Coyote Blog

Good for Megan McArdle:

when did it become the government’s job to intervene in the bankruptcy process to move junior creditors who belong to favored political constituencies to the front of the line?  Leave aside the moral point that these people lent money under a given set of rules, and now the government wants to intervene in our extremely well-functioning (and generous) bankruptcy regime solely in order to save a favored Democratic interest group.

No, leave that aside for the nonce, and let’s pretend that the most important thing in the world, far more interesting than stupid concepts like the rule of law, is saving unions.  What do you think this is going to do to the supply of credit for industries with powerful unions?  My liberal readers who ardently desire a return to the days of potent private unions should ask themselves what might happen to the labor movement in this country if any shop that unionizes suddenly has to pay through the nose for credit.  Ask yourself, indeed, what this might do to Chrysler, since this is unlikely to be the last time in the life of the firm that they need credit.  Though it may well be the last time they get it, on anything other than usurious terms.

I am not sure I agree with the last part.  While banks seem to have an unbelievably long memory when it comes to you or I trying to get a loan after we forgot to return those Columbia House records 15 years ago and couldn’t pay our bills, major banks have goldfish memories when it comes to major losses.  Whether it be lending to Latin American companies or to industries like airlines that go bankrupt with clockwork regularity, banks seem perfectly capable of repeating the same mistakes over and over again.

This is in part due to something I was trying to tell folks waaaaay back in October with the threatened liquidity crisis — banks have to lend.  There is simply no good business model for a bank that involves sitting on hoards of cash under the mattress.  And when you have tens of billions of dollars to lend, you can’t just do it in $100 increments — you have to lend big slabs to large institutions.  And given that lots of other banks are trying to lend to the same guys, someone is going to issue that $300 million line of credit to Chrysler a couple of years hence.

This is an update to these two posts on the Geithner toxic asset / bank bailout plan.  In those posts, we looked at a hypothetical investment with a 50/50 chance of being worth 0 or 200.  From this, we said that the expected value was 100, and looked at payout scenarios under the Geithner plan.

A number of folks wrote me that I had missed part of the point of the Geithner plan.  The original assumption of the plan was that the banking system is in a liquidity crisis, and fire sales of assets are reducing the pricing of such assets well below their expected hold-to-maturity value.  According to the Treasury white paper:

Troubled real estate-related assets, comprised of legacy loans and securities, are at the center of the problems currently impacting the U.S. financial system…The resulting need to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. While fundamentals have surely deteriorated over the past 18-24 months, there is evidence that current prices for some legacy assets embed substantial liquidity discounts…This program should facilitate price discovery and should help, over time, to reduce the excessive liquidity discounts embedded in current legacy asset prices.

Their point is, in our example, that the asset worth 100 is only trading at, say, 50 due to a liquidity discount and the point of the plan is to make this discount go away.

This does make it clearer to me how these guys are justifying this program.   If we look at the program on the original analysis, based on expected values of assets held to maturity, we got this profile of returns:

The bank returns in the analysis were based on the alternative of hold to maturity.  It is all a zero-sum game – gains at the banks and investors come directly out the the taxpayer’s pocket.

If, however, one assumes the asset is trading below expected value, say at 50, due to a liquidity discount, then Geithner can argue the banks get a higher return for the same taxpayer subsidy IF the returns are based on a base case of selling out at the fire-sale market price.

In this case, with these assumptions, we get some “free value” or a multiplier effect of the taxpayer subsidy equal to the liquidity discount.

Is this a valid way of looking at it?  Well, the first problem is that this seems like an awful lot of money to spend of taxpayer money just to eliminate a fleeting (in the grand scheme of things) liquidity discount.  Banks have a zero-subsidy alternative to achieving the same end, which is simply to hold the investments to maturity, or until the market eliminates the liquidity discount.  Those of you who own a home know that you are going to take a hit on value if you have to sell now, while the market is a flooded with homes for sale, vs. two or three years from now.  Anybody proposed lately to bail ordinary folks out of this liquidity discount?

