Sunday, March 22, 2009

The Private Public Partnership is a Scam

Yeah - why mince words? The soon to be announced Private Public Partnership (let's call it the PPP!), which aims to get bad assets off of bank balance sheets, will be another royal reaming for the U.S. taxpayer. Let's start with the details, from a NY Times article:

"To entice private investors like hedge funds and private equity firms to take part, the F.D.I.C. will provide non-recourse loans — that is, loans that are secured only by the value of the mortgage assets being bought — worth up to 85 percent of the value of a portfolio of troubled assets.The remaining 15 percent will come from the government and the private investors. The Treasury would put up as much as 80 percent of that, while private investors would put up as little as 20 percent of the money, according to industry officials. Private investors, then, would be contributing as little as 3 percent of the equity, and the government as much as 97 percent."

Just to restate that simple math: an investor will put up as little as 20 percent of 15 percent of the purchase price of the assets! Right away this should set off alarm bells for anyone thinking this will be a solution, as I've said numerous times already: YOU CANNOT SOLVE A LEVERAGE CRISIS WITH MORE LEVERAGE! Yet, Tim Geithner is proposing to do exactly that, by offering over 30-1 leverage to the buyers in this plan.

But wait - it gets better. Who is providing the leverage? The FDIC - a fund who is ALREADY overlevered to the point of insolvency! The FDIC providing funding right now is analogous to AIG writing insurance it couldn't possible cover. The FDIC has less than $50B in assets, and trillions in liabilities it is already insuring. Now, in a perfect world, it would be nice if the FDIC, relying on funds collected from its member banks, provided the financing. However, that is also a complete bastardization of the purpose of the FDIC: the FDIC doesn't exist to protect the banks' ASSETS - it exists to protect the banks' LIABILITIES - in other words - the deposit you put in the bank. Yes - that deposit is a liability for the bank. Now, I am still confident that if and when the FDIC needs more money, the Fed/Treasury will give it to them, and I think that's the right thing to do to protect depositors and avoid the literal collapse of our deposit banking system - so let's just consider the FDIC and the Treasury one and the same for the purposes of this post - it's not an oversimplification. Another simple proof of this point is the question "Where will the FDIC get hundreds of billions of dollars to fund this PPP if they have less than $50B?" Answer: the Treasury.

So, where were we: oh yes - getting the assets off the banks' books by levering up potential buyers 30-1. Yves Smith at Naked Capitalism weighed in on the subject already, with an example a reader left her in comments from a previous post. You can see my comments on that thread, as well as a number of crafty ways to scam the PPP from other readers, but I'll give you a few simple examples here:

Let's say you're SpankBank, and you have $100B in assets on your books marked at 80c on the dollar. The problem continues to be that the market is valuing these assets at 20c on the dollar, while you're insisting that there is just a temporary market dislocation, and that the assets will prove to have more value.

Enter the PPP: SoCal Asset Management (SCAM), a hedge fund, is feeling generous, and offers SpankBank 75c on the dollar - or $75 Billion for the pile of assets. Of course, SCAM only has to put up 3% of that, as Geithner's magic financing committee takes care of the rest of it. So SCAM puts up $2.25B, gets government funding via the FDIC, FED, Treasury, FCC, FDA, and whatever other corporations the Treasury wants to throw in the middle to confuse the taxpayers - and now SpankBank only has to take a $5B hit on these assets ($80B mark - $75B sale price).

Wait - you say - why would SCAM do such a thing? Ah-hah - herein lies the rub: there are a number of ways for them to be potentially isolated from losses.

1) SpankBank could fund SCAM directly, providing all the capital. SpankBank would be happy to do this - eating the $2.25B loss on the seed funding, and the $5B loss on the asset sale, instead of the $60B loss they'd have if they sold the assets at market prices. The Taxpayer would eat the loss between the overpaid purchase price and the ultimate value of the assets at maturity. Fortunately, I hope even Tim Geithner and Barney Frank are smart enough to figure this out, and would clearly disallow it. (quick side note - for all the Geithner fans who say "stop picking on the guy, he's only had a few months to work this out" - Geithner was the head of the NY Federal Reserve when Bear and Lehman blew up - it was his JOB to do these talked about "stress tests" BEFORE the banks blew up to prevent exactly what happened. Thus, I have no faith in his ability to solve a problem he was SUPPOSED to be responsible for preventing.)

