Gaming the Legacy Loan Auctions

My colleague Ilya Podolyako is back with a comment on the Geither Plan to buy toxic assets, as well as an update to his previous post about the constitutionality of government takeovers of private property. He discusses in particular the possibility (also suggested by one of our readers) that the government could “seize” toxic assets and pay “just compensation,” even in the absence of a bankruptcy or a takeover. Ilya is a 3rd-year student at the Yale Law School and, among other things, an executive editor of the Yale Journal on Regulation. The post below is by Ilya.

PPIP for Legacy Loans = Free Put Options for Banks

I finally got a chance to read through the PPIP plan in detail. I noticed one curious point: under the program as announced, auctions for the legacy loans do not appear to be binding on the contributing entity.

The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing assets in the Legacy Loans Program will occur through the following process:

. . .

Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.

Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.

This is quite odd, since, if I read it correctly, it turns the entirety of the program into a put option for participating banks. That is, they could identify certain assets, put them up for auction seemingly risk-free, check the result, and reject anything below their internal valuation without any further capital contribution.

The structure, which seems to be confirmed by the term sheet (“Once a bid(s) is selected, the Participant Bank will have the option of accepting or rejecting the bid within a pre-established timeframe”), amplifies the lemons problem that Simon and James mention in their LA Times op-ed. If the plan revolved around binding auctions, a temporary market for the toxic assets could develop while investors make government-guaranteed “probing” bets on the precise toxicity of the assets for sale. If banks wanted the auctions to recur instead of being a one-time event (perhaps to sell a larger or more diverse set of loans), they might mix in some good assets with the bad ones. This move would assuage concerned investors and probably make it easier for the banks to get approval from their regulators for the particular sale. Investors who were smart/lucky enough to win the good assets with bids below their “worth” to the bank on a medium-term basis would then get to profit from their decision. Other buyers would want to follow suit, at least until the point in time when they would expect a bank to cash out on any previously established confidence with a large offer of only toxic securities that would earn a lot of money even in the absence of future auctions.

By contrast, if banks can selectively reject bids, they could offer an enticing mix of good and bad assets (say, 50/50) and then accept only the ones that grossly overpay for the bad ones. That is, they would get full power to exclude intelligent, accurate price setters from the auction process, undermining the efficacy of the program to an even greater extent than adverse selection would in a committed-sale context. Of course, it is not clear whether the current setup is objectively worse than the repeated-game lure-and-hook scenario, but the question is worth considering.

Updates on the Constitutionality Issue and the “Brute Force” Plan B

I thought I would provide some clarification on how I see the Fifth Amendment applying to the current stage of the economic crisis.

First, contrary to what some have suggested, the constitutionality of government policy is not irrelevant. As long as the courts are open, private parties can file suit either to stop prohibited actions from going forward, or, in a less extreme scenario, to get money damages. True, courts often dodge heated constitutional issues, but in the 1950′s, they saw it fit to prohibit the nationalization of steel mills during a time of war, so the Fifth Amendment is still a force to be reckoned with.

Second, I am suggesting that sudden regulation of previously unregulated entities would constitute a taking, not that all new regulation does. Retroactivity is key here: the Fifth Amendment protects vested interests from being nullified or diminished by new laws, but does not prevent Congress from forcing new entrants to comply with a fresh framework. Furthermore, cases on the topic make it clear that when investors knew ex ante that they were buying into a highly regulated business, new rules would not trigger constitutional scrutiny unless they explicitly contradicted previous administrative promises. For present purposes, this means that even if Congress passes a bill allowing Treasury to seize hedge funds or nationalize large conglomerates at will, the Department will still have to provide “just compensation” to previous owners.

Of course, the extent of this compensation matters a great deal for evaluating the viability of particular administrative actions. As I mentioned in the previous entry, constitutional law clearly includes contractual rights to cash flows in the definition of property. Stock and subordinated bonds fall into this category. Furthermore, there seems to be judicial consensus that, for constitutional purposes, equity has value even when the operating business appears to be insolvent, provided that this business is not actually in bankruptcy proceedings. The approach makes sense: in the face of uncertainty, both junior debt and common stock constitute a call option, and call options have value even if they are deep out of the money.  For example, while Citigroup may well be unable to function without government aid right this second, its common stock is trading at $2.62 because of the possibility that the company will survive the crisis intact and generate dividends/appreciate in value in the future. If the government were to nationalize Citi and push the value of the stock to 0 by decree, it would potentially be on the hook for the entire $14 billion market cap.