But perhaps the more telling criticism of Geithner’s assumptions come from a recent paper by a group of Harvard Business School and Princeton professors who have looked at the current market pricing of these toxic assets, and have found little or no liquidity discount.

“The analysis of this paper suggests that recent credit market prices are actually highly consistent with fundamentals. A structural framework confirms that bonds and credit derivatives should have experienced a significant repricing in 2008 as the economic outlook darkened and volatility increased. The analysis also confirms that severe mispricing existed in the structured credit tranches prior to the crisis and that a large part of the dramatic rise in spreads has been the elimination of this mispricing.”

Three conclusions are drawn:

• Many banks are now insolvent. “…many major US banks are now legitimately insolvent. This insolvency can no longer be viewed as an artifact of bank assets being marked to artificially depressed prices coming out of an illiquid market. It means that bank assets are being fairly priced at valuations that sum to less than bank liabilities.”

• Supporting markets in toxic assets has no purpose other than transfering money from taxpayers to banks. “…any taxpayer dollars allocated to supporting these markets will simply transfer wealth to the current owners of these securities.”

• We’re making it worse. “…policies that attempt to prevent a widespread mark-down in the value of credit-sensitive assets are likely to only delay – and perhaps even worsen – the day of reckoning.”

Update: Critics of the study argue the authors only looked at the most liquid portions of the toxic asset portfolios, thus missing the problem they claim to be studying.  From this brief critique, they seem to have a point.

Michael Rozeff looks at the paper’s findings in the context of Austrian economics, and concludes that in fact, Geithner and company are delaying a recovery in lending, as bankers are frozen in a game of chicken, hoping to make things bad enough to attract government subsidies without making them so bad the institution fails before subsidies arrive.

By contrast, the Austrians, as well as other financial analysts, have argued from the outset that the basic problem is not liquidity of the financial system. The argument on the Austrian side is that the banks and other financial institutions have not been in trouble because there is not enough liquidity to buy their loans. They are in trouble because they made bad loans that are worth far less than their values as carried on the banks’ books. The banks are often insolvent. Furthermore, these banks do not want to and refuse to sell these loans at the low values to get the liquid funds they want. They are playing politics. They are getting a better deal (a) by shifting some of these loans to the FED in return for Treasury securities, and (b) getting bailed out by taxpayer funds.

In the Austrian interpretation, the banks have waited while the government came up with various devices to bail them out with other people’s money. The latest is the Geithner PPIP that uses an FDIC guarantee to private parties to buy the bank loans at prices above market value. In the same vein, the accounting regulatory authority known as FASB has just allowed the banks leeway not to carry these bad loans at their market value by voiding the mark-to-market rule.

Kevin Drum quotes the Financial Times:

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.

….Wall Street executives argue that banks’ asset purchases would help achieve the second main goal of the plan: to establish prices and kick-start the market for illiquid assets.  But public opinion may not tolerate the idea of banks selling each other their bad assets. Critics say that would leave the same amount of toxic assets in the system as before, but with the government now liable for most of the losses through its provision of non-recourse loans.

Wow, no one could have predicted this.  Except for anyone who spent 5 minutes with the numbers:

There is an interesting incentive to collude [in the Geithner plan] between banks and investors.  The best outcome for both is for investors to pay a high price to banks and then have the bank kick back some portion to the investor.

I will confess that I did not take the next logical step and consider that the ultimate collusion would be for banks themselves to be the investors, but the incentives for doing so were dead clear (part 1, part 2).

I will stick by my original conclusion — Taxpayers are hosed at any price.

By the way, can anyone tell me what the evidence has been for the contention Barack Obama is “really smart,” because I sure don’t see it.  Yeah, he went to an Ivy League School, but so did I and there were plenty of people there I wouldn’t trust to run a lemonade stand.  Sure, he gives a nice prepared speech and seems to have invested in that vocabulary building course Rush Limbaugh used to peddle on his show, but what else?  All I see is a typical Ivy League denizen of some NGO who thinks he/she can change the world if only someone will listen to them, who just comes off as puerile if you really spend any time with them.  I will go back to what I wrote on inauguration day:

Folks are excited about Obama because, in essence, they don’t know what he stands for, and thus can read into him anything they want.  Not since the breathless coverage of Geraldo Rivera opening Al Capone’s vault has there been so much attention to something where we had no idea of what was inside.  My bet is that the result with Obama will be the same as with the vault.

