Let the People In

The Geithner Plan is out. I don’t have time to look at it in detail, but in the meantime, PK, one of our readers (and someone we correspond with a lot), had an idea:  If we’re going to subsidize the private sector, why not let individuals into the deal? In his words:

If Geithner’s taxpayer subsidized toxic public/private plan goes forward, I think it would be fair if the federal government allow non-institutional investors to participate via a no-fee investment vehicle.  I think if Americans had the option of investing in this program (without having to pay the egregious fees to the investment advisors/PE shops), it would be much easier to swallow since they would at least get the same deal the sharks are getting.  There is probably more money on the sideline with individual investors than all these institutional investors.   Maybe they could set up some ETF equivalent for it.  I think the willingness of the administration to do such a thing would tell us a lot about whose for whose interest they are really looking out.

Capital for the investment funds will come from private fund managers (raising new capital from their limited partners) and from Treasury. Perhaps either a fund manager or Treasury could create an ETF- or mutual fund-type structure, where the government subsidizes the usual management fees, and use that to raise some of the capital. I know that because most individuals aren’t “sophisticated investors” this would subject the fund – or at least the individual part of it – to a higher degree of regulation, but that doesn’t seem like a bad thing.

I think it’s a brilliant idea.

(As far as the plan itself, my first reaction is that the Legacy Securities Program actually doesn’t do enough to attract private sector participation, since the leverage is only 50% or maybe 100% of the capital.)

Update: Matt Yglesias and F. Blair (below) have pointed out the following language: “The program will particularly encourage the participation of individuals, mutual funds, pension plans, insurance companies, and other long-term investors.” I believe that’s from the program for loans, not securities (the latter involves up to five professional asset managers, who generally raise their money only from qualified investors). So maybe there is something there.

By James Kwak

29 thoughts on “Let the People In

  1. My issue with this plan, as reported os far today on the WaPo web site, is that it leaves TReasury holdin gthe bulk of the investments in one way or another. You see, FDIC and Fed Reserve loans are still federal dollars, from the federal pot. Add to that direct Treasury purchases,and we once again have federal ownership but no apparent control. That is arecipe for taxpayer disaster.

    Time for Geithner to go, me thinks.

  2. I’m already participating! Aren’t those my tax dollars funding the “public” side of the “public/private plan”?

    That begs the issue. Aren’t the Feds getting the same deal as the sharks? If not, why not? And if not, why am I subsidizing the sharks’ risk but not getting the return?


  3. My concern in the announcement today is a lack of leverage on the banks “selling” assets to accept pricing at levels this subsidized market will pay. By definition the banks will try to lay off the worst of their loans and even with this artificial pricing support (government guarantees and leverage) what is to make them act if they don’t like what the market is telling them re: pricing?
    Perhaps this comes after the stress tests tell the institutions to sell or get a Camel rating of 5 (government takeover).
    In regard to PK’s idea of individual investors, if its small investors they will be crushed by the fees charged in the existing plan, should they be allowed to play.

  4. I had exactly the same thought as PK this morning while I was listening to a summary of Geithner’s plan on the radio. (OK, since I was putting my hair in rollers at the time, I might not have been giving it my full attention.) I can buy T bills, so I don’t see why I can’t buy subsidized toxic — pardon me, legacy — assets as too.

  5. The 50/50 match of TARP funds to private dollars means nothing. It’s the seven-fold leverage that the FDIC is providing.

    “The Treasury Department offered this illustrative example of how the program would work: A pool of bad residential mortgage loans with a face value of, say, $100 is auctioned by the F.D.I.C. Private investors would submit bids. In the example, the top bidder, an investor offering $84, would win and purchase the pool. The F.D.I.C. would guarantee loans for $72 of that purchase price. The Treasury would then invest in half the $12 equity, with funds coming from the $700 billion bailout program; the private investor would contribute the remaining $6.”

    I’m assuming that these are non-recourse loans — elsewhere, the NYT articles says that the govt would bear most of the losses in a worst-case scenario. So what does this non-recourse leverage do? It cuts off the low end of the probability distribution of returns, and thus leads to a higher price.

    Consider an asset whose expected value is $100, with a probability distribution that is Gaussian with sigma $30. How much would you pay for it? Up to $100, the center of mass of the distribution. Now suppose that the govt is going to absorb all of the downside risk below $83.33. Essentially, take that entire portion of the probability distribution and pile it up as a point probability at the $83.33 mark. The center of mass has shifted to the right, and you’d be willing to bid somewhat more than $100.

    For a Gaussian, this distortion is not so bad. But consider a mezzanine tranche of a CDO that quite probably has a value of $0, with a tail probability of actual value. Say 80% chance of $0, otherwise uniformly distributed up to $100, so the expected value is $10. But with the govt absorbing 6/7 of the downside risk, you’d be willing to bid, you’d be willing to bid about $28. (If the true value comes in $24 or less, an 85% chance, you lose $4. Otherwise a 15% chance that your value is drawn from the $24-$100 range, i.e. 15% x $34 is about $5).

    So the worst assets are the most distorted. The plan is to use the FDIC to absorb losses when the probably-worthless junk is bid up to unrealistic levels on the hope of seven-fold leveraged profits.

    It’s still not clear whether banks will want to sell at these prices, vs. continuing to carry them at whatever imaginary levels on their balance sheets. But at least we know why Congress pushed to get explicit $500B backing for the FDIC. The Fed and Treasury have spent their political capital, but the FDIC still has cred as “looking out for the little guy”. So they’ve tapped it to take the fall this time around.

