Back in the old days of derivatives (the mid-1980s), there was an international commercial bank that was famous for declaring how much good derivatives had done for it.

It was famous because it was common knowledge in the marketplace that the bank would have its swap counterparties "buy out" the positions where it was due money, while those on which it had a debit debit were kept on its books.

So I wasn't exactly either surprised or believing when the NYT announced, to much fanfare, that there was a "profit" being made on the bailout funds. As Bruce Webb noted here at the time:

These early returns are by no means a full accounting of the huge financial rescue undertaken by the federal government last year to stabilize teetering banks and other companies.

The government still faces potentially huge long-term losses from its bailouts of the insurance giant American International Group, the mortgage finance companies Fannie Mae and Freddie Mac, and the automakers General Motors and Chrysler. The Treasury Department could also take a hit from its guarantees on billions of dollars of toxic mortgages.

But it got nice headlines at the end of August, when talk of "green shoots" and "inflation fears"needed to get momentum.

Featured less prominently is a now-week-old LAT article with a more realistic perspective:

The Treasury is unlikely to get back the full amount of money lent under the Troubled Asset Relief Program despite a recent spate of repayments from large banks, warned the program's watchdog.

The program "played a significant role" in rescuing the financial system from a meltdown, Neil Barofsky, special inspector general for TARP, testified before the Senate Banking Committee on Thursday. But it was "extremely unlikely that the taxpayer will see a full return on its TARP investment," according to his prepared testimony.

The official story remains that the large banks will be paying everything back. If that's true, then the answer to Rebecca's question of how to drain liquidity from the financial system is clear: take the paybacks and disappear the monies. It's only if there is an excess shortfall on the securities that excess money will be in the system.

So, if the NYT was correct at the end of August, or the cheerleaders are correct now, there will not be an inflation issue, or an excess bubble, just a little "extra lubricant" making certain that valuable securities attain their full value that will naturally be removed from the system (both as cash and as Lines of Credit) as the value is realized.

Indeed, the only reason to fear inflation from TARP/TAF sources is if you expect a significant shortfall in the actual values, something for which you can only compensate by leaving a large quantity of excess lendings in the market. Which, by definition, will not and cannot happen if all the major players repay their allocations in full (let alone with interest).

Second derivatives don't make inflation. And money loaned by the Fed that is fully repaid doesn't make inflation unless it is loaned out ("multiplier effect"), which hasn't been and still isn't happening.

What there is is "excess" cash sitting on bank balance sheets in lieu of full repayments. But it's not being used for other things—no multiplier effect—and it can be disappeared by the Fed as it is paid back.

So where is the inflation, unless money has been added to the system without there being value behind it?

Somewhere, an old derivatives manager is watching. Maybe he recognizes his strategy in the story unfolding. Maybe, just maybe, he also kept underlying deals that didn't have losses as big as the gains he took.

It's possible. But it was never the way to bet.

by Tom Bozzo

Back in 2005, I argued at Old Marginal Utility that "Greenspan exceptionalism" was not very well founded in that observers rarely engaged in a proper counterfactual analysis of how well Alan Greenspan performed relative to the next best monetary policy technocrat. That's a fairly stringent evaluation criterion, and even Brad DeLong's glass-half-full response revealed what could be considered major errors in Greenspan's judgment. 2009 hindsight of course shows that there was another major error in inflating the housing bubble, failing to recognize it, and allowing his Rand discipleship to overcome common sense in using Fed powers even to skim the froth.

Now some elite opinion favors Ben Bernanke's reappointment, but politicians are irritated over Fed stonewalling of bailout oversight and others (e.g. Dean Baker) point out that Ben Bernanke who put the Fed throttles to the firewall to save the world is also the Ben Bernanke who carried over Greenspan policy until it was too late among other things.

So what should the counterfactual-based evaluation of Bernanke say? What would the hypothetical panel of smart graduate students have done? It seems even harder to suggest that Bernanke was essential than Greenspan — in this case, because well-read economists should have had it from Ben Bernanke the academician that in a depression-level crisis you don't skimp on the monetary policy intervention. Meanwhile, Bernanke gets no points for prescient instincts as the save-the-world interventions have seemed to be firmly of the close-the-barn-doors-after-the-horses-have-bolted variety.

Meanwhile, significant elements like the opaque lending programs have the appearance if not reality of being in part the predator state (a la Jamie Galbraith) in action. There's a line of 'b-b-but Bernanke and Paulson saved the world' opinion along the lines of this bit of fail from the often incisive Joe Nocera:

So why the anger? Why the suggestions of “cover-up” and “lies”? On Thursday, as I watched Mr. Paulson being castigated, it dawned on me. Seven months later, with the palpable fear of a financial collapse largely subsided, it really all boils down to how you view what happened last year. Was it, as Mr. Towns believes, a bailout of a handful of unworthy but too-big-to-fail institutions? Or was it, in the eyes of Mr. Paulson, a rescue of a teetering financial system? My vote is for the latter.

To which the obvious response is, duh, who says it has to be one or the other? A reality-based critique of the bailouts allows them to be both effective at saving the world and unconscionable screw-jobs that kept an array of bad actors from paying for their greed and incompetence. (The latter clearly feeds a lot of the underlying sentiment of the tea partiers, even if it's ultimately the greedy and incompetent who are marshalling it.) However, considering Team Obama's political tone-deafness, it'll be a pleasant but major surprise if they don't let Bernanke go back to Princeton for some R&R.

