Wednesday, March 25, 2009

Detoxification of the banking industry

I've had a chance to look at the new bank detoxification plan. On the surface, it has some positive features, foremost among them the opportunity to get a better idea of what the frozen assets are worth. If hedge funds or private investors are willing to risk any of their own money, one would assume they think there is a reasonable chance of turning a profit -- especially in the current, risk-averse environment. If "Hedgehog Investments", say, will bid fifty cents on the dollar for a batch of Citi's CDOs -- even with 93% government leverage -- one could finally establish at least a nominal value for those CDOs -- half of face value.

True, without the government leverage Hedgehog would not have bought them at all, but by buying a diverse assortment of derivatives the Hedgehog traders might assume that some of those would turn out to have real value. (This is the classic definition of a "hedge.") On the winners, Hedgehog takes 50% of the profits. On the losers, the taxpayers take 93% of the losses. Do the math. If a substantial majority of the paper is pure crap, Hedgehog still comes out ahead -- but unless the opposite is true, and most of the paper turns out to be worth more than the price paid, the taxpayer loses, big time.

Great deal, huh?

Let's look a little harder. Under Treasury's plan, the banks get to decide which assets go up for sale. The most senior tranche of a security -- the shareholders entitled to be paid first when the asset pool is distributed -- is fairly safe even if the security as a whole is not performing well. Banks traditionally hold on to those senior shares. The problem for megabanks like Citi and BofA was that they were unable to unload the more junior tranches, and are stuck holding them on their books. Only those junior tranches will go to the auction block, and I think it is safe to assume that, by this late date, the banks have a pretty clear idea of which are likely to yield a profit and which are completely worthless.

Trying to get rid of the ones that are totally worthless may be tempting, but hedge fund managers rarely are total idiots, so nobody will want to buy the most junior tranches. Nobody buys a turd, no matter how deeply discounted it may be -- so the bank that made the offering would be forced to mark down the unsold turds on its books, perhaps all the way to zero. Uh oh! Here comes formal insolvency! Better to keep the turds on the books, and pretend they're still worth thirty or forty cents on the dollar.

So all trading necessarily will be in the middle tranches, but even with their heavy government subsidies, private investors still may be unwilling to pay as much as the banks need to regain real solvency. It's quite possible that hedge funds will make large profits, taxpayers will suffer enormous losses, and the big banks still will fail.

Here is one last scenario -- and I certainly hope somebody at Treasury has thought of it and is making sure it can't happen:

Citi bids 100 cents on the dollar for $300 billion worth of B of A's most toxic "assets." Under the government program, Citi puts in $21 billion of its own money, and the rest comes from the government. In the meanwhile, B of A bids 100 cents on the dollar for $300 billion worth of Citi's most toxic assets, similarly investing $21 bilion of its own money. Then, both Citi and BofA "discover" that the assets they bought are worthless, so each writes down $21 billion in losses. Each bank ends up $279 billion ahead of when it started, and the government is on the hook for $558 billion. Brilliant!

In that scenario, the taxpayers have purchased a truckload of worthless crap for 93 cents on the dollar -- probably a substantially higher price than even Henry Paulson would have been willing to pay. Could the banks get away with it? Not in the form I just presented it, but with appropriate use of proxies and the usual lack of transparency, perhaps. With complicity from key players in government, well...

Doesn't it make a lot more sense to nationalize all the big banks that can't make it on their own -- now? Fire the thieving buffoons who ran their banks into the sewer, and replace them with technocrats on the government payroll. Let those specialists take as many years as necessary to break up the megabanks and and sell off their assets, getting the best price possible for the taxpayers. In the meanwhile, Congress must enact legislation to make certain that no bank ever again becomes too big to fail. (Glass-Steagal comes to mind, for starters!)

A bank that is too big to fail is too big to exist. If Obama and company would just grow some balls and stop cringing when Republicans call them naughty naughty socialists, they will discover a great deal of popular support. Americans will accept nationalization, provided the "evil, greedy bankers" who "did it to us" are punished.

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