The application of the takings doctrine to debt is more complicated. Suppose the government takes over Citi and says it will pay only 30 cents on the dollar for its junior unsecured liabilities, which matches the market price for these bonds. The Supreme Court has wavered on the extent of just compensation required for this 70% haircut. The traditional test for regulatory takings in Penn Central emphasizes diminution of value as the takings metric, and one could argue that paying market price for the assets does not diminish their value. On the other hand, unexpected termination of the option on future cash flows does foreclose the valuable possibility of getting more money back. I really don’t know which way a court would come out here. I do know, however, that a failure to give the debtholders a chance to argue for a higher price for their assets (either in court or some special tribunal) would probably incur judicial wrath for breaching either the takings and due process clauses of the Fifth Amendment or the Seventh Amendment guarantee that civil controversies over $20 will be settled by juries.

Again, if investors in AIG, Citigroup, SAC Capital Advisors, or General Motors knew that this kind of executive intervention was possible when they put up their money, the story would be completely different. It is the sudden imposition of new, costly rules that is the problem. This temporal element highlights the difference between nationalization and various versions of bankruptcy: even if Article I, Section 8 of the Constitution did not explicitly authorize a uniform bankruptcy code, it could pass muster under the Takings Clause merely because some version of the judicial power to settle claims on insolvent debtors was in place long before any current investors were born. That is definitely not true of the power to summarily seize any institution that poses systemic risk to the financial system, as evidenced by the fact that Geithner and Bernanke made their plea to Congress this week in the first place.*

There is an upside to all of this – the “brute force Plan B.” If the Public-Private Investment Partnership fails due to a lack of participation by banks, investors, or both, the government could just file suit in a federal district court to take control over any toxic assets it wants. The fact that the judicial branch would oversee the action would preempt any due process or Seventh Amendment challenges. Banks would come in as defendants in the action. Treasury would still be on the hook for “just compensation,” but in the current political climate, juries are likely to be pretty stingy with taxpayer money. Indeed, banks may prefer a quick hand-over of the assets to actually litigating the claim. For the sake of expediency, the government could also attempt to seize the assets first in exchange for their “market value” and litigate any factual questions later. I am not persuaded that this course of action would actually be any faster, since banks could ask a court for a temporary restraining order to block the action. This would move the policy back to litigation square one, but now the executive branch would look like it was avoiding judicial scrutiny instead of trying to maximally honor the constitution in difficult financial times. All things being equal, it is better to get to the judges first.

Thanks to Jesse Townsend for feedback on the constitutional analysis above.

By Ilya Podolyako; posted by James Kwak

28 responses to “Gaming the Legacy Loan Auctions

  1. Here is some commentary from Morgan Stanley on the PPIP. You might be interested their take on why they think the loan component will not work:

    The legacy loan program is less likely to succeed simply because the gaps between bank marks on their loan portfolios and their economic value appears to be so wide. Our large-cap banking team have estimated cumulative losses to date by bank and asset class. The team believes that banks are 40% through their provisioning for these portfolios. Marks consistent with those losses to date – for example, 95% for residential construction – clearly are well above what investors will bid for the assets.

    So, unlike CMBS (or other securities that have ‘money goodness’ characteristics), no amount of leverage will likely bridge the continental divide between the bid/offer. To us, in the case of the non-securitized assets residing on balance sheets, the uncertainty around collateral performance inevitably trumps the government’s grand plan of creating price insensitivity through leverage. If our intuition is correct, we question the strong positive reaction in the equity market to the announcement of the PPIP, as the most critical aspect of the plan in restoring the health of the banking system is likely the least effective.

    http://www.morganstanley.com/views/gef/index.html#anchor7619

  2. Since the group allowed to participate in the public/private scheme is limited, it will only fail to the extent necessary to give some more reason for more ways to extract value from future taxpayer dollars–with such a small group it is easy to see the back scratching that will go on to accomplish whatever mission will benefit the small group.

    The Latest round of new “powers” to deal with the too big to fail is not only dangerous in all of the well articulated senses, but it also serves as another way for a frame of reference to be made for the makers of the fall bank robbery scheme so that they can insist that they didn’t have the “authority” to do anything but what they did, although they had plenty of time to lobby for the scheme that is viewed as bank robbery by the world, and the scheme that has forclosed on our country’s credibility, and that we may seen soon, has taken all value from our country’s currency.