(Cross-posted at Marginal Utility.)

I'm just going to "Go Thoma" on him, since I can't find anything to cut:

Barack Obama tells us we should not investigate American intelligence agents or their overlings who are responsible for torturing hundreds of suspects in their custody. We have to forget about the past, he says, to concentrate our attention on the future. That might be a convincing argument if Obama were going all out for an ambitious program to remake our economy and our relationship to the rest of the world. But the future is on hold because the number one job today is bailing out the financial system, so we can preserve the money moguls who juiced our economy in the past.

Tom Bozzo

I've been hearing about various potential schemes to game the PPIP, and Jeffrey Sachs gets in on the action with a pure self-dealing scenario (via Americablog):

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.

Did Sachs read the PPIP Legacy Securities term sheet [PDF] before writing that? [Though see the addendum below.] That sort of transaction appears to be forbidden under the 'Governance and Management' section of the summary terms:

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.

Geithner and Summers may or not be the poster children for 'regulatory capture,' but they're not stupid. (For that matter, Sachs's scenario presumes that only Citi can detect the underlying worthlessness of the asset, so FDIC will permit the maximum leverage under the program.)

There are also some more complicated scenarios that use secret deals and kickback schemes to get around the anti-self-dealing provisions of the PPIP. For now, I would judge those to represent descriptions of serious frauds rather characterizations of actual PPIP loopholes. Such time as Treasury (or DOJ) is caught playing see-no-evil with those, then there may be something more than an attempt to pile on.

This is not at all to say that there are not serious and valid concerns regarding PPIP design. Among other things, I'd be much happier if I saw the likes of Larry Ausubel and Peter Cramton hired to ensure that the private managers effectively compete for the public subsidies and do not overpay relative to some reasonable assessment of fundamental (not necessarily 'market') asset values.

Added: The anti-self-dealing terms from the Legacy Securities program, quoted above, are from a 4/6 revision of the term sheet (thanks to KHarris for pointing that out) and may have crossed paths with Sachs's article (also of 4/6); they're a little different from the Legacy Loans terms sheet where a prohibition on self-dealing has been a feature all the time. Here's the original (and apparently current) language for the Legacy Loans sheet:

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.

It would take a lawyer to determine how this compares to the Legacy Securities terms. The ban on communication prior to asset sales looks new and makes it clear that schemes to coordinate Legacy Securities sales with purchasers are improper.

An issue with many of these critiques is that they seem to combine elements of the two programs. Sachs's example is based on leverage ratios allowed under the Legacy Loans program but not Legacy Securities, in which case other Legacy Loans program terms should apply.

Suppose I told you that there was a crisis with a stock, say, GE. That the price of the stock had dropped around 75% in the past year. And you responded, "But the problem is solved; the prices of long-term Call Options (say, the January 2011 20s) has gone up, as has their Open Interest.

You will (rightly) point out that this won't revitalise the assets themselves and I will (rightly) note that option markets rather saved the equity markets in 1987, for instance. You will note that I am too optimistic, and I will agree, holding up a Brad DeLong mask (since I'd rather have DeLong's [relative to mine] abundant hair than Geithner's abundant forehead).

Then I will drop the other shoe and say that the toxic ("legacy") assets should be priced as if the Fed-supported trades were options, with the underlying current price worked out by Black-Scholes. (As I've noted before, B-S is specifically INappropriate for this exercise, as it will overvalue the option. And therefore anyone suggesting the toxic ["legacy"] assets should be priced—or carried on their books—at a level higher than that model will clearly be insane.)

Ladies and Gentlemen, welcome to The TARP Solution. Details beneath the fold.


TARP is the Treasury Department's attempt to confront two realities: (1) it isn't a "market" in any reasonable sense of the word if the Fed is putting up 85% of the cash. (People who tell us that this means firms are committing a "large amount" to the process either do not understand the English language,or are hedge fund managers trying to sell something.) So let's put some random numbers together.

Those "legacy" assets are trading in the market around 30. The Big C and others are carrying them on their books around 80. Several people who should know better (Summers, Geithner, DeLong) have conflated "the market is underpricing the assets" with "the true price of the assets will make the banks solvent again."*

So we know three things. (1) People are willing to pay 30% of their own money to buy these assets, (2) the Fed is only requiring them to pay 15%, and (3) the fair value is between 30 (the current market price) and 80, and probably closer to the former than the later.

So again, using back-of-the-envelope principles, let's pretend that we think the recovery will be soon, that the defaults will slow (or at least that resales will be quick and frictionless), and that the market reaches that consensus quickly. And so fair value should be around 50.**

So let's say the Fed offers to buy a MBS for 50. How, as an investor, do I make money off this? Three possible ways:

1. If I own securities for which I paid <50, I sell them to the Fed.
   
2. If I own securities for which I paid >50, and which I cannot sell for 50 without revealing myself to be insolvent, I buy securities at 50 along with the Fed and "average in." (This is the "how to stay solvent longer than the market can be rational" act.)
   
3. If the Fed is buying securities at 50 so that I can no longer buy them at 30—I buy a LONG-dated Call Option on the security.

It is that last that explains TARP. Effectively, the co-investors with the Fed will be buying a Call option at 7.5 on the security at 50.***

Of course, it may not be an at-the-money Call option. More likely, the hedge fund effectively will be buying an out-of-the-money option (say, a 49.5 Call for 8) where some portion of the purchase is put up by the government.

