I don’t have the energy to fully explain what a bonehead Jeffrey Sachs is, but I can show you a taste. Sachs is a professor of Economics at Columbia University, so you would think he might have some clue what he is talking about when he opines about the dangers of the Legacy Securities Public-Private Investment Funds proposal. But he has no clue. Sachs starts with alarming news.
Two weeks ago, I posted an article showing how the Geithner-Summers banking plan could potentially and unnecessarily transfer hundreds of billions of dollars of wealth from taxpayers to banks. The same basic arithmetic was later described by Joseph Stiglitz in the New York Times (April 1) and by Peyton Young in the Financial Times (April 1). In fact, the situation is even potentially more disastrous than we wrote. Insiders can easily game the system created by Geithner and Summers to cost up to a trillion dollars or more to the taxpayers.
Sounds terrifying, doesn’t it? How can ‘insiders’ accomplish this task? Sachs provides a scenario.
Here’s how. Consider a toxic asset held by Citibank with a face value of $1 million, but with zero probability of any payout and therefore with a zero market value. An outside bidder would not pay anything for such an asset. All of the previous articles consider the case of true outside bidders.
Suppose, however, that Citibank itself sets up a Citibank Public-Private Investment Fund (CPPIF) under the Geithner-Summers plan. The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow $850K from the FDIC, and get $75K from the Treasury, to make the purchase! Citibank will only have to put in $75K of the total.
Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank’s net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K.
First off, the Treasury Department has two programs: the Legacy Securities Public-Private Investment Funds and the Legacy Loans Program. The Securities program involves “securities backed by mortgages on residential and commercial properties”. The Loans program involves “troubled
and illiquid loans and other assets in substantially sized pools from insured banks and thrifts.” When you hear talk of the government providing non-recourse loans up to 85% of the selling price, they are talking about the Loans program. Here is the rule for the Securities program:
Each Fund Manager will have the option to obtain for each Fund secured non-recourse loans from Treasury (“Treasury Debt Financing”) in an aggregate amount of up to 50% of a Fund’s total equity capital; provided that Treasury Debt Financing will not be available to any Fund Manager in respect of a Fund in which the private investors have voluntary withdrawal rights.
When Sachs talks about a ‘toxic asset held by Citibank’ that has a face value of $1 million but potential sale value of zero, he can only be talking about securities because home mortgage loans can never fall to a value of zero (if nothing else, there are foreclosed homes to resell). So, Citibank’s shadow PPIF could not necessarily obtain 85% financing on a $1 million package of toxic securities. They can only borrow up to 50% of the money they raise for making investments.
That changes his calculations considerably. The new numbers? If the Citibank PPIF raised $1 million to invest, they could borrow up to $500,000 to buy securities.
For example:
The CPPIF will bid the full face value of $1 million for the worthless asset, because it can borrow
$850K$500k from the FDIC, and get$75K$250K from the Treasury, to make the purchase! Citibank will only have to put in$75K$250K of the total.Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against
$850K$500K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank’s net profit on the transaction is$925K$750K (remember that the bank invested$75K$250K in the CPPIF) and the taxpayers lose$925K$500.
It still sounds pretty terrible. The taxpayers still lose a lot of money. But fortunately Sachs is making several more mistakes. For one, would Citibank really be able to set up a PPIF? What are the rules?
Fund Managers will be required to present monthly reports to Treasury on Eligible Assets purchased, Eligible Assets disposed, current valuations of Eligible Assets and profits/losses on Eligible Assets included in each Fund.
Prices of Eligible Assets for reporting purposes must be tracked using third party sources and annual audited valuations by a nationally recognized accounting firm.
A Fund Manager may not, directly or indirectly, acquire Eligible Assets from or sell Eligible Assets to its affiliates, any other Fund or any private investor that has committed 10% or more of the aggregate private capital raised by the Fund. Private investors may not be informed of potential acquisitions of specific Eligible Assets prior to acquisition.
Fund Managers must agree to waste, fraud and abuse protections for the Fund to be defined by Treasury in order to protect taxpayers.
Fund Managers must agree to provide access to relevant books and records of the Fund for Treasury, the Special Inspector General of the TARP, the Government Accountability Office and their respective advisors and representatives to enable appropriate oversight and taxpayer protection.
It would take a very elaborate conspiracy for Citibank to hoodwink all the regulators and set up a PPIF of the kind envisioned by Sachs. Even this fantasy of Sachs’ is unlikely to be attempted, let alone to fly.
…the gaming of the system doesn’t have to be as crude as Citibank setting up its own CPPIF. There are lots of ways that it can do this indirectly, for example, buying assets of other banks which in turn buy Citi’s assets. Or other stakeholders in Citi, such as groups of bondholders and shareholders, could do the same.
Yeah…that’s not gonna happen. But what about those 85% (6-1) non-recourse loans in the Loans program? Even those are not guaranteed.
Third Party Valuation Firm will estimate Eligible Asset Pool values and
advise the FDIC on loan-to-value and debt service coverage for each PPIF. In assessing the supportable leverage of the asset pool, the
Third Party Valuation Firm will analyze characteristics including expected cash flows based on type of interest rates, risk of underlying assets, expected lifetime losses, geographic exposures, maturity profiles
and other relevant factors.Leverage will be determined on a pool-by-pool basis at the FDIC’s sole discretion, with input from the Third Party Valuation Firm. It is
anticipated that the debt to equity ratio will not exceed 6 to 1 for each PPIF.FDIC will provide credit support for PPIF financing through guarantees of debt issued by the PPIF. The FDIC guarantee is collateralized by assets purchased by each PPIF.
Financing terms will be as set forth in the FDIC Guaranteed Secured Debt for PPIF term sheet.
The PPIF will be required to maintain a Debt Service Coverage Account (“DSCA”) (as stipulated in the FDIC Guaranteed Secured Debt for PPIF Term Sheet) to ensure that working capital for each
PPIF is sufficient to meet anticipated debt servicing obligations, interest expenses and operating expenses. A portion of cash proceeds
from the sale of Eligible Asset Pools will be retained until cash flow from Eligible Asset Pools has fully funded the DSCA, at which point
the escrowed cash will be released to the Participant Bank.
What does that mean? It means that financing terms will be determined on a case by case basis, that participating firms must demonstrate their ability to repay loans, that the FDIC will hold the assets as collateral (like any mortgage-issuer), and that banks will have some of their money held in escrow until the PPIF’s have fully funded their Debt Service Accounts.
I could go on but, like I said, I’m tired. In conclusion, Professor Sachs got his math wrong and came up with an alarmist scenario that has no connection whatsoever to reality. And Krugman (who surely knows better) goes right along. This post should go down in history with the worst of Judith Miller.
As Jeff says, a bank can create an off-balance-sheet entity that buys bad assets for far more than they’re worth, using money borrowed from taxpayers, then defaults — in effect a straight transfer from taxpayers to stockholders.
If there’s a mechanism to police such deals, it isn’t clear. And the sense that the administration is just too close to Wall Street continues to grow.
The only thing growing is the length of Krugman’s nose.
