All about public-private partnerships

Well, luckily, I picked an uneventful weekend to go on vacation.  Having slept in yesterday, I got the invitation to the Treasury conference call about Geithner's plan approximately an hour after it ended.  So you'll have to make do with warmed-over thoughts which were formed without benefit of input from the horse's mouth.

Leave aside whether it is a bailout for Wall Street:  of course it's a bailout for Wall Street.  The persistent fantasy that we are going to recapitalize the financial system without, y'know, giving them a lot of new capital, needs to end.

Let us also temporarily overlook any moral questions underlying such a massive transfer of taxpayer wealth--or qualms about the efficacy of doing so rather than leaving the bankers to stew in their own juices.

Leave off asking even the question so intelligently posed by Felix Salmon:  why the hell do we need these trivial amounts of private capital?  The ostensible rationale--price discovery--won't do:

The key insight here is that bidders for the banks' toxic assets don't care particularly about the idiosyncratic risks of any given loan portfolio or CDO. Instead, they're worried overwhelmingly about systemic risks associated with the ongoing financial crisis

Essentially, we are not living in a world where investment prowess is repaid, and the fate of the private-sector participants in Geithner's public-private partnerships is pretty much out of their hands. Either all of these assets are going to appreciate in value, or all of them are going to decline in value. And that's largely a function of what happens to international financial markets and to the global economy as a whole. The potential buyers of these assets can do all the homework they like, trying to bid on slightly better assets rather than slightly worse ones, but the big risks -- to both the downside and the upside -- are systemic.

In other words, the private participants in the Treasury plan aren't really adding value, they're just gambling that things are more likely to get better than they are to get worse. For this we need to pay them much more of the profits than their share of the total investment?

Let's just consider the simple question:  will the auction succeed?  That is, will the sellers sell?  And if they do, will the buyers buy?

On the former question, it's really not clear that they will.  People putting their securities out to market are taking a huge risk:  that the price discovery process will write down the value of their assets to well below the price at which they are carrying them.  Even if they set a reserve price, they're in trouble if the auction doesn't meet that reserve.  They can't very well go along claiming that their impaired mortgage bonds are worth 75 cents on the dollar if the market is only willing to pay them 25.

For the banks in real trouble--i.e. the ones you are trying to save with this auction--there's a real risk that too many lowball auctions will knock their regulatory capital below the floor, and the FDIC will swoop in.  Wouldn't it be better to sit on the sidelines and see if more direct help isn't forthcoming?

The idea seems to be that by offering private companies a "heads I win, tails Uncle Sam loses--a lot" deal, Geithner has actually raised the value of the assets to the private sector.  This is true--these deals are highly leveraged, as lots of bloggers have complained.   And a leveraged deal with no downside is worth a lot more than an unleveraged deal without.  If you have a choice between staying in a Budget Inn room or the Ritz-Carleton, if you're like most people, you'll probably choose the budget in--you value the hundreds of dollars you'll thereby save far more than the added luxury.  But say someone gets you a fantastic deal, and you can either stay at the Budget Inn for $75, or the Ritz-Carleton deluxe suite for $150?  Sure, it costs twice as much, but you're getting a lot for your extra $75.  Some people would still choose the motel, but a lot of people wouldn't.  In essence, that's what Geithner is betting.

For the banks, of course, it's even more explicit:  they're not valuing intangibles, just the cold, hard, likelihood of cash.

There are two problems with this scenario.  The first is that all the leverage means that your profits erode quickly with each new bid.  Let's say the bidding starts at 30 cents on the dollar, the bank has marked it down to 80 cents, and you think the asset is probably going to pay off 50 cents on the dollar.  At 30 cents and 6-to-1 leverage, you're putting in about 5 cents, with a good likelihood of splitting a 20 cent profit with the feds on each dollar's worth of security you buy.  That's a fantastic deal: a 200 percent return.  

Now bid it up to 40 cents.  Suddenly you're putting in about 7 cents, with a likelihood of splitting a 10 cent profit will the Treasury.  Your return just dropped to less than 100%.  That's still a mighty good return.  But here's the problem:  you don't really know what the securities are worth.  Who's got the best information about the value of the securities?  The banks holding them.  And there's every reason to suspect that they are going to want to dump their weakest securities on the suckers investors at the auction.  When you factor in the risk of losing your 7 cents, the deals start looking uglier.  Meanwhile, maybe the banks can't sell at 50 cents because they'd end up in receivership.

There's another wrinkle:  the AIG bonus clawbacks.  Doing business with Uncle Sam suddenly seems awfully risky.  If the banks do make money on these sweetheart deals, will muckracking reporters and pandering congressmen just decide to take it away again?   Mighten't it be safer just to sit on the sidelines? Anecdotal evidence suggests that this is crossing a lot of minds on Wall Street, and that a lot of bankers may be torn between the prospect of juicy profits, and the risk of having them taken away again amid another ugly media storm.

That said, we won't know for sure until we try the auctions.  And maybe it isn't really supposed to work; maybe it's just supposed to establish that nothing else but nationalization will work.  But as Ezra Klein has pointed out, this is not necessarily very comforting:

"Many of the critics," one official sighed to me, "are underestimating the difficulty of their counterfactuals." Ben Bernanke does not appear to think the administration has the legal authority to forcibly take investment banks into receivership. What happens if a legal challenge disrupts the process?

Virtually no one thinks that Congress is willing to quickly offer either the legislation authorizing such an action nor the massive upfront money that receivership would require. Will Ben nelson and George Voinovich vote to take control of the banks? And what happens to the market while Congress is debating? And to Congress if the market dives?

No one knows if the Treasury Department has the technical capacity or simple competence to swiftly assume control of much of the United States banking sector. If Treasury seems unable to simply build out a banking plan and claw back bonuses, what makes anyone think they can run the banking sector?