"The Biggest Travesty of Capitalism"

Maybe my last post was neither as informative nor as insightful it could have been. And maybe I'm already too late to lay out the details of the new Geithner Plan, the so-called Private-Public Investment Fund. It's been about a week now since its release, so maybe you've all already had plenty of time to read about it, and to decipher it and to decide whether or not you give it the thumbs up or the thumbs down.

But in case you haven't, here's what the thing is in simple, non-metaphorical or narrative terms.

Background:*

Banks have assets which they have purchased and which are no longer worth as much as they were once deemed to be by those expert few who buy and sell them. What are these assets? Essentially, these assets are loans. Perhaps the bank has made this loan directly to a borrower or perhaps the bank has purchased the loan from another bank. In any event, the underlying value of the asset is based on whether or not the borrower who accepted that loan actually pays the loan back with interest. If he or she does, the asset is fairly valuable. If not, then the asset is worthless. In reality, things get a bit more complicated since these assets are not one loan, but many many different segments of many many different loans. But that basic principle--the perceived reliability of the borrower determines the percieved value of the asset--holds.

The banks do not wish to sell these assets at prices that are too low because, having purchased so many of them, were the banks to sell them at these low prices, they wouldn't have enough money to pay off their debt and their shareholders. Such a condition is called bankruptcy and it is generally to be avoided if you are a bank.

Unfortunately, those who generally buy these assets just aren't at the moment. After a year's worth of news coverage detailing how these particular assets are really, really bad (that is, the borrowers who took out these loans are not so likely to pay them back anymore), investors have gotten it into their heads that these assets are really, really bad.

So this the problem which the Geither Plan seeks to fix. The banks won't sell at the prices being offered by the buyers. And even where buyers want to buy at higher prices, most people are so nervous about lending money these days that those aforementioned potential buyers can't easily or affordably borrow the money required to buy enough of these assets to make the whole deal worth it.

The Plan:

First, the Geithner plan sets about establishing a price for these assets. Right now, buyers are offering $30 while the banks are claiming $90.** There is a giant gap between the former and latter and in the meantime, no assets are being sold, banks are unable to loan and the credit market stands still. The FDIC (Federal Deposit Insurance Corporation, a government agency) has therefore been instructed to go to major banks and offer to hold an auction for the assets which the banks cannot sell. If the bank agrees, an auction is held in which an agreed upon list of private investors bid on the price of the asset. Like any auction, the highest price is selected and the private investor is given the oppurtunity to buy the asset (or asset pool) from the bank at the chosen price. The bank obviously must agree to this price.

Assuming a price is agreed upon, the investor buys the asset. Why would this investor buy assets which he or she or it was not willing to buy without the auction? Because Uncle Sam is offering a little help. First, the FDIC is offering the investor an enormous loan. How enormous? The loan may be up to (though is not necessarily) 6 times the number of dollars actually invested. So, given the 6 to 1 example, if the auction price of the asset is selected at $84, only $14 need be invested while the FDIC coughs up the remaining $70.

But wait, hesitant investor: it get's even better! The Department of Treasury is so eager to make this deal, it has agreed to invest along with you, dollar for dollar. So in the above example, all you need to do is put down $7 for the $84 asset. The Treasury invests $7 too, and the FDIC provides the rest as a loan. And a very reasonable loan at that. Not only will the interest charged be lower than anything else you're likely to find, it will be considered a non-recourse loan. This means that if the borrower is unable to pay back the loan, the lender is limited in its recovery of the lent money to seizing the underlying asset. For instance, mortgages in the United States are non-recourse; if a home-owner is unable to pay back his or her debt to the bank, the bank can take the house for which the mortgage was written. But if the value of the house is not enough to pay back the bank in full, the bank cannot then go after bits and pieces of your property and income. In case of the PPIP, if the private investor puts down $7 to buy the $84 and then is subsequently only able to sell the asset for $50, the investor (and the Treasury) have lost the entiretly of his investment. Not only will they not be able to recover their $7, but they will not be able to pay back $20 of their debt to the FDIC. Too bad for the FDIC, who gets the $50 asset to sell and pay itself back, but that's it.

So this is the reason that the United States government has provided to investors to buy risky assets that they otherwise wouldn't. In the worst of cases for the investor, he or she or it loses the initial $7 investment (only 8% of the actual value of the loan, which is a leverage deal about 6 times better than you can get on the New York Stock Exchange), whereas the best scenario (the so-called "upside of the deal") rewards them with infinite possibilities. As one might expect, the potential payoff distribution for the FDIC is a mirror image of that for the private investor. If the auction price for an asset turns out to be much higher than the assets actual value, the FDIC picks up the tab. If, on the other hand, the auction price turns out to be a good bet (that is, the loans backing the assets preform at or above that price), the FDIC gets its money back with much less interest than it could have otherwise gotten and perhaps a fee.

The Feature Presentation:

If the above explanation didn't make much sense (or you prefer visual presentations anyway), the video below has many a bell and whistle which my humble attempt at a summary so transparently lack.

If you'd prefer not to, I'd really recommend skipping to the 6:25 mark; the following content provided the impetus for this post. Salman Khan, the person who put the film together, outlines just how easily (and thus inevitably) most of the participating banks will be able to scam the system.***





*I apologize if I'm just repeating what a lot of people already know.

**these numbers are just illustrative though I think roughly accurate. Also, they are based on the assumption that $100 is the value of the asset if every borrower were guarenteed to pay back their loans.

***When he talks about public loans coming from the Fed, he means the FDIC. I'm not sure why he missed this distinction, but it's an important one. The FDIC's principal revenue source comes from charging insurance fees to all depository banks. In other words, if the the FDIC ends up getting screwed in order to bail out the banks, its likely that a lot of that cost are going to end up biting the entire banking system in the ass with increased FDIC charges. But then again, Congress can always just give the FDIC more money like it did a few weeks ago, so maybe that's naive.