Dennis Snower works out the arithmetic behind the Public-Private Investment Program and shows something that we’ve suspected: if the assets are really toxic (the gap between book value and long-term expected value is big), the subsidy just isn’t big enough. He also shows that if the assets are only a little toxic, the government subsidy induces private sector bidders to overbid, making the subsidy bigger than it needs to be.
Snower’s hypothetical asset has an expected value of $50. According to his calculations:
- If the bank has it on its books at $70, the private sector will bid it up to $85 because of the government subsidy. The government would have been better off under the original Paulson Plan (just buy it off the bank at book value, in this case $70).
- If the bank has it on its books above $85, the private sector will not buy it at all and the plan will do nothing.
Now, his asset has different characteristics than the assets out there in the real world, whose expected values are not knowable, let alone known. That may change the analysis, but I doubt it changes the ultimate result.
Thanks to the reader who recommended this.
By James Kwak
The Baseline Scenario 
Why do we even need this program again? I thought the banks were fine.
Sounds familiar.
Of course, the “50% chance of being worth $100 and 50% chance of being worth zero” is not terribly realistic. But I have to agree, it makes for a great example.
Yes as I remember someone took you to task for a similar example once upon a time.
Another problem with this type of analysis is that it ignores one thing. If these assets are on the books of a TBTF institution they are already de facto (whether you like it or not) subsidized. So if you are being honest with the numbers, you’ll try to compute that subsidy and subtract it from the PPIP subsidy.
My sense (no, I haven’t done the math here) is that the PPIP subsidy is larger than the implicit TBTF subsidy, but not by a huge amount.
> If the bank has it on its books above $85, the private sector will not buy it at all and the plan will do nothing.
If the private sector does not buy it at all, the plan still does not “do nothing”. If the private sector won’t buy it at an artificially inflated price, the ‘real’ market price certainly has to be less than the bank’s mark. So the plan has done something important: it has provided information to banks and their regulators about which marks are not reasonable.
James, you’re bringing me down with this post!
If the assets are truly toxic (as Paulson led us to believe they are), we’re not throwing enough money at the issue.
If they’re just “a little toxic” – the taxpayer’s getting screwed and the bankers get even richer as they shed the toxic assets clogging their pipes.
I’ve never understood Geithner’s desire to start up a market in toxicity. It has always seemed like lose-lose kind of deal for all but the bankers….
This is a great post. Finally someone has clarified this. I’ve always thought that the Geithner plan was virtually the same exact thing as the Paulson plan, with the exception that Geithner’s is giving free money to funds in addition to capital to banks. Paulson was only give money to the banks.
The funny thing about Geithner, is that he calls this a partnership. Name me one partnership where one partner takes all the risk and puts up 95% of the capital and yet the other partner gets the lion’s share of the profits?
Geithner plan is a scam, plain and simple. A brilliant scheme concocted again by Goldman and other big investment banks to enrich themselves with free government money.
Thanks for the article…but I’ve always wondered why the banks just wouldn’t buy back their own toxic assets through the program.
“If the bank has it on its books above $85, the private sector will not buy it at all and the plan will do nothing.”
Why wouldn’t the bank itself buy it? If you only need 8% equity, seems like the bank should bid it up to face value and get out at 92 cents on the dollar (since the bank would have to put up and most likely lose their 8% equity). I must be missing something here.
PS If you read the original article by Mr. Snower, he mentions a government average loss of -500%. How is it possible to have a greater than 100% loss? There are no negative value financial instruments, that I’m aware of. Can someone possibly explain how the writer can talk of losses greater than 100%? Doesn’t seem to make any sense.
he considers only return on equity, not return on the funds loaned.
this overstates the loss both in absolute terms and relative terms.
he ignores the interest the treasury receives on funds loaned. the interest rate is not given in the march PPIP description, but it’s not zero.
That is essentially what would happen were the banks allowed to buy assets off of one another.
Another view of the PPIP is presented below. Thank you.
