DeLong: Geithner’s Way or Mad Max

Playing the role of semi-official spokesman, Brad DeLong makes the case for the Geithner Plan. At its core, it's the second argument I described in Obama's Vietnam?. Here's DeLong:

Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?

A: Then we have worse things to worry about than government losses on TARP-program money—for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.

Why does the taxpayer have to put up 97% of the money in the form of non-recourse loans, but get only 83% of the upside?

A: The private managers put in $30 billion, but the Treasury puts in $150 billion—and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.

One point for DeLong and Geithner: the taxpayer getting 83% of the upside — if any — is much better than the 0% first rumored.

But the core assumption behind the Geithner Plan, which DeLong endorses, is this: that the so-called 'toxic securities' on bank balance sheets are in fact

risky and distressed but probably fundamentally undervalued assets

You believe that? James K. Galbraith says it's possible to get actual facts ex ante, rather than depending on the Invisible Hand to provide them ex post.

The central Treasury assumption, at least for public consumption, seems to be that the underlying mortgage loans will largely pay off, so that if the PPIP buys and holds, at an above-present-market price governed by auction, the government's loan to finance the purchase will not go bad.

Recovery rates on sub-prime residential mortgage-backed securities (RMBS) so far appear to belie this assumption. IndyMac lost $10.8 bn on a $15bn portfolio (and if you count the wipeout of equity, the total loss is about $12bn). That's an 80 percent loss. It's possible that recovery rates at other banks will be better, but how can we know? No one is examining the loan tapes.

The NYT article points out that pools of RMBS can be sold for about 30 cents on the dollar now. But banks are unwilling to sell for less than 60 cents — either because they really think the loans will experience only a 40 percent loss rate, or because they fear that acknowledging market value will put them into insolvency. Which it might very well.

The way to find out who is right is to EXAMINE THE LOAN TAPES. An independent examination of the underlying loan tapes — and comparison to the IndyMac portfolio — would help determine whether these loans or derivatives based on them have any right to be marketed in an open securities market, and any serious prospect of being paid over time at rates approaching 60 cents on the dollar, rather than 30 cents or less.

Note that even a small loss of capital, relative to the purchase price, completely wipes out the interest earnings on the Treasury's loans, putting the government in a loss position and giving the banks a windfall.

There are only three reasons I can see why one might not adopt Galbraith's suggestion:

  1. If one believes that the empirical evidence needed is not in fact on those tapes.
  2. If one believes that the empirical evidence needed may be on those tapes, but extracting and analyzing it would take so long that the crisis would deepen too much before one had the answer.
  3. If one is afraid to find out the truth because it will cause a Mad Max moment.

Ask yourself this: if the fund proposed by Geithner et al is so great, should we open it up to regular folks to invest? No? Why do you say that?

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6 Responses to DeLong: Geithner’s Way or Mad Max

  1. jim says:

    There’s a fourth reason. There may be no loan tapes.

    My understanding is that most of the “toxic waste” securities that the banks retained were the socalled “super-senior tranches”. These are synthetic securities, constructed from CDSs of real securities, real in the sense of being derivatives of derivatives of pools of actual mortgages. Since they’re synthetic, they were constructed to have characteristics superior to real, AAA-rated tranches. Hence the terminology, “super-senior.” Which is why banks retained them, instead of selling them. But since they’re synthetic, there aren’t any actual mortgages, pooled, securitized and tranched, behind them whose documents could be inspected. Since they’re not contructed to be exactly like any real tranche, you can’t use documents of mortgages supporting some real tranche to value them. More, since there’s no contractual chain tying these securities to any underlying mortgages, the holders have no claim to inspect any mortgage documents, even those that might be relevant in valuing them, because such documents are, after all, confidential.

  2. Tiny Tim Geithner and Helicopter Ben Bernanke are going to ruin this country. They both need to GO!

  3. joe1 says:

    I have the same understanding that Jim has (but not to the same level of technical detail). The securities cannot be tied to any real property. If the securities could be tied to addresses or land descriptions, you could make a valuation attempt.

  4. Chuck Darwin says:

    Since the “super senior tranches” are apparently based on CDSs of derivatives of actual mortgages, then they are tied not to real property but to the loans. Accordingly, the question whether the actual mortgages are likely to perform is relevant, and the mortgage documents are relevant. Unfortunately, the second problem you mention (the holders would have no right to inspect the mortgage documents) remains.

  5. Rhodo Zeb says:

    This is a very interesting discussion. I would like to know more about how the securities could possibly be completely removed from the underlying mortgages. I have been touching on this issue on my blog,

    Josh Marshall over at TPM made a comment that China’s purchasing of foreign assets was the fuel that created the housing mess in the US. That got me started on the topic, as I felt bringing the Chinese into it avoided a lot of issues.

    Galbraith has an article in Washington Monthly saying that one of the rating agencies did a small review of the tapes and found evidence of fraud and so on (paraphrasing) in nearly every mortgage. But what Jim and Joe1 are saying is a different matter entirely.

    So there are no ties at all? How is that possible? That would mean no intrinsic worth I would assume?

    I am going to try to crank out a post on this issue, and maybe get the guy over at Economics of Contempt involved. I just found his site recently and its pretty interesting.

  6. Rhodo Zeb says:

    Ok I got a reply from EoC, anyone want to jump in?

    “Well, it’s not entirely clear what the commenter is claiming, but my sense is that he’s wrong. He seems to be saying that all super-seniors are synthetic (i.e., created out CDS rather than cash bonds), and that since CDS sellers don’t have the same rights as bondholders, they have no right to inspect the underlying loans. That’s not right. Super-senior tranches don’t have to be synthetic.

    Whether the owner of a super-senior tranche has the right to inspect the underlying mortgages depends on a variety of factors, including whether there has been an initial “event of default,” whether the CDO collateral is dynamic rather than static, etc. Remember, the owner of a super-senior tranche has only purchased a bond issued by an SPV, which may or may not own the collateral underlying its bonds.

    For CDOs backed by mortgaged-backed securities (MBS), the real question is whether the documentation of the underlying mortgages even exists anymore. A lot of these mortgages were originated by fly-by-night mortgage servicers, most of whom have gone belly-up and long ago filed for Chapter 7 liquidation. If they were the ones ultimately responsible for maintaining records on the underlying mortgages, it’s 6-to-5 in pick ’em whether the underlying mortgage documentation actually exists anymore.”

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