Now you will note that, technically, TARP requires the hedge fund to buy the asset. So you might argue that this is not an option. But let's look at the generic payoff diagram to the hedge fund of the two scenarios.

Amazingly, you can't tell the difference on the payoff diagram as the security gains.**** In both cases, the hedge fund manager has just gone long volatility.

Expect that to have a ripple effect—I'm guessing dampening, cet. par.—on other option volatility trades.

All that is left is to back out what actual value of the security was assumed by the hedge fund when they bought the option. Which I will also leave as an exercise to the reader, while suggesting that a fair indication is min[x, TotalFedContribution] s.t. x a.s. approaches TotalFedContribution.

Will this bring the markets back, or make bank balance sheets more stable? I'm still saying "No," and hoping to be proved wrong.

But what it should do is reduce volatility buying, especially in the other debt markets, for the foreseeable future. So if any of those Bankrupt "legacy asset constrained" institutions has a long volatility position, there will be even more "Unintended Consequences."

*In fairness to Brad DeLong, I don't believe he believes this. As Dr. Black noted, George Voinovich "wants to see a pile of money in flames before he's willing to vote for what's necessary," and DeLong therefore sees this as a necessary evil. Having seen no evidence from the Obama Administration that they Have a Clue, I am naturally suspicious that this particular idiocy will do anything other than waste time and money—both of which are in increasingly short supply—but, since Larry Summers has shown his brilliant foresight before and clear has no skin in the game, I am reassured that there is no Principal-Agent problem at work here, as they was when Christopher "I never saw a regulation I like" Cox was named head of the SEC by the Previous Administration.

**While we're at it, can we pretend that Amber Benson will be my next wife, which is probably very little less likely than those other possibilities (especially since I'm already married to an sf-writing actress/director)? (Amazingly, even without those conditions, we would be using a BotE number of 50: though there is a legitimate argument that 60 would be easier to work with, I'm assuming no one is that stupid.)

***This is why 60 would have been easier; 15% of 60 is 9, so I wouldn't have to pay attention to decimal places. 40 would also have been easier—and both certainly more realistic than 60 and arguably more realistic than 50, but I want to maintain the pretense of the U.S. Treasury that this is a liquidity, not a solvency, crisis. (They're wrong, but it's their game.)

****The reason we can tell the difference on the losses is the possibility that the hedge fund treats the position as if it were an in-the-money Call option for which the Fed paid the in-the-money portion; the real returns to the hedge fund of the position in a TARP security are the same in both cases; there would be differences in the way the rest of the portfolio was managed, though, which are left as an exercise to the reader.

This is why we don't believe the bailout will work the way you think it will (i.e., to increase lending):

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

Instead of using the bailout monies to lend, or even make their balance sheets more creditworthy, the firms have been doubling-down on the assumption that they will be fellated by Timmeh and Larry. (At least Bill Gross and PIMCO (h/t Robert) did it when there was still a chance of sane monetary policy.)

I take back part of what I said earlier: this isn't comparable to hitting on 17 because you're drunk; it's hitting on 19 because you're desperate and insane. As Barry R. closes:

If anything, this argues against bailouts and in favor of nationalization, firing management, wiping out S/Hs, zeroing out debt, haircutting bond holders, etc.

Some economists may need to spend less time reviewing brilliant analysis from Barry Eichengreen (link is to PDF) and more reviewing Friedman and Savage (link is to PDF) in the context of principal-agent problems.

Via Instaputz, an explanation of why stealing tax dollars in order to decouple securities from the assets they are allegedly securitizing is A Really Stupid Idea, presented directly, yet also in a way an econometrician wiill understand.

The idea that they aren't inviting Yves, CR, and Roubini onto the calls either led me to wonder for a moment if there was another factor in the invitations.

But skipping Felix, even if he is a short-timer, means that they weren't judging by the blog in the first place.

Via Robert's Twitter Feed, and to avoid ranting about 401(k)s before the end of May, here's a Rant Well Worth Reading. (Warning: PG-13 or R rating; D. Aritophanes channels The Rude Pundit).

Clean Excerpt:

What’s the catch? That’s the beautiful thing … there is none! It’s all totally risk-free for you from start to finish! You’re last in, first out! The rubes front 97 percent of the buy-in with their taxes! And for their troubles, they get 100 percent of the exposure!

In this context, Brad DeLong's "I trust my friends more than I do George Voinovich" post does not exactly warm the cockles of my heart.

Effect

Cause

Ken Houghton

wants to sidebar today into looking at the general application and implications of an Accounting Identity:

Assets = Liabilities + Equity (A=L+E, or the ALE Rule).

Let us assume that, since the housing bubble burst, I believe that my house has fallen in value by too much. I would understand a 20% decline, but the "market price" that the experts (realtors) tell me I can get is 40% below the price of the last "comparable sale" (a smaller house in perfect condition).

But there are ancillary factors—proximity to NYC, good public transit infrastructure, good schools, convenience to the airport and major roadways—that I believe the market is undervaluing. So I "carry" the house in Quicken at 80% of the last sale.

Since I refinanced a couple of years ago, someone out there owns the Mortgage-Backed Security that was formed from that refi. Let us pretend it is Citibank, who are carrying that security on their books at 80, even though the last similar trade in the market was 60.