Imagine you are a highly placed government official with responsibility for the nation’s and to some extent the world’s financial system.
Confronting the worst banking crisis in over 80 years, you and your staff, together with others in the government with responsibility in this area, have been considering the widely recommended strategy of putting one or more of the nation’s largest banks into receivership, or temporary nationalization.
The good parts of the bank, the “good bank,” made up of good loans and liquid assets, will be washed through the receivership quickly and put back to work, nicely starched and pressed, as it were.
You estimate that some $2 trillion of assets, at par or face value, will remain with the government. The value of these assets, and indeed the correct valuation methodology, is controversial.
Half the assets will be worth 100 cents on the dollar and half will be worth zero is what the economists and statisticians are telling you, a flip of the coin.
The banks are carrying these “toxic assets” on their books at anywhere from 50 to 85 cents on the dollar. Short of seizing the banks, the toxic assets carried on the banks’ books represent impaired capital.
So far, write-downs, marks-to-market or to model and reserves represent unrealized losses. Like any investor whose positions have declined in value, the banks are hoping for a rebound. If they are forced to dispose of their toxic assets at current prices, the damage to their capital base will be unrecoverable, except through new capital infusions or earnings.
One thing you know for sure is that there is no way that any agency of the government can handle the volume of assets that appears to be headed its way. That will require setting up some kind of institutional framework and more than likely paying asset managers to handle the volume. It will not be cheap.
Moreover, with $2 trillion at face of assets held for disposition, bargain hunters will carry the day. It is well known that when banks sell foreclosed properties, they end up with less than market prices. It will be worse with the government selling so-called “toxic assets,” when the supply side is so huge. Chances are good that assets from the government’s toxic junkyard will be sold at prices that at most represent no probable loss to buyers. Many will be sold at prices that guaranty attractive returns. Some will be given away for cents on the dollar, like thrice-worked credit card chargeoffs. Net of costs, at the end of the day recovery rates to the government will likely be in the range of 5%.
In an earlier phase of the crisis, when it seemed as if the problem in the banking system was a matter of illiquidity stemming from uncertainty about asset values of synthetic securities, your predecessor in office offered an ill-considered proposal that the government buy up almost a third of the toxic assets and attempt to make a market in them. At least the ground has been plowed.
Taking all these things and more into consideration, a decision is taken not to pursue the fast nationalization strategy at this time.
Instead, an effort will be made to quantify the additional capital cushion that may be required to give the banks some freedom to take additional write-downs and to recognize some level of write-offs. Regulatory pressure will be brought to bear to force banks to raise private equity to the extent it seems likely that markets will respond favorably. Other steps will be taken to present the banks in the most favorable light.
And, instead of waiting until an overwhelming volume of toxic assets accumulate in government junkyards, a pro-active choice is made to come forth pre-emptively with an orderly institutional mechanism for recycling toxic assets from the banks to private markets. A 5% recovery rate is the presumptive breakeven. The program will attempt to induce private investors into purchasing toxic assets in an orderly process by offering leverage.
Of course, the leverage granted to buyers will cost the government nothing. It is money already lost.
But the offer of non-recourse finance does give the government some potential upside.
Although unlikely, by magnifying the potential upsides for investors, the non-recourse financing may induce buyers to pay something more than what they believe to be a completely risk free price. The nation’s largest asset management firms are brought into the process by the prospect of making large fees. None of this is possible if the government allows toxic assets to pile up too quickly and waits until after the fact to begin to address their disposition.
Notably, as a public private investment partnership, the leverage offered in the toxic asset disposition program is lower than the leverage afforded regulated banks.
Well laid out. I guess my question would be why aren’t the small banks being given the same options to survive? Sure, new regulations will emerge for the big banks but will over time most likely be watered down or run-around. In 10 years, the only thing the banks will remember from this debacle is the lesson: Go big or go home.
If these assets turn out to be really toxic could we be in store for another collapse or will we just lose a lot of money?