I had someone ask me whether the results in this post on the economics of Geithner’s latest brainstorm were an artifact of the selected purchase price for the distressed asset of 150.  The answer is no.  Investors are willing to buy this asset on these terms at any price under 175, and banks are willing to sell for any price over 100.  Here is the graph of expected values as a function of the purchase price

Note the taxpayer gets hosed at any price  (kind of the Obama-Geithner update on “unsafe at any speed”)  Two things I had not realized before:

• Without competition among investors to drive up the price, a very large percentage of the taxpayer subsidy goes to the investors rather than the banks.
• There is an interesting incentive to collude here between banks and investors.  The best outcome for both is for investors to pay a high price to banks and then have the bank kick back some portion to the investor.

Nobel Laureate Joseph Stiglitz has a great deconstruction of the Geithner toxic asset plan in the NY Times.  If you want to see how the new corporate state works, where the government works with a small group of powerful insiders to the benefit of those insiders and the detriment of everyone else, this is a great example.

Stiglitz walks through how the Geithner plan will operate, and I want to do so as well.  I have added a few tables to help illustrate his example a bit better.

Let’s begin with a financial asset that was originally worth $200.    To make things simpler, we’ll assume that with the current economy there are now two outcomes for this asset — a 50% chance it recovers and eventually pays off its full value of $200, and a 50% chance it becomes effectively worthless  (more realistically, there is a range of outcomes, but this does not really effect the following analysis).

The average “value” of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is “worth.”

This is a classic expected value analysis.  At business school, you spend a lot of your time doing these (trust me).  Expected value is just the percentage chance of each outcome times the value of the outcome, on in this case 50% x $0 + 50% x $200 = $100.

So Stiglitz hypothesizes a situation under the new Geithner plan where a private entity might be willing to pay $150 for this $100 asset.  That’s certainly a windfall for the financial institution that owns the asset currently, since the asset is only worth $100 on the open market.  But why would someone pay $150?  Well, it starts with this:

Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses

The actual percentages are 8% from the private purchasers, 8% “equity” from the government, and 84% in a government-guaranteed loan  (Equity is in scare quotes because most investors learned long ago that if you provide 80%+ of the capital in a risky venture, you can call the investment “debt” all day long but what you have really done is made an equity investment).

So let’s look at how the purchase cost is divvied up based based on a $150 purchase cost:

But we have already posited how this will come out:  a 50/50 chance of $0 and $200 for the final asset value.  So we can compute the outcomes.

So there is a huge built-in subsidy here.   Now, I don’t personally think the government needs to be injecting equity in banks.  But  I understand there are a lot of people who support it.  So perhaps the $50 subsidy of the banks in the above example is warranted.  But why the $6.5 subsidy of Geithner’s old pals in the investment world?  This is a pure windfall for them, like finding money laying on the street.   Even Vegas does not tip the odds so far in favor of the house.

I agree with Stiglitz’s analysis:

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a “partnership” in which one partner robs the other. And such partnerships — with the private sector in control — have perverse incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it’s the kind of Rube Goldberg device that Wall Street loves — clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

Update: I posted an update on the plan and these numbers here.

Nothing makes purity more interesting than temptation.  This applies to ideological purity just as much as the physical sort.  As a libertarian, my greatest temptation to call for government action comes when I deal, as a retailer, with Visa and Mastercard (V/MC).

This post is not a call for government action, so I guess I am resisting temptation.  But I at least need to vent, sort of like a monk pounding his head on the wall after getting the Victoria’s Secret catalog in the mail.  So here is my rant.

