speeds up as it may.

in short i think that they are looking at debt-deflation -- with deleveraging brought on by liquidation of holding companies -- as a real possibility and attempting to put a floor (through a potentially large subsidy) on market values for a class of assets that hold large places on the balance sheets of these intermediaries.

when you say that the treasury is allowed to ignore mark to market risk that doesn't mean that the holder is allowed to ignore it -- i might panic sell if i was looking at possible insolvency.


personally i think that any solution to the crisis will involve some sort of hiving off of legacy assets -- a split into good and bad banks or a split into old and new assets. the only reason to mark old assets at all is to get a sense of what and where the losses are. they will be what they will be in the end. if these are too big for an institution to bear and the institution needs to be shut down, then i think we should do it -- but i think we should do it without liquidating the legacy assets, because liquidation would bring lower asset prices which could bring down otherwise solvent intermediaries. this plan has a little of that -- it hives off some of the tail risk of these assets.

anyway, i am just sort of rambling here; and this is pretty far off the topic of the post anyway. perhaps it would be better for me to write out my ideas clearly.

and in any case i think there is a big chance of this going nowhere. the loans side, probably nowhere, given where they are marked. the securities side, probably some securities move.

Hello. I'm a regular reader, and always very intrigued by your post.

I've set up my blog a couple of days ago, and have elaborated some arithmetic on PPIP. I also did some simulation using lognormal PDF. Maybe some results may serve as food for thought.

I've made four posts so far. In the first one I derived general formula of break-even purchase price, and in the second I described fund position using option formua, and in the third I related two-state model to more general form of PDF, and in the fourth I did some simulation using lognormal PDF.

quick clarification: it's the IMF not world bank, and it's $3.3T of US originated loans and $4T worldwide.