2) SpankBank could offer SCAM cheap protection (ie, write them CDS!) on the assets SCAM purchases! This is still a win for SpankBank, and will also result in a win for SCAM, as they've been purchased (in reality "been given") protection on the assets. Again, the Taxpayer eats the losses. Quick numerical example: SCAM buys protection on $10B of the assets from SpankBank, for a nominal cost of, say $1B. At maturity, if the assets turn out to be worth only 50c on the dollar, SCAM will have a $5B payout on the protection it bought, and will realize a $4B gain on their "hedge" ($5B payout - $1B cost). Subtract their $2.25B investment, and they have a healthy gain. SpankBank is still happy to do this, because their loss on the CDS protection which they basically gave away at below market rates pales in comparison to the loss they would have taken on the underlying assets - the loss that is now eaten by, you guessed it - the Taxpayer! Did Geithner think of this? Who knows - what would probably happen is that Barney Frank would figure out the scam in 10 years and impose a retroactive 90% tax on employees of SCAM.

3) We can get more creative and more devious: SpankBank could form shell corporations to buy assets from IdiotBank, and IdiotBank could reciprocate by overpaying for assets from SpankBank. The two firms structure complex off balance sheet vehicles that look like private companies, and the Taxpayer eats all the losses.

4) A commenter on Yves' post (Anonymous, 3/21 9:20pm) proposes basically this - no CDS needed:

In the simplest version, some entity buys $100B face MBS from SpankBank at price of 80%. 3% down, 97% financed means that they put down $2.4 billion.

BAC gets $80B cash.

The next day, BAC buys the structure back from the entity for $2.5 billion (this can be done via total return swap, if needed).

The entity has made $100 million for a day's work.

SpankBank has an purchased an option on the spread between the income on the mortgages and the cost of financing.

For $2.5 Billion, SpankBank has transferred all price risk to the taxpayer and taken out $80B in cash.

It gets even better... SpankBank is clearly incented to have it's SCAM corporation bid as high as possible for the assets, since Uncle Tim is eating 97% of the losses! So imagine what happens if SCAM bids Par (100%) on the assets - then SpankBank actually books a gain!

The ultimate question is, will the government be smart enough to prevent any and all potential gaming/scamming of their program. I don't think I'm out on a limb when I say that if recent history is any indicator, the answer is a resounding "NO." The money will find a way to beat the program - it always does.

I want to close with another great comment from the Naked Capitalism post (Anon, 3/22 11:34am):

"The problem is one of perception.

1) The government wants to give the banks as much as $1 trillion from taxpayers

2) Banks have nothing worth anything remotely close

3) Taxpayers are not going to take a direct transfer with nothing in return

3) Treasury tries to concoct a scheme that will get the blessing of or at least confuse the media (CNBC, WSJ, etc.) that hides this direct transfer. Hank Paulson tried this and managed to give away several hundred billion dollars with praise from the likes of CNBC, WSJ and CNN.

4) In Geithner's scheme, the Treasury lies to the taxpayer and says that the price has been set by the private sector and the taxpayer has the potential for upside.

5) Bottom line, taxpayers fork over $1 trillion to the banks and get maybe $200 billion back in five to ten years."



Anonymous said...

Kid Dynamite -
After reading all your Government slander recently, we have decided to impose a 90% income tax on you for 2008. Whats that? You don't work and have no income?? WTF... in that case, your parents, siblings, and fraternity brothers will now be taxed ONE-HUNDRED and ninety percent instead. Teach you to mess with the Geithner. DKNWTFIA???

Anonymous said...

Is it too late to become a bank with bad assets?

Anonymous said...

KD, have you worked on the sell-side? Trying to figure out if you are the KD I know. --Bill

Kid Dynamite said...

yes, Bill, for many years - but I did not tell my colleagues of my alter KD ego - for fear of retribution from The Man

Barnacle Bill said...

Were you in lower Manhattan for a spell at DB? --Bill

Kid Dynamite said...

i can neither confirm nor deny that ;-). tell me how to get in touch with you.

Barnacle Bill said...

KD, gimme a shout at when you can. Apologies if this turns out to be a goose-chase!

Anonymous said...


now that we have the plan out...can you do a follow up post ?

is it good or bad ?

Kid Dynamite said...

so the bottom line is that the leverage offered by the government is 12-1 (6-1 debt to equity leverage, but the Treasury puts up 50% of the equity), and not the 30-1 initially reported.

HOPEFULLY this makes it harder to scam (Although, as you can imagine, there's still plenty of incentive for banks to essentially try to buy their own bad assets with Taxpayer dollars).

on the other hand, i'm sticking to my claim that if the program cannot be scammed, it won't do anything, because the investors still don't want to pay what the banks are asking for these assets!

leverage only magnifies expected return - it doesn't turn losing trades into winning trades

Anonymous said...

Can you please explain #4 reasoning. Even though the entity is making 100M in one day, I am unable to understand that isn't the entity still has to pay back the non-recourse loan? Where will it get the money to pay the loan back?

Kid Dynamite said...

Sumit - they've sold their risk back to the same party they bought it from - BAC - with the taxpayer in the middle eating the potential losses. (this was all hypothetical of course.)

Anonymous said...

Yeah I got it. Thanks.