First, let’s start with how credit card companies make their money.  I will confess that I do not know how the card companies (V/MC) and the card processors (often large banks) split the take, so this is how they make money together.  V/MC and the processors charge fees to merchants.  Typically this is a fixed fee per transaction plus a percentage.  On average, a merchant might be paying 2.5-3.5% of a transaction.  The card companies also make money from card holders, charging annual fees, interest fees, etc.

You will have seen of late that most credit cards offer various loyalty programs, from airline miles to cash rebates.  You might have thought those were marketing expenses paid by the credit card companies.  Wrong.  The card companies simply charge merchants a higher fee for processing transactions using these cards.  In a sense, the card companies have organized with card users to use their power to extract extra value from merchants.

All of this I can generally live with.   Visa and MasterCard, through both their credit facility and their implicit standardization, bring enormous value to retailers and customers.  Its a big circular game anyway — customers get 1% back and think they are getting a deal, merchants pay this extra 1% in fees, and then add it into the price of what they are selling.  It’s a wash, except to the extent that customers with reward cards in the end extract a bit of value from customers who pay cash (for reasons explained below).

For this value one must accept the typically arrogant and indifferent customer service provided by any monopoly  (American Express is particularly awful to deal with as a retailer).   But they are no worse to deal with than the government, so its unclear how the government could make the service any better.

What tends to tick me off, though, are rules and restrictions.  Like the creeping work rules in the UAW contract, these are in many ways more insidious than the service and pricing.  Here is what set me off today, from one of my card processors  (in this case Bank of America, which, to be fair, is someone I would recommend for merchant account processing).  Click to enlarge.

So, why are businesses breaking these rules so often?  Let’s take a look:

• No minimum transaction. Remember that V/MC charges a minimum fee, from 10-40 cents or so, per transaction.  So if someone buys a pack of gum in our store, likely 100% of the sales price is going to V/MC.  Typically it takes at least a one dollar total sale for there to be any money left over beyond paying cost of goods sold and the credit card folks.  So merchants logically want to set a minimum.   V/MC hates this practice, but it is rampant.  I plead the fifth on our own practices.
• Surcharging. Credit card customers cost more than cash customers.  Sure, we get some non-sufficient funds checks, but the eventual cost of these is nowhere near 2.5% of sales.  Merchants logically don’t like having their cash customers having to subsidize the frequent flyer rewards of their credit customers.  However, unlike transaction minimums, card processors have mostly been able to drive out cash discounts.
• Requiring ID and Fraudulent Transactions. I will take these two together, since they are so ironic one after the other.  V/MC is telling merchants that they can’t check ID, which is the only reasonable approach to limiting fraud, but that they can’t submit fraudulent transactions.  You say that the text says “known fraudulent?”  Well, read on –

To the latter point, I think most people assume that the credit card companies are absorbing the fraud, which is how they justify the fees they charge.  Wrong again.  Credit card companies only absorb credit risk.  Over the last 10+ years, they have pushed fraud back on the retailer.  If a consumer claims fraud on his card with some transaction, then the credit card company refunds the customer and takes the money from the merchant unless the retailer can absolutely prove he made delivery to the consumer personally (which he can’t prove because he can’t check identification) .  Merchants bear the cost of fraud, not card companies.  Which I could accept (since I have more ability than the card companies to control fraud) expect the card companies ban me from controlling fraud.  So I have to take financial responsibility for something I am not allowed to prevent.  And that really ticks me off.

Anyway, maybe someday we can organize a large merchant boycott, where, even for a day, we all refuse to accept Visa and Mastercard.  Of course we would be breaking the rules, because that is not allowed by our V/MC agreement.

Postscript: I suspect that a few retailers with some power are starting to crack this, at least for themselves.  Costco only takes American Express.  Sams Club only take one card (MC, I think).  My guess is that both, with their large size, bargained for exclusivity in exchange for concessions on fees and/or terms.

Postscript #2: I expect comments like, “Well so-and-so always makes me show an ID.”  I don’t doubt you.  I am merely saying that by doing so, they have either negotiated an exception to the V/MC agreement (very unlikely, as V/MC holds to these rules like the Maginot Line) or the retailer is breaking the rules.