  3. To Wake Up America: What a post! Thanks Much! A must read by all!!!!

    As far as the PPIP is concerned, I want to know how this plan prevents the banks from conspiring with the like of PIMCO to actually provide inflated bids for these so-called legacy assets. The bank uses a certain amount of its TARP I money to fund an LLC, cuts a deal with PIMCO to front for it, PIMCO buys the assets at an inflated price, the bank’s secret LLC borrows the balance of the funds from the FDIC necessary to purchase the assets. When all the math is said and done, the bank wins even as the assets fail over time because the LLC’s losses are limited as per the PPIP. Better explanations of this scam are on, of all places, Youtube.com.

    The other question I have was directed toward my Congressman: Why doesn’t Congress have to vote on the PPIP?

  4. Bond Girl,

    I agree with this argument. My biggest concern, as I think we wrote in the LA Times op-ed, is not that this will be a huge taxpayer subsidy. Rather, I think the most likely scenario is that the market does not clear, so there is no taxpayer subsidy, but at the same time no positive effect in cleaning up the banks.

    James

  5. To question #2: Technically speaking, there’s no appropriation, since they are using money from the original TARP bill, plus loans from the Fed and loan guarantees from the FDIC. The one bit that may be a little questionable is the FDIC loan guarantees, as this may represent an expansion of FDIC powers. But I haven’t seen an in-depth discussion of that issue.

  6. adios amigos

    So, in the midst of a global financial meltdown directly caused by finagling in the worlds largest credit markets, the solution is: MORE FINAGLING in the worlds largest credit markets. Well that’s just great….and it’s my understanding that this current “Master Of The Universe” plan has been engineered by none other than Tim “The Tax Man” Geithner. Isn’t he the guy who deliberately didn’t pay his own taxes? Committed tax fraud? Isn’t he the guy that was the head of The Federal Reserve in New York City when this whole mess got started in the first place? You know what amazes a lot of us in far away places? That all of you Americans are now “SHOCKED” and awed that your own government is now engineering a way to transfer yet more wealth to the influence pedalers on Wall Street…..all of you are SHOCKED!!!!!!!!!!!!! Did it dawn on any of you yet that this plan isn’t supposed to work? That’s not the plan….have you not figured that out yet? When your own Titans Of Finance (Geithner, Bernanke, et al) have come up with a plan that is so clearly idiotic, how is it possible for all of you NOT to realize that the “BIG Plan” is designed to fail, and transfer ALL of the bad paper liabilities squarely onto the backs of the US Gullible-Asleep at the switch- Taxpayers. When, in the name of god, WHEN are you idiots over in America going to wake up? When are you finally going to realize that your Government is NOT acting in your best interest? What the hell has to happen over there before you realize that? Do you really think this plan solves anything other than getting these toxic investments off the backs of the I-Banks? Why the hell do you thin the big plan requires such small equity from the private equity guys to play, with massiVe upside on ANY actual profit? Huh? Why IS that exactly? Jesus Christ…….WAKE THE “F” UP AMERICA!!!!!!!!!!!!!!

  7. THANK YOU ADIOS AMIGO

    Thank you adios amigos!

    The country is drugged in complacency–the only people wide eyed and bushy tailed are the beneficiaries of the bank cartel.

    While pontificators preached that we didn’t want to make the same mistakes that Japan made with banks in the early 90′s, these words were a method of manipulation that made the public believe that by ‘infusing’ money into the system that all would be well… when in fact, the US population is zombified by the intentional financespeak of all those who hold a stake in completely robbing the US of it’s future….

    i think that the trust, good faith and confidence of the country has been betrayed by the acts bank actions lobbied for in the fall, and these acts are hurting our sovereignty–isn’t that an imprisonable offense?

  8. adios amigos

    Your welcome. It just amazes me that 300,000,000 people could be completely asleep. I give the Banksters credit though….this will be remembered as the largest fraud ever perpetrated. Amazing…there must be some kind of tranquilizers in the water in the U.S. Amazing….but sad. I feel bad for the kids in the U.S. though. They had nothing to do with this insanity, but they will be paying for this all of their lives, as will probably their kids as well. Amazing. And why though?……Money? Unbelieveable.

