A far bigger scandal than any bonus payments – but also far more difficult to understand – is the latest scam to come out of Treasury:
The Treasury Department is expected to unveil early next week its long-delayed plan to buy as much as $1 trillion in troubled mortgages and related assets from financial institutions, according to people close to the talks.
Actually, this buries the lede; the big issue is that the government is almost, but not quite, buying $1 trillion of garbage. Rather, it is going to pay for almost all of the garbage, but give a investment management firms the upside. Move over, Goldman Sachs, PIMCO is the new girl in the government’s bed:
Although the details of the F.D.I.C. part were still being completed on Friday, it is expected that the government will provide the overwhelming bulk of the money — possibly more than 95 percent — through loans or direct investments of taxpayer money.
To entice private investors like hedge funds and private equity firms to take part, the F.D.I.C. will provide nonrecourse loans — that is, loans that are secured only by the value of the mortgage assets being bought — worth up to 85 percent of the value of a portfolio of troubled assets.
Think about this as an auction for someone else’s wallet. You know for certain that whoever buys the wallet is overpaying, since its contents are known only to the seller and he is not compelled to trade if he doesn’t like the bid. Furthermore, in this case the nominal principals – the funds making the investment decisions – are actually agents of the government, since they are using the government’s money. But they are paid if money comes in and suffer no losses if the government loses money. So what is to discipline them on prices? The competitive nature of the auction only exacerbates the problem; only a “successful” bidder has a chance to make money, so it behooves the private firms to bid high. Good for the banks. But the losses are also ours, so all that happens is losses are transferred from the books of Citigroup to the books of the FDIC. We are keeping Citi on life support, and we are bound full faith and credit to support the FDIC.
The hope is that in moving the shells, the public will lose track of who was paid what, when, and why. And it is a shame that the government that came for hope and change is treating the financial sector the way the Bush Administration treated Halliburton.
UPDATE:
Naked Capitalism has a fantastic example of just how much of a scam this giveaway will be (to think, Geithner is coming up with these ideas when he is not resigning):
Say I am SAC Capital. I get to be one of the bidders on bank assets covered by the program
Citi holds $100mm of face-value securities, carried at $80mm.
The market bid on these securities is $30mm. Say with perfect foresight the value of all cash flows is $50mm.
I bid Citi $75mm. I put up $2.25mm or 3%, Treasury funds the rest.
I then buy $10mm in CDS directly from Citi [or another participant (BOA, GS, etc)] on the bonds for a premium of $1mm.
In the fullness of time, we get the final outcome, the bonds are worth $50mm
SAC loses $2.25mm of principal, but gets $9mm net in CDS proceeds, so recovers $6.75mm on a $2.25mm investment. Profit is $4.5mm
Citi writes down $5mm from the initial sale of the securities, and a $9mm CDS loss. Total loss, $14mm (against a potential $30mm loss without the program)
U.S. Treasury loses $22.75mm
Great program.
It’s just a scheme to transfer losses from the bank to the taxpayer with an egregious payout to a middleman (SAC) to effectively money launder the transaction.
UPDATE OF THE UPDATE
The Krug is on this with a more basic example:
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.
