7thriv

Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard.

This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized. And I fear that when the plan fails, as it almost surely will, the administration will have shot its bolt: it won’t be able to come back to Congress for a plan that might actually work.

I will admit - I am experiencing shock and awe at the level of leverage in the latest proposal (and I am not alone) - I wasdefending the notion with a hypothetical leverage of 2-1; the leaked plans contemplate leverage of 6-1 (i.e., 85% debt).  If time permits I will present a dramatic example illustrating the problem with the Geithner plan on offer.  But nothing I saw last week could have left people thinking that Congress is poised to oversee some of the largest, most complicated banks in the world.

The problem is that there is a perverse incentive for a bank to participate through some back channel if it can, given sufficient leverage.

Let's say I'm "Frobozz Bank" and have $100 billion of this trash (a lot!) on my balance sheet.  Its mostly performing (for now) on a cash-flow basis, but I know what the deterioration in on-time payment flow looks like, and as a consequence I know in advance that eventually this paper is going to be worth much less than my "internal" marks (that I'm reporting every quarter on Level 3.)

So here comes Treasury.  They offer 20:1 leverage (I put up 5%) and the "private parties" bid for the assets, with their maximum loss being capped at their contribution (that is, if there's more than a 5% loss the taxpayer eats it.)

Aha!  Now if I can be the "private party" I can overpay on purpose, capping my losses at 5% of whatever I "buy" from myself!  I am thus able to transfer the other 95% of the risk onto the taxpayer and I escape with a 5% penalty off the purchase price!

That, if it happens, is an enormous scam and Treasury and the FDIC must absolutely guarantee that it not occur.  If it does, we the taxpayers are going to be violated to an insane degree while the true "risk money" (and there's a lot of it out there) won't go anywhere near this program, because they, being unwilling to overpay, will simply lose the bidding contests.

So in order to prevent intentional overpayment you must as a matter of policy (and even law) enforce strict separation of the funds that are doing the buying from anyone that has an interest in the sellers, and make clear that if you catch anyone cheating extremely severe sanctions - like 100 years with Bubba - will be the consequence.

If you do not the process will get gamed and the taxpayers will lose.

like I said, I'm against it.