The method can be found here. Here is how you do it:
Let’s say that I am a bank (“financial institution”) with $100 billion in “toxic assets”. I have them on my balance sheet at 80 cents on the dollar. The market has them marked at 30 cents. We do not know what the held-to-maturity performance will be, since that requires knowing the future, although for the moment let’s assume that they are cash-flowing at the present time.
What I (the bank) do know, however, is that if I sell them at 30 cents I take a monstrous loss – perhaps enough to force me under Tier Capital limits and thus render me subject to an FDIC enforcement action. I therefore will not sell for 30 cents so long as I have any belief whatsoever that the cash flow – or any government subsidy – will exceed that value.
If I, as a “financial institution” can participate as a bidder in these auctions I can foist off my loss onto the taxpayer. Here is how I can rig the game so as to avoid an otherwise-inevitable loss:
I become a “bidder” and “bid” on my own assets at 75 cents.
I am providing 5 or 10% of the money. The rest is covered by Treasury, The Fed and the FDIC via guaranteed bond issuance.
The loan, ex my contribution, is non-recourse. That is, I can lose 5 or 10% of the total portfolio purchased, but nothing more.
Now the “assets” (a passel of CDOs?) turn out to be worthless. I lose 5% of $75 billion, or $3.75 billion that I put up, plus the other nickel on the original mark, but that’s all.The taxpayer gets hosed for the remaining $71.25 billion dollars.
This reminds me of the California electricity market back about 8 or 9 years ago. At that time the major utilities had to buy any and all electricity they needed on the spot market. Further their retail price was fixed by law. On top of that the state is constrained in terms of both tranmission and generation capacity. With a flexible price wholesale market (i.e. the spot market) and a fixed price retail market and that any single generator can influence the wholesale market price it shouldn’t take a genius to see that a problem will arise. For example, imagine you have an estimated demand of 1,000 MW. Suppose there are three providers each capable of generating 400 MW each. Two of them bid in 400 MW at $50/MW. The last guy bids in 200 MW at $1,500/MW. Now the market clears and all the generators get $1,500 MW. The retail market however can only collect about $40-50/MW. Since final consumers see the fixed retail price they have no incentive to cut back–i.e. no demand response. The utilities were put into a serious bind. However, for the consumer/taxpayer their situation of avoiding such prices was to be short lived. Established rate doctrine allows any utility to recover any costs that are deemed reasonable. And the way things were in California at the time all purchases of power off of the spot market were deemed reasonable irrespective of price. Now California has ridiculously high electricity prices.
Back to the gaming of Geithner’s Plan by Karl Denninger,
I like the outline of this program if and only if it cannot be gamed in this or similar fashion. Provided that does not occur, this program has the potential to provide great benefit to both the banking system and our economy.
Karl, let me introduce you to my friend here called the Folk Theorem. The idea that any plan be made “gaming proof” is likely to be rather difficult at best. You see, any outcome is feasible in a repeated game which is what we have here. In other words, the number of outcomes is very, very large. The subset of ones where “gaming” takes place is also likely to be very, very large. As such the idea that all gaming can be prohibited is likely not going to happen.
Even if we prohibit the actual financial institutions that hold these toxic assets from bidding other players might figure out other strategies for gaming the system and capturing a nice windfall.
Photo by Flickr user vinduhl, used under Creative Commons license.