I think you can see where this is going.


So along comes the U.S. Treasury to "fix" the crisis and Get Banks Lending Again. (Apparently, they can't lend because the market values their assets as being less than their liabilities plus their equity.)

In doing so, the Treasury will supply so random number—say, 85%—of the capital required so that a Private Investor can swoop in and Save Citibank's Securities, by buying them "closer to their real value."

So the Private Investor says, "Yo, Big C! I see you own the MBS that covers Ken's house. Even now, his house is worth more than he owes on it, so I want to buy that security from you."

Big C says, "I'm carrying that security on the books at 80. And there are a few billion others just like it."

Private Investor: "Well, the market says all those securities are worth 60."

Big C: "I can't sell it at that level. I would have to mark down everything else, and people would see that my liabilities exceed my assets, leaving me with negative equity. And everyone is still pretending that my equity shareholders should not be revealed to own bupkus."

PI: "Well, I'll tell you what. Since we can foreclose on Ken for more than the amount owed, I'm willing to pay a little more."

Big C: "I need you to pay something close to 80, or The Truth will out."

PI: "Well, since the U.S. taxpayer is going to support 85% of my purchase in the worst of scenarios, I can pay you--how about 76?"

Big C: "Make it 78 and you have a deal."

PI: "All right; I'll do that. After all, I'm only having to put up $11.70 of that."

Big C: "And I'll be able to pretend we're solvent. After all, we have some Inside Investors who need loans, and the Fed wants us to loan more."

But wait a minute: the real value of that security is supposed to be the cash flows from The Underlying Assets. In short, it's based on my (and others) ability to pay the mortgage. So let's look at the other side.

I carry my house in Quicken at 33% (20/60) over what the realtors tell me it is worth. So Quicken shows me that cool Net Assets thing, and I have a Net Asset Value $30,000* higher than "the market" believes.

But it's not liquid, and I don't run a Treasury operation, nor am I necessarily required to abide by the ALE rule. So in general I feel more solvent, but may not (or may, but let's assume not) change my behavior because of it.

So tomorrow I have a heart attack and can't work for a while.** And my wife needs to help me with recovery, as well as keep the kids going to school and activities, so we spend six months to a year living on savings and whatever safety net there is. And finally we realise we have to downsize our life and move to Northern Indiana where my family can help us out for a while.

So we put the house on the market, at the price the realtors said it was worth.

But—as happened last summer—there are no bidders. And when there might be a bidder, they can't get a bank loan from The Big C.

Eventually, we realise we're not going to move back and stop making payments on the property, which stays on the market until it is foreclosed. And then the bank that owns the mortgage sells the house short to a developer who pockets a quick few bills.***

We file for bankruptcy.

Now, in the real world, the Securitized Asset that looked so great above is now a losing proposition. But in GeithnerWorld, the asset is secured by the U.S. Treasury, and the "investor" takes no hit at all; indeed, Private Investor is made whole with...taxpayer funds!

In short: Debt that my child will have to pay.

The Geithner Plan is the ultimate in Financial Reality. Derivatives were at least based on underlying assets; if the five-year Treasury price fell, the five-year swap was worth more.**** GeithnerBuys have no relation to the "securitized" asset at all, except to add to the expenses of bankrupt taxpayers.

It is the final Decoupling of Wall Street and Main Street, so while Arlen Spector makes certain that workers can't organize and Ellen Tauscher ensures that mortgages can only be reset to market value if it is a Vacation (or "second") Home (despite an earlier agreement), Tim Geithner and Larry Summers—with the support of Some Economists who Should Know Better—are ensuring that any damage to the real economy is not felt in the financial sector.

Welcome to Brighton Rock. Or maybe Faust.

*Possibly not the real number.

**Knock wood, this is not real either.

***Anyone got the link on this one? Saw a piece earlier today about Citi selling a foreclosure for $131K to a developer who flipped it, doing nothing, for $249K.

****Reminder: lower price = higher yield.

Following up on Robert's post (he started later and finished earlier):

Dr. Black:

[T]he idea that all this came about simply because the banksters decided a bit of extra risk was good is an idea only a macro finance person could sanely entertain.

All right, I represent that remark in more ways than one. So let's Tell the Truth, Shame the Devil, and make the case for Financial Intermediation—all while agreeing with him that Geithner's statement is absurd.

(For my next trick, I'll spin plates on poles and juggle cutlery while riding a unicycle. You might want to stay clear of the area for a while)

So let's talk about weather derivatives, the driving habits of government employees, and Miss Spider's Sunny Patch below the break.



It was 1993, I think, when Richard Sandor gave the closing presentation at the ISDA Conference in Washington, D.C. Sandor was enthusiastic; there was finally enough weather trend data that you could model damage expectations for an area and reasonably estimate, for instance, the likely exposure of an insurance company to hurricane or tornado damage.

We may not be able to do anything about the weather, but we can do something about managing the risk associated with it.

Sandor's argument was, in short, That's what we do. We manage risk.

Contrast that with the story of GEICO, the current crown jewel of Berkshire Hathaway. GEICO started as an insurance company dedicated to Government Employees. It started that way for a reason, and the reason has everything to do with risk. Because GEICO management looked at the data and realised what anyone who thinks about it for a second will already know: government employees are safer drivers than the rest of the population.

