Monday, March 23, 2009

Geithner's Plan Not Bad

I really disliked Tim Geithner's 'stress test'. Taking over companies that could be insolvent in the future is a horrible precedent, setting a vague standard for solvency, because if you are insolvent in the future under the government's opinion, you are insolvent today. Thus, insolvency is not the exit criteria, rather one has to plan for future 'future' insolvency as defined by the government. This is a political football, meaning, it's all lobbying and appeasing regulators to maintain market power and beat down new entrants. I noted in his WSJ editorial, Geithner mentioned that people will be more confident in banks after having passed this vetting process, and that may have been the motivation, but passing a politically infused stress test is not reassuring.

On the other hand, his new plan is to basically match fund private investors in buying distressed securities, with over $500B set aside. This mitigates poor incentives, because they are not providing the first loss or senior piece, just sharing parri-passu. They are not giving purchasers leverage, even. An investor who thinks it is a bad risk-return investment will not be incented to invest, because this government involvement does not change the payoff space. This is just adding liquidity, and is not a subsidy, because the expected value of this is zero if we assume market prices are expected values of future payoffs. The cost is actually negative if we think the markets are in a panic, but costs are quite high if we think this is the mid point in a massive financial cataclysm.

Thus, Krugman thinks this is a huge subsidy because he thinks market prices are way too high for CMBS and RMBS securities, though I think this is really because he believes anything that would justify greater government control of economic activity. He has presented absolutely zero data on the prices and corresponding historical loss curves for the various vintage-product types (eg, Alt-A mortgages, 2006, average current price and losses). He doesn't have the data, he wouldn't know how to set it up. It's the kind of detail he is ignorant about but does not think is important. Details matter. Subprime, Alt-A, conforming,vintage, seasoning all matter. AAA 2007 subprime tranches trades at around 25% via the Markit ABX index. Is that really reasonable? What are the losses on the collateral? He just wants to take over the banks asap because asymmetries and imperfect information prove markets are inefficient (heh).

I found 94 subprime mortgage tranches, and some referred to the same underlying mortgage pool. You can find these by going to the Markit ABX index page, looking at the constituents, and see they refer to 20 tranches that vary by seniority for the various grades (eg, CWALT 2007-21CB M Mtge, BSABS 2007-AQ1 A1) . Anyway, the average cumulative 90+ delinquency is about 25%. That's pretty high historically, but after seasoning 21 months, this means a conservative estimate of total 90+ delinquency is going to be around 50%, and losses on those delinquencies no more than 50% (housing prices did not fall more than 50% in most places, on average). Thats for all of subprime in 2007. The market price for AAA rated assets (better than average) is a mere 25 cents on the dollar, suggesting the average subprime mortgage is priced below that, say 10 cents on the dollar. This is way too low.

I suspect most banks will be unwilling to sell off assets at market prices, because the market prices are so low. In that case the plan 'fails', but it would also then cost us nothing, and in the meantime not screw anything up (in contrast to the stress test).


Anonymous said...

It seems to me that the availability of non-recourse debt financing will increase the price that investors will be willing to pay for the bank's risky assets, relative to what the investors would pay using all equity or a combination of equity and recourse debt. With non-recourse debt, investors have the option of walking away from the assets if their value falls below the value of the debt. You're the sharpest analyst I know of on this situation though and you don't seem to agree...

Anonymous said...

What do you mean they aren't giving purchasers leverage? The FDIC is putting up 85% of the money as debt. The private investors put in 3% of the total equity invested, the Government puts in another 12% of equity, and the FDIC puts in 85% as debt. Thus, the private investors get one-fifth of the upside but put in only 3% of the total invested.

The FDIC takes all losses greater than 15%. This is a big put option for the private investors.

Correct me if I'm wrong.

Eric Falkenstein said...

As I read the document, they are always match funding the equity, so if this does not have a positive NPV, there are no investors.

You are correct that there is leverage in the Legacy Loans program of 6:1, but equity is parri passu.

Anonymous said...

Anonymous 1 here again. Let's say potential investors agree with Eric on the intrinsic value of the assets. I think that the presence of the no-recourse financing will tend to cause the investors to bid above intrinsic value, for the reason that Krugman explains here:

Which I had not read when I first commented here, but spent half the morning puzzling over why no one that I regularly read pointed this out. Asset values don't have to have 15% downside from current market quotes, there just has to be at least a 15% spread in intrinsic value estimates to cause investors to potentially overpay. Banks should be willing to sell at or above intrinsic value. The taxpayers will overpay in expected value terms, but if the plan can get the banks unstuck the positive effect on the economy might feed back to realized values for the mortgage assets coming in at the high end. I think that's what Krugman's really afraid of.

Anonymous said...

Anonymous 2 here.

Plus. What is to stop the banks from colluding to bid up the price for their assets? Each dollar of overpayment goes 100% to them, while only 1/6 of the overpayment is made by them.

Eric Falkenstein said...

They could, but it would be pretty obvious. I don't think as a CEO that tactic would be worth the risk. The letter of the law is not necessarily the only law.

Anonymous said...

Very interesting perspective. I dont think there is any doubt that this program is intended to attract 'investors' because of its attractive risk profile and offered financing. It is obviously a perversion of market forces which is financed by the stat/govt/you/me and yet you believe this is the market at work. Created skewed incentives for someone else to take risk with your money is not the kind of market we need. In fact that is probably how we got into this mess, and just because prices clear does not mean that the market is right in this scenario. I think that is the real concern about this plan. If without incentives market clearing prices are a lot lower, then we can assume that those reflect real levels, as opposed to create the market we want to believe in.

Anonymous said...

These massive manipulations of the market can have one of two outcomes:
(1) It works. The government and the academy will love it and it stays in place forever. Adieu free market (the little we had).
(2) It doesnt work. The long winter.

anonymous 3 aka j

ed said...


Can you explain how you find delinquency rates for a package of mortgage securities? I can't seem to find anything like that on the ABX site. Is that data available for free somewhere?

Kiara said...

Very interesting perspective. But I have little confusion. It would be better if you can explain how you find delinquency rates for a package of mortgage securities!!