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April 06, 2009

Zombie banks could pillage treasury under Geithner plan

You thought Bernie Madoff's $50 billion Ponzi scheme was impressive? Well, economist Jeffrey Sachs explains how the Geithner bailout plan could fraudulently transfer trillions of dollars from taxpayers to bankers if the banks game the system with front companies.

The Geithner plan is supposed to encourage private investors to buy up the toxic assets, thereby creating a market where none existed. In order to do that, the government will loan the private investors the overwhelming majority of the money they need to buy this crap. The private investors will only have to come up with a fraction of the cost of the assets out of their own pockets.

Sachs' worry is that there is nothing to stop the banks that are holding the toxic assets from creating straw companies to buy up their own bad assets with our money.

The plan was supposed to create an incentive for banks to price their toxic assets fairly in order to appeal to private investors who were highly motivated to scour the refuse pile for the hidden gems that Tim Geithner believes are hidden in the detritus. If a bank prices its toxic assets ridiculously high, the argument goes, private investors will find a competing bank that's charging a more reasonable price for its dreck.

This public-private partnership strategy is supposed to be better than having the government buy up the toxic assets at some arbitrary price. Maybe it is. A direct buy is a bad option too, because a) nobody knows what a fair price is, and b) the banks are guaranteed to overprice their assets and gouge the government.

Sachs asks us to consider the following scenario: A toxic asset on Citibank's balance sheet has a face value of $1 million, but it's actually worth nothing. (In real life it would have some value, but we're simplifying.)

Suppose Citibank creates what we'd normally call a front company, a legal fiction to disguise who's really doing business with whom. Let's call it the Citibank Public-Private Investment Fund (CPPIF). 

Under the Geithner plan, there's nothing to stop CPPIF from buying the asset at Citibank's ridiculously inflated asking price of $1 million. The government lends CPPIF a total of $925,000 and Citibank kicks another $75,000 to make a cool million.

What happens next? Citibank gets $1 million dollars for a worthless piece of paper. CPPIF now owes the government $925,000, but if it quietly goes bankrupt, so what? Citibank made $925,000 on the deal (the $1 million it got for the toxic asset, minus the $75,000 it fronted to CPPIF to buy it).

If this plan is going forward, Congress better be drafting legislation to stop banks from buying up their own overvalued assets with our money through front companies. But if Congress is going to start regulating what kinds of companies bailed-out banks can invest in, why not just nationalize the banks already?

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Comments

The front company wouldn't even have to declare bankruptcy.

Geithner is giving out nonrecourse loans.

That means that after the company gets a big government loan and buys trash, it could just give the government the trash instead of repaying.

Wait, what happens to the remaining $200,000?

I screwed up the paraphrasing. It's revised now. The taxpayers kick in a combined total of $925,000 from the FDIC and the Treasury and ZombieCiti kicks in $75,000 of brokeass real Citi's money.

Sach's piece is a disgrace and paradigm of lazy commentary.

From Geithner's plan:

The FDIC will oversee multiple PPIFs which will be established to own and manage pools of assets. These PPIFs will be vehicles established to purchase pools of loans and other assets from insured depository institutions (“Participant Banks”) under criteria established by the FDIC. Equity in the PPIFs will come from private investors (“Private Investors”) and the UST. The PPIFs will issue FDICguaranteed debt to expand purchasing power.

The FDIC will provide oversight for the formation, funding, and operation of new PPIFs that will purchase assets from banks. . .

A third party valuation firm (“Third Party Valuation Firm”) selected by the FDIC will provide independent valuation advice to the FDIC on each Eligible Asset Pool.

...Private Investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF.

Each PPIF must agree to waste, fraud and abuse protections to be defined by UST and the FDIC in order to protect taxpayers.
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.

In other words, Sachs is a major tool.

Geek, Esq. -

It's ironic for Tim Geithner to demand "waste, fraud and abuse protections" amid his handing a trillion dollars in nonrecourse loans (the cash never has to be paid back) to hedge funds to buy trash.

Sounds pretty toothless in its current form, GE. For example, "A third party valuation firm (“Third Party Valuation Firm”) selected by the FDIC will provide independent valuation advice to the FDIC on each Eligible Asset Pool." What status does this advice have. Will there be enough transparency to ensure that the third party is really independent and free of conflicts of interest? Would the public ever know if the FDIC disregards the advice of the third party?

What do they mean by "affiliate"? Is the definition tough enough to avoid flagrant self-dealing to companies owned, say, by the friends and families of CEOs?

"Affiliate" means a corporate parent, sibling, or subsidiary. In other words, if you own a toxic asset-holding bank or a toxic asset-holding bank owns you, or the same entity owns you both, you can't participate.

Friendship isn't a recognized legal conflict of interest, and in most cases neither is a familial relationship. Orrin Hatch and Ted Kennedy are friends, as are most NBA coaches who face each other. The real danger, such as it exists, is collusion between non-friends. But, that exists in virtually every market.

Larger point is that the Geithner plan isn't quite the Three Stooges routine Sachs made it out to be.

So, all the rules say is that banks can't sell to themselves. They don't say that it's against the rules to collude with some friendly party and offer them a kickback. That's against the law, but so much has already been criminal, it would be insane to discount the likelihood of massive fraud in the bailout.

In a really free market, collusion is less of a problem. If I want to buy your toxic asset, I want to get a fair price for it. If you want to sell it, you want to get a fair price for it. If I pay more than your asset is worth, I loose money.

If there are a bunch of competing buyers and sellers, we have a market that will help us figure discover what stuff is actually worth. The whole point of the plan is to create this market so we can figure out what all these assets are actually worth.

Whereas, if you say to the buyers: "Here's our money, go buy some stuff. If you make a profit we get a cut and you get X times as much profit as you would have if you just invested from your own pocket. If you lose your money and ours, you walk away." Being rational and self-interested, buyers are going to say, "Hmmm, I can make risk bets on toxic assets, or I can overbid with someone else's money and split the spoils with the bank."

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