They are safer drivers because they are more risk-averse. They take a job with, as a rule, lower pay than they could get in the public market, but better security. They prefer stability. Short version: they are risk averse.

Therefore, they are safer drivers than the general populace (who don't want to be stuck behind them when they are time-dependent).

SO when Brad DeLong says:

I think the private-sector players in financial markets right now are highly risk averse--hence assets are undervalued from the perspective of a society or a government that is less risk averse.

my immediate response is at best Inigo Montoya ("I do not think those words mean what you think they do") and at worst a version of Nelson Algren's amendment of Thackeray ("That's Not the Way to Bet").

Because risk management means managing risk, not just taking chances. Hitting on 17 in blackjack isn't the way to get rich. Paying $50 for something that is worth $35 to you isn't the way of getting rich.

And, worse, it isn't the way to get capitalism working again.

Because sooner or later, the professionals have to take over again.

The kids were watching Miss Spider's Sunny Patch this weekend, an episode where the young Dragonfly flies for the first time, accompanying a bunch of "Daredevil" dragonflies. They fly for a while and then the whole place gets covered in fog. The daredevils find a place to sit and wait. The youngster keeps chiding them: "C'mon, I thought you guys were Daredevils."

The Daredevils explain, roughly, that they don't fly without knowing where they are going.

Unlike, apparently, the U.S. Treasury.

Robert already dealt with the basic illiquidity of the market. So let's talk about Price Discovery, but this is getting long even for me, so...

CONTINUED ON NEXT ROCK

In this corner, as previously mentioned, Yves Smith goes for the slam dunk:

Let's see, the credit default swaps market, due to some netting, is now somewhere north of $30 trillion (as opposed to its earlier "north of $60 trillion" level). Investment banks were believed to have hedged most of their exposure via offsetting contracts, but AIG wrote naked protection. And as jAIG itself is at risk of getting downgraded again, the collateral posting requirements keep rising.

Some analysts (including Chris Whalen of Institutional Risk Analytics) have offered theories as to how the government could void a lot of CDS (some have argued for getting rid of them altogether, others argue for eliminating them in cases where the protection buyer does not hold the underlying bond/exposure). Before you say, "they can't do that", recall the effective confiscation of gold in the Great Depression. rationing, wage and price controls, the suspension of habeus corpus. There is a good deal that the Feds could do if they chose to, trust me. But it's easier to bill the poor chump taxpayer than take on the financiers, even after they done so much damage.

And in the other corner, I am joined by Felix Salmon, who rejects the slam:

The scandal here is not the size of the losses from the global financial meltdown -- those are losses which sooner or later, in one form or another, would have had to be borne by the government anyway.

The problem, as obliquely noted by me ("So there is a viable, separable business that is making pennies [US$0.01] while the rest of the firm loses Benjamins [US$100.00]") and explicitly declared by Yves is summarized well by Felix, in a statement to which I suspect all three of us would agree:

Rather, the scandal is that AIG could have earned billions of dollars by selling insurance against a meltdown, even as it was wholly incapable of paying out on those policies. I wouldn't be surprised to learn that Hank Greenberg was still a billionaire, even as the policies his company wrote have cost the average American household some $1,600. It's time for his wealth to be confiscated: it might be only a drop in the bucket compared to AIG's total losses, but it would feel very right.

As I suggested yesterday of the successor-AIG, "So long as that board doesn't include Hank Greenberg, I'll be cautiously optimistic."

The problem is that's probably not the way to bet. More on that later; for now, keep watching Joe Nocera deliver the goods and summarize the issue:

Yet the government feels it has no choice: because of A.I.G.’s dubious business practices...it pretty much has the world’s financial system by the throat....

A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system. [edits mine*]

By the way, Joe, Yves, citing an early Bloomberg report, named some names:

Goldman Sachs Group Inc., Societe Generale SA, Deutsche Bank AG and Merrill Lynch & Co. are among the largest banks that bought swaps from AIG, according to a person familiar with the situation. The insurer handed over about $18.7 billion to financial firms in the three weeks after the September bailout, said the person, who declined to be named because the information hasn’t been made public.

*Which improves the NYT editing, since the fact of the "housing bubble" has nothing to do with AIG's mis- and malfeasances.

Dr. Black (you know the site) links to AIG Strike Three. And unlike the Citi debacle previously discussed (relatively) positively and rather negatively here, this one makes some form of sense.

The difference comes down to the meaning of an accounting concept: ongoing concern.

More below the break (yes, this might get wonkish. It's me, after all.)

The Big C and AIG are both large entities with several pieces. Some of those pieces are successful; some of them are AIG Financial Products. Some of them—Citibank branches and office space, for instance—fall somewhere in between.

What we do know is that it is currently not possible to slice and dice The Big C so that something would be left that would be an "ongoing concern." Those assets that are part of the company are dwarfed by the liabilities, and run across business lines. It's not as if you could just magically, say, sell Smith Barney, spinoff any remaining insurance business, and ritually execute Vikram Pandit and produce a working company from the remains. At best, it's a Good Start. There's a reason I refer to the company as The Big C: it's in the lymph nodes, the brain, the lungs, and the brain. You probably couldn't even survive with "just" the Retail and Private Banking operations.

Any auditor who releases The Big C's next 10-Q and describes the firm as a(n) "(on)going concern"**—with the attendant implication that there is a functional business model there and that the firm can create the future unencumbered* cash flows to remain viable—should be barred from the accounting profession.

