The Treasury's Plan to Buy Bank Assets

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.

In my post on Sunday I gave an example to illustrate the Treasury's plan to buy the "toxic" assets of banks. Since I left a few quite important implications of the example unclear, this addendum will consider the same example in more detail. Recall that the Plan would encourage hedge funds and other financial institutions to bid for bank assets. These institutions would only have to put up about 7% of their bid price since the Treasury will supply another 7%, and the FDIC will loan the remaining 86%. If assets appreciate in value over the bid price, the Treasury and funds share the profits equally after the FDIC is repaid. If the asset declines in value, funds are only liable for 7% of the decline, and the FDIC and Treasury absorb the rest. In my example, there is a 10% chance that an asset will be worth $1000, and a 90% chance that it will be worthless, so that the full expected value of the asset is $100. Assuming competition among funds forces them to bid the expected value of this asset to them, how much will they bid? When the asset pays off $1000, a fund would get half the difference between $1000 and 86% of its bid price, while if the asset becomes worthless they would be compensated for everything but 7% of what they bid. The expected value of these outcomes is approximately $243, and that would be the price that competition forces hedge funds and other funds to pay for the assets. Since the expected value of the asset is only $100, government subsidies would encourage funds to bid about 2 1/2 times the true worth of the asset! The government would pay the difference between the bid price and the worth of an asset, or $143 in this example. Contrary to many assertions made about the Treasury Plan, this subsidy does not on average go to successful bidders since the expected cost of the asset to them equals the expected value of the asset to them. Of course, the luckier buyers of these assets can make a lot of profits, and they could be subject to Congressional wrath that they profited at the government's expense. The $143 subsidy goes to banks, for they would receive almost 2 1/2 times the worth of their "toxic " assets. Perhaps good reasons motivate the government to use this indirect way to subsidize banks rather than to give them the subsidy directly. However, it is a strange program indeed where banks get subsidized in proportion to how many "bad" assets they hold. This will make banks wish that they had made even greater mistakes, and held more assets that are likely to be truly worthless. However, these worthless assets could be worth a fortune to banks.