  6. Yes, I see that for buying loans, but I don’t see the 6x leverage for buying securities. That’s what puzzles me.

  7. Once again, I wonder if foreign institutional investors will be invited to partake in this subsidy?

  8. Actually, I also wonder if sellers can also be buyers of the same asset. Anyone?

  9. Of course taxpayers are not getting the same deal as the sharks, taxpayers are providing the non recourse financing, not accessing it.

    I think the sharks will be pussycats. Imagine, a bank owns $100 worth of this stuff. Can put 3% down and unload it at a high price. Why in the world not sell, write off the 3% purchase cost, and be happy?

  10. Perish the though, these are honorable people. Just kidding.

    Even if they are not the same, what about a bank providing non recourse financing? Selling credit default insurance?

    These banks make their money figuring out ways to do things, this plan is ripe for the plucking.

  11. I’m assuming the fees paid to the 5 FM’s will be greater than or equal to the equity contribution from the investors.
    The devil will be in the detail. Have you seen anything discussing the asset management costs?

  12. If i have a bunch of toxic bonds,
    why shouldn’t I just sell them to myself (possibly thru a front
    organization) at a very high price, so that I
    pocket everything but 6%,
    courtesy of the US govt??

    Or I can agree to buy, at a very high price,
    from someone else who holds such bonds
    if he will buy mine. In any case its going to be the
    very same banks buying these up, that are holding the toxic stuff, so this is not just a farfetched possibility.

    The subsequent evolution of the bond’s value is of no interest
    to the auction buyers or sellers. they can comfortably write off the 6%.

    Individuals without alot of toxic assets
    would only lose in this scenario.

  13. James, individuals are allowed to buy in. From the White Paper: “The program will particularly
    encourage the participation of individuals, mutual funds, pension plans, insurance companies,
    and other long-term investors.” I’m not sure how, but the plan is clearly meant to encourage participation from all sorts of investors.

  14. PPS
    I’m assuming the auction mechanism is a
    simple “highest bidder” setup,
    but I don’t see any other mechanism
    that would get around my scheme.

  15. RE: F. Blair

    The paper clearly says that only *5* funds will be allowed to participate directly. It lays out criteria to become one of the managers. (10 billion under management, ability to raise 500 Million or more, etc, etc)

    My guess is that PIMCO will be one of the 5 involved. They will sell various classes of shares in this new venture that will be available to all the types of investors mentioned.

    The small or individual investor does NOT and will not have direct access this financing like a PIMCO, BlackRock, or a Goldman Sachs, will.

    They will sell pieces of it to us.

    The US taxpayer is essentially financing and subsidizing the creation of an entire new secondary mortgage market.

  16. 1) You can get a similar deal through the TALF. There is a $10 million minimum.
    2) The difficulty in offering this deal in a fund for individual investors is that Federal securities law prohibits more than 33% leverage.

  17. It doesn’t sound like a terrible idea to me. Maybe some people are now more interested in hurting the banks than increasing employment. If the programme can be considered like a CDO, then the private investors have the equity tranche. Their reward is greater than the taxpayers, because they will bare the first losses, and could lose all of their capital. They have an upside so that the process works. This way they will not mismanage or overpay for assets. The taxpayer has less upside, but the taxpayer is not trying to make money. The taxpayer is trying to raise employment.

  18. The application for private asset managers for the legacy securities program says that “The Applicant must note whether, and if so how, it plans to structure the Fund to facilitate the participation of retail investors in the Fund.” Clearly this will be an important factor in evaluating applications.

    The leverage for the securities program will come from the TALF (i.e. the Fed).

    Why do people keep saying that the purchasers will grossly overpay for assets because of the leverage? The private investors and the Treasury will share (50/50) a first-loss position on the assets. If the assets are overpriced then the private investors and the Treasury will lose their entire investment before the lender (FDIC or Fed) loses anything. Certainly, the leverage will magnify potential returns, which might be worth a little extra risk (=slightly higher price) for investors, but the investors will not just put their entire investment at risk because the lender might also lose money.

    The more you study this plan the better it looks for taxpayers (and the worse for existing bank shareholders when the banks sell the assets at a loss).

  19. Even if they were to allow me to invest, as an individual investor without a huge amount of capital, going in for these loans is still a big risk.

    If they want to make the proposition attractive to normal people, I think that the investment needs to be structured like an investment fund. That way I can just drop my money into a pool with a lot of other small fish, and we may have a large enough school to swim with the big fish.

  20. There is an awful lot of speculation here. We really won’t be able to draw any conclusions at all until we see how this sifts out. I suspect that the amount of investment from the private sector, if in fact they can find a reasonable price level, will not be money that they expect to lose (i.e. billions), and, even with the amount of available leverage, will expect to get a “net” on their money of at least 50%. This is what they expect, and unless the pricing is favorable enough (after a determination of the “actual” estimate of value), they just won’t do it. After all, the duration and management costs will probably be fairly high – at least 10% – that is entirely borne by them. I don’t see the issue as risky for the taxpayer, because the investors will be very smart not to get into a shaky deal, if that is their perception. After all, they are not even concerned about the government’s risk profile, only theirs.

    I am somewhat skeptical that, after all is said and done, these partnership will actually buy very much. Geithner is hoping for a trillion of toxic assets. It think if they actually succeed in getting the banks to slough off half of that, it will be a success.

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