AIG is different. Think Enron: there are pieces of the business that are still viable (now, the insurance and re-insurance pieces; then, the power plants and transmission facilities), but they are dwarfed by the losses at AIGFP. So there is a viable, separable business that is making pennies while the rest of the firm loses Benjamins.

The difference is that there is a possible end in sight. AIG-Prime could go back to doing the things AIG knew how to do, and stay away from the things that made Hank Greenberg rich and pauperized U.S. taxpayers.***

So, if we were to assume that a leaner, less mean AIG will come out of this, can we look at the plan changes and say they point toward a goal?

Unlike The Big C, the answer is clearly "yes."

Under the deal, the interest rate on AIG's credit line from the government would be cut to match the three-month London Interbank Offered Rate (Libor), now about 1.26 percent, a source with direct knowledge of the matter said.

This is perfectly reasonable for the moment: AIG is a financial institution, the reconceived version will be a financial institution of respectable size and strength, and the current version has the strong support of the U.S. government, which can borrow well inside LIBOR. While I suspect the final company will end up looking more like State Farm than Morgan Stanley, it's not out of the question that it could borrow at LIBOR, which is approximately a AA rating level anyway—a perfectly reasonable assumption for the reconstitution of a formerly-AAA company with some carryover liabilities.

The additional equity commitment would give AIG the ability to issue preferred stock to the government later, the sources said.

This would presumably be the reverse of the deal with The Big C: "equity" for debt. Again, a sign that regulators expect there to be a survivor/successor firm of the current mess.

The most interesting quote in the piece is:

[Robert Haines, senior insurance analyst at CreditSights] said. "The counterparties on most of the book are (European) banks that would be hammered if the U.S. walked away."

Note that Mr. Haines does not speak of AIG as an independent entity. Note also that, in supporting the AIGFP fiasco/deals, the U.S. can reduce the overall size of the bailout needed while ensuring that domestic entities retain full access to capital markets. It doesn't make anyone happy, but the option is worth keeping open.

Then we get to the meat of the deal:

AIG will also give the U.S. Federal Reserve a preferred interest in its American Life Insurance Co (Alico), which generates more than half of its revenue from Japan, and Hong Kong-based life insurance group American International Assurance Co (AIA) in return for reducing its debt, they said.

The U.S. doesn't really want to own either of these, but they have a promise to be valuable assets.

The government likely will get a 5 percent cumulative dividend on its ownership stake in Alico and AIA, said one source. AIG had been trying to sell Alico and part of AIA in a bid to raise money to pay back the government.

Sales of these assets are still a possibility, with some bids already received, said one person. [italics mine]

Think very carefully about the italicized part above. Markets clear—but they don't always flow well. Combining the two, it appears that the government is effectively giving AIG a bridge loan on those two entities. In the worst case, it will become a "pier loan" (h/t CR), but that's not the way to bet, especially if others follow the Chinese model of buying international assets while they are cheaper.

The rest of the moves look as if the outlines of the new company are already falling into place:

AIG may also securitize some U.S. life insurance policies and give them to the government to further reduce its debt, the source said.

The company may securitize up to $10 billion under that plan, one of the sources said.

The debt-to-equity swap would help AIG repay much of the roughly $38 billion it has drawn from its government credit line, the source said.

Translation: we know this business, and can do it well and continue it.

Last year, AIG said it planned to sell all assets except its U.S. property and casualty business, foreign general insurance and an ownership interest in some foreign life operations, to pay back the government.

While the company has announced some sales, it has found it difficult to find buyers and get a good price for assets amid the financial crisis.

Translation, again: if the market ever comes back, this is what we plan to look like. And we will again be a "going concern."

In short, unlike The Big C, there is a plan, there are moves afoot to move closer to the end game, and targets by which they plan to keep the viable parts of the business going. For instance,

The company now plans to spin off up to 20 percent of the property-casualty business in an initial public offering, said a person with direct knowledge of the plans.

The business would be renamed to differentiate it from AIG, and have its own board of directors.

So long as that board doesn't include Hank Greenberg, I'll be cautiously optimistic. The other piece of spinoff is more problematic:

To aid the auction of at least one major asset, the government could help potential buyers of aircraft lessor International Lease Finance Corp with financing, the sources said.

ILFC has some debt coming due in 2009 and, if needed, AIG could use its new equity commitment to help potential buyers with that, one of the sources said.

This is a piece that probably still needs to exist for non-business reasons, at which point we might be able to argue that there could be a Public Good in government support of its sale. Under any condition, it doesn't fit into the trimmed-down model of AIG-Prime that appears to be envisioned.

None of this means there won't be another round—asset sales are very dependent on buyers—or that they should be paying non-contractual bonuses this month (which they are). The company still needs to reach its full restructuring, and this is not exactly a prime time to be a seller in the marketplace. But at least this restructuring/new bailout has a clear Endgame in sight.

*I use "unencumbered" in place of the usual "free" for the sake of clarity.
**It appears that "Ongoing concern" is used in the U.K., "going concern" in the U.S. I won't pretend to know which will be the standard as accounting standards are weakened standardized.
***This is, of course, another case where I will point to the results and ask how anyone can take "we'll get 2/3s of the money back" seriously. But that dead horse has been soundly beaten for the moment, so I'll leave the tanning of the hide to Yves (She likes the new deal a lot less than I do) and Paul (who hasn't discussed it yet, since he's still rewriting 2 Henry VI and checking out The Great Solvent North) and the rest.

