the party selling the assets (presumably a large and stressed bank) is also subsidized

TO BE NOTED: From Bronte Capital:

"A little bit of careful thinking – and why Krugman’s despair is misplaced

I am not an economics academic. I gave that game away for the lure of lucre and funds management. But this job throws up more than a few ideas for publishable economics papers – whereas when I was a student I was desperately short good ideas.

Here is one – a pure throwaway – for anyone that wants it. (It’s a nice paper for a masters thesis.)*

It has also explained neatly the problem of not getting banks to bring assets to the Geithner Funds – and in a way which I suggest is surprising.

It started as I tried to pick apart Rortybomb’s analysis of the Geithner Plan. Rortybomb does – in more formal form what Krugman does – analyse the non-recourse financing of the plan as a subsidy. He suggests that the non-recourse nature of the funding is a put option to the Treasury/FDIC of the assets – and that the correct way to model it is using (standard) option pricing models. Rortybomb’s posts are here and here. Krugman is a little more simplistic – but the idea is the same. Krugman produces a two-outcome model (rather than the range implicit in the option pricing model) and demonstrates there is a subsidy. Krugman’s post is here.

Anyway if you use a standard option pricing model and assume some volatility of outcome it is not hard to quantify the subsidy implicit in the plan. I have borrowed Mike’s (ie Rortybomb’s) diagrams. I hope he doesn’t mind.

The subsidy is dependent – as Rortybomb would acknowlege – on the leverage of the fund, the diversification of the fund and the variability of outcomes (particularly stress outcomes). All of this is standard option theory.

Now this is all fairly convincing until you work out that the party selling the assets (presumably a large and stressed bank) is also subsidized. The policy of the US Government (stated many times) is that there should be “No More Lehmans”. You may argue with this policy (reasonable people myself not included) think that this is the wrong policy. But you can’t argue that it isn’t the policy. The demonstration is that any bank that gets into any kind of liquidity trouble gets a “Sunday Night Liquidity Fix”. The availability of that Sunday Night Fix is a subsidy for the bank – just as surely as the non-recourse funding is a subsidy for the Geithner Fund.

So the issue is whether the Geithner Funds reduce the tail risk for the government – not whether the funds are themselves subsidized. After all the assets being sold are from non-recourse finance banks (losses beyond capital borne by the taxpayer) to non-recourse financed funds (losses beyond capital borne by the government). It depends on the relative solvency of the banks and the Geithner funds.

Thinking carefully there should be four broad outcomes:

• Both the bank and the Geithner fund is solvent

• Both the bank and the Geithner fund is insolvent

• The Geithner fund is insolvent but the bank is solvent

• The Geithner fund is solvent and the bank is insolvent

When both the bank and the Geithner Fund is solvent ex-poste there was no cost to the government. Sure there was an ex-ante subsidy but it didn’t cost anything. This case should not worry us.

The second case – when both the banks and the Geithner funds are insolvent the government will lose money – but it will lose less money than it would without the Geithner Plan. After all there was some private money in the fund – and that reduced the end loss borne by the government. In other words subsidy be damned - the plan reduced government losses.

The third case is problematic. If the Geithner Fund is insolvent and the bank is solvent then the Geithner plan cost the taxpayer real money.

The fourth case where the fund is solvent and the bank is insolvent is also problematic – but in a different way. The fourth case is where the banks sold good assets to the fund (presumably for liquidity) and kept the bad book for itself (because it could not sell it). Now in this case the subsidy to the Geithner Funds is not a problem – rather it is the desperation of the banks to sell assets, any assets and only being able to sell good assets. The more subsidy you give the Geithner Funds and the more competition between Geithner Funds you have (bidding up the price of the asset) the lesser the end problem for the banks. Either way however we shouldn’t be that stressed about the subsidy to the Geithner Fund.

Indeed the only place that we should be really stressed about subsidy to the Geithner Funds is the third case – where the fund is insolvent but the banks are solvent.

Oops. The people that are really stressed about the subsidy to the Geithner Fund (Krugman, Felix Salmon, Yves Smith of Naked Capitalism, Mike of Rortybomb) are also worried about or even convinced that the banks are insolvent. Indeed several of these people just advocate nationalisation now.

This is illogical. It is the second time I have accused Krugman of gross illogic – but it is simply illogical to believe that

(a). The banks are largely insolvent,

(b). The right or actual government policy is guarantee big banks (ie no more Lehmans) and

(c). The subsidy to the Geithner Funds is a real problem.

If both (a) and (b) applied the Geithner Fund MUST save the government money - so the subsidy is irrelevant.

This illogic extends to several of the bloggers I admire most. That is why I think there is a good academic paper in there. Krugman actually expresses “despair” over the subsidy. His despair is misplaced.

I guess the extension is to model it with many Geithner Funds, some of which are solvent, and some of which are insolvent. The situation might wind up more nuanced. Indeed my rough modelling (Monte Carlo rather than rigorous maths) suggests that it is more nuanced – but only slightly. The nuance disappears if the diversity of the Geithner Funds matches the diversity of the banks.

Success of the Geithner Plan

One concern with the Geithner plan is that the banks won’t actually come to the party and sell assets. It’s a concern taken up by Charlie Rose when he interviewed Timothy Geithner and dismissed in the Bronte Capital submission on administration of the plan.

Now – thinking about it I am not quite so sure. There are simple explanations as to why banks won’t bring assets to the plan – see for instance this post from Accrued Interest. But the most obvious reason is that the relatively good assets logically belong with the party with the biggest subsidy. And that might be the banks. The fact that banks won’t bring assets to the Geithner funds is in fact a measure that the relative subsidy of the Geithner funds is too low.

John Hempton

*At one stage I tried to contact Brad DeLong possibly about being involved in a PhD program at Berkley (ideally with him). We managed never to connect. And I have since given up that goal."