  9. THANK YOU ADIOS AMIGO

    It took about a year of hearing nothing before, finally there was some movement on the ENRON fraud–i am still hoping that Americans will wake up and cause our “poorly or Non-representing representatives” to decide that if they are to be reelected, they must go after the BIG DOG BANK CARTEL (BDBC), since, even though the BDBC may pay for their campagnes, they won’t have a chance of getting reelected if they don’t put the BDBC and it’s enablers (and those in power in the prior administration) in jail.

  10. Ilya Podolyako

    I agree with James. I think banks just dont have the incentive to sell assets at a loss, through auctions or not. I was just pointing out another significant flaw in the system that could aggravate the fundamental issues if they were not already fatal on their own.

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  12. 1 currency now

    Oh please if Congress wanted to nationalize the banks they could pass a law redefining capital for reserve. Get rid of mark to myth and expand the FDIC. Poof, and no taking.

    There is not the will. They have been “captured”.

  13. Even if banks are not constrained by marking down assets and drawing the wrath of regulators, banks’ shareholders will be hesitant to sell their assets at even above market prices according to my paper “The Put Problem with Buying Toxic Assets” at http://ssrn.com/abstract=1343625.

  14. Could this change raise the cost of the toxic assets to the PPIP? Not to mention creating the illusion of solvency. As for me I am not buying any financial’s until this shakes out.

    Mark-to-Market Lobby Buoys Bank Profits 20% as FASB May Say Yes

    http://www.bloomberg.com/apps/news?pid=20601109&sid=awSxPMGzDW38&refer=home

  15. Ilya Podolyako

    The bulk of constitutional law on the topic suggests that such a sudden revision of an existing standard would itself be a taking if it was unexpected and had detrimental economic effects. This is exactly the point I was trying to highlight in my posts.

  16. Wandering Mind

    What I have been wondering about this plan is whether, if the banks decide to sell some of their bad assets backed by mortgages, the buyers will have to agree to modify those mortgages to make it more likely that the homeowner will stay in his/her home. Does anybody know?

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  18. Sudden revision? Fasb just changed the rules under Congressional pressure. Just in time for next quarter. Yes, there will be detrimental economic effects.

    They’re called toxic for a reason. If the FDA finds out the saccharine they’ve been approving for years is toxic, they ban it the next day. Forget taking, they can’t even use it to get out of tort liability.

  19. When they change income tax rates suddenly to reflect new crisis conditions, is that a taking?

  20. 1 currency now

    That was me, sorry.

    When they change income tax rates suddenly to reflect crisis conditions, is that a taking?

  21. Ilya Podolyako

    No. The Supreme Court has always looked at taxes through a completely different lens; basically, the takings doctrine does not apply to taxes.

  22. 1 currency now

    Ok then we tax banks into nationalization, instead of changing the rules in their favor at the last minute so they can feast on one another’s losses.

    I’m suggesting the takings doctrine will prove elastic in the unwinding of 1.28 quadrillion dollars. Would the reimposition of Glass-Steagall be “sudden unexpected regulation”? How about reducing FDIC insurance back to 100k, and limiting individuals to x number of insured accounts. Then sell short term T-Bills at high interest. Take that!

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  24. adios amigos

    TAKING?????????????????? They certainly had no problem TAKING the money fro our pension funds here in Europe when the Americans sold us their toxic investments. Oh…..you mean taking THEIR stuff in America. Yeah, I forgot, they only have no problem TAKING when it’s actually outright fraud. I forgot !! oops

  25. adios amigos

    When the Americans sell us here in Norway their toxic investment scams and they take our money from our pensions after thirty-odd years of savings, is that “Taking”? Or…..is that fraud? I’m just not sure, and I certainly wouldn’t want to offend any of those trustworthy Americans.

  26. The regulation requires that the seller have no more than a 10% interest in the buyer. I am sure that the final draft will state this as a direct or indirect interest, so your scenario would be fraud.

    Also, PIMCO is going to make a mint on these trades as well as in advisory fees for managing the govt portfolio. Why would they risk their franchise as well as their profits to assist anyone in circumventing the regulations. Even if a seller bank were so incentivized, they would have a hard time finding a partner.

  27. I think Adios Amigos has cut to the heart of it. The majority of these “assets” will be worthless and become the taxpayers problem. This is really the the point that needs to be made somehow. I think there are many,many people in this country that would readily fight… We just need to create a voice, a forum to be heard. It’s clear that our “representatives” will not be that voice.