I've spent most of the past two weeks alternating between dizziness and sleep. Maybe the dizziness explains why I find myself in agreement with a WSJ editorial:

In a better world, Citi would have long ago been put into bankruptcy. The FDIC could have taken over and disposed of the bank's assets, while protecting insured deposits as it always does. The profitable parts of Citigroup could then have been sold off to people who could better manage them.

Let's do some elementary math in support of the WSJ position:

Taxpayers have already put more than $50 billion in capital into the bank, while guaranteeing $301 billion of its bad assets, and the bank still can't stop its slide.

All right, I'll work with the low number, which is the most optimistic estimate anyone has published recently: $50 Billion. The Big C's market capitalisation (the Present Value of the Expected Unencumbered Future Cash Flows as expressed as the stock price times the number of shares) as of last night is $8.18 Billion.

Can we stop talking about the evils of "wiping out the existing shareholders"? They were wiped out more than $40 Billion ago.

The WSJ does make one mistake:

But in this vale of taxpayer tears, Citi is "too big to fail" and thus must be propped up lest it (allegedly) spread contagion through the financial system. While that may have been true last fall amid the worst of the financial panic, we don't think the contagion would be the same now that the federal government has guaranteed anything in the financial system that moves.

Well, not exactly. By my count from the FDIC Failed Banks list, 28 banks have been closed since October of 2008, including two yesterday. And there's no sign that that trend is ending. But this is spot on:

That isn't the view at Treasury, which yesterday agreed to a stock swap that will buy Citi more time to, well, who knows? The feds will trade the preferred taxpayer shares for Citigroup common, which means giving up their 5% dividend and taking on more future risk in return for a 36% ownership stake.

Let's review below the fold:

1. The Fed has put at least $50 billion into The Big C.*
   
2. The Big C is worth, according to its best-informed shareholders, slightly over $8 billion.**
   
3. The Fed's $50 billion will get it a 36% share in The Big C.
   
4. Basic Math Interlude: $50B=0.36x => x = $50B/0.36 = $138.89B implied value
   
5. Pause to repeat: The market thinks The Big C is worth just over $8 Billion. The current "book value" of the institution—a mythical number only an accountant could love, and her only because she is paid to love it—is just over $80 Billion. The Best Case Scenario for the Fed commitment is that The Big C is worth nearly $140 Billion.
   
6. Interlude: [search Internet for a picture of The Nile to insert here. Settle for trying to get the Sadly, No! guys to photoshop Tim Geithner's head onto Pam Tillis's body.]
   
7. Remind the blogsphere of Simon Johnson's answer to Question 8:
   

   8. How many of the largest 5 banks will likely end up with government as majority owner?
   
   - Any honest market-based valuation of bank assets will show a majority of large banks are presently insolvent but can be righted with substantial new capital.
   
   - If the answer isn’t “at least two,” then either the Treasury does not plan to properly value assets, or someone is not yet prepared to tell the full truth.

   
   
8. Point out that, if you believe the market, there are two banks that are currently Serious Outliers in Book-to-Market Value, The Big C and BofA.
   

   
   
   

   
   

9. Decide not to discuss stress testing, which indicates that Wells Fargo is also seriously endangered, in this post, in large part because of its acquisition of WalkAllOverYa, which had previously acquired World Savings Bank. Leave for later; tell audience not to hold breath.

Now, let's pretend that past is prologue and that Timmeh! is just making the best deal he can. (Pause for laughter to subside.) Let's just Focus on the Future.

The Obama Administration is commonly described as planning to ask for $750 Billion in additional "bailout funds." They are claiming that this should be shown on the budget as $250 Billion, since they expect to get about 2/3s of the funds back over time. [link added, h/t Frank Rich in the NYT]

Given the above details re: The Big C, and the abundant reports with multinational historic examples that shows nowhere near that size of return, why should we be expected to believe them?

With regard to The Big C, I'll give the penultimate word, once again, to the WSJ editorialists:

Meanwhile, Treasury is forcing the bank to get some new, and presumably more competent, directors. Many of the current directors were going to leave later this spring anyway, but at least this imposes some discipline in return for the federal largesse. Citi's management will stay in place, at least for now.

Again in a better world, the new board and Treasury would find better managers. But yesterday's announcement included no roadmap for how the bank plans to restructure, if it even plans to do so. The hope is that it can earn itself back to profitability. More realistically, a bank that has failed as often as Citigroup needs to shrink until it is no longer too big succeed.

As followers of the Iraq War know, Hope is not a Plan. When the WSJ endorses nationalisation, it's clearly an idea whose time has come.

*We can pretend the asset guarantees—a Really Stupid Idea from people Robert assures me are smart—are independent of the firm; that is, if Goldman or BofA owned them, they would have gotten the same deal.

**I maintain that the current stock price is approximately the price of a two- or three-year call option at a price marginally above the current level—say, $3 or $5—and as such we should rightly view the current stock value as $0.00. But that's for another post.

by divorced one like Bush

Let's talk jazz: Still cashing the income inequality
berries, clams, dough, heavy sugar, jack, kale, mazuma, rubes, simoelan, voot. It's all money.

I started this series to develop a simple model of income inequality so that I wouldn't sound like I was chewing gum and people wouldn't get all balled up on the heavy sugar.

The first one presented the model. 100 people, $1000 of total income. 1976: 8.7% of the dough to the One, all the rest of the jack to the Many. 2005: 23% of the sugar to the One, the rest of the voot to the Many. Basically, it showed why income inequality ain't allowing the Many to by orchids. Also, maybe it'll help you know one's onions.

The second post addressed the concerns that the model was to simple. The sugar was heavier, the times were percolating I'm told. Except that the only real issue for my model was that the population would have to increase against the 1000 clams for the model to reflect the coffee made. There was less mazuma for everyone. Oh, and the total dollars to be made up with a tax cut to duplicate the take of 1976 is $1.4 trillion dollars.

In the end, none of this bodes well for the concern about multiplier effects and money velocity. Yet here we are all these plans being put into action to get people spending 'cause that's the problem and the issue still gets no respect. We want to get more kale into the hands of the many, but we aren't taking about anything related to increasing the share of income to the many (which would include the trade issue as Stormy has been hammering it).

HELLO! The reason people have no money is not because their taxes are too high, their health care is too high, their interest rates are too high; THEY NEVER HAD IT TO BEGIN WITH!

So, let's see how much the 99 people of the Many would need in 2005 to have stayed even with their position in 1976.

First here is what the $1000 should be in 2005:
$3,429.93 using the Consumer Price Index
$2,811.66 using the GDP deflator
$3,891.74 using the value of consumer bundle
$3,296.90 using the unskilled wage
$5,013.86 using the nominal GDP per capita
$6,805.40 using the relative share of GDP
My model using actual income data came up with $6940 total, but based on per capita, it was only $5130.

Each of the 99 people had $9.22. In 2005 they would need the following:
$31.62 using the Consumer Price Index
$25.92 using the GDP deflator
$35.88 using the value of consumer bundle
$30.40 using the unskilled wage
$46.23 using the nominal GDP per capita
$62.75 using the relative share of GDP
My model, using per capita income resulted in $39.90.

Interesting No? The total personal income in the model comes out to be pretty close to the GDP per capita and relative share. So, the percolating of the economy did result in the same economic coffee in 2005 as in 1976. Unfortunately for the Many, the semoelan handled is less than the per capita and relative share of GDP. Can you say SCREWED?

My model also resulted in the number of $47.31 for each of the 99. That is the number to make up for the share of income lost to the One. It is essentially the number calculated based on nominal GDP per capita. Or, the unscewed number.

But, these numbers just show that using the percentage split, the One stayed even with the percolating economy and the Many dropped down to something less. It does not show the loss of purchasing. For that, we need to reverse calculate.
For the Many, they have $39.90 each in 2005. In 1976 it looks like this:
$11.63 using the Consumer Price Index
$14.19 using the GDP deflator
$10.25 using the value of consumer bundle
$12.10 using the unskilled wage
$7.96 using the nominal GDP per capita
$5.86 using the relative share of GDP

I think what we are seeing here by looking forward and then backward, is that the Many are earning more for their labor (wage went up), but they are not earning wages comparable to the contribution made to the rising GDP by their laboring. Who knew, Slave Wages is a real wage!

Tom Bozzo

Reader Roger Senserrich listened to the Obama reply that also caught CR's eye and sends a relatively favorable (to the administration) interpretation:

Let´s see if it makes sense.

1. Obama says that America doesn´t nationalize; it is not something we do. That´s actually false; ask IndyMac or WaMu shareholders on what hit them. The FDIC does nationalize.
2. The political system, however, does not perceive it as the "N" word. There was little backlash against those actions, as the FDIC is seen as non-political; some sort of a technocratic guardian that does what is needed.
3. Enter the stress test: Geithner talks about testing the banks to see if they can swim in these troubled waters. Only some banks; the 14 with assets over 100 billion, will take this wonderful "test". Depending on how well they fare, they will get more or less capital, and the treasury will grab more or less stock.

See where am I going? The administration could be looking for a way to benchmark and nationalize what is needed using a technocratic procedure with a clear way out, as a way of doing the work with some political cover. Essentially, the idea is to get the "N" word out of the debate, and make it about banks getting "intervined" after failing to comply with the "agency"´s regulations.

It is convoluted, and I might be looking for a rationale that is not actually there, but it makes sense; it gives them a way to do what is needed without actually having to name it. Nationalization might be economically necessary, but is not politically feasible; this could be a way to create political cover for it.

Tom here. For another sympathetic view, see Jeff Frankel. I read Obama's statement through the filter that Obama is a smart lawyer and note that he's foreclosed nothing going forward; the money quote in my view is that what we've seen so far represents "some of the tough love that's going to be necessary."

Now Geithner and Summers could yet find their pictures attached to the Wikipedia entry on regulatory capture, but we also need to avoid reacting as if we've been overconditioned to eight years of life under Davies' Law. This is not to counsel against vigilance with respect to the administration's deeds so much as to suggest a la Frankel that the "they have no clue and the Obama presidency has already failed" reactions are at least premature.

The political issue is not irrelevant. Policies that don't need to go through Congress would appear to operate under the constraint that it has to be able to be done with $350B in TARP Part II funds, the exercise of various Fed powers in coordination with Treasury, and whatever TARP Part I funds get paid back by institutions who think they can live without help from a Treasury less pliant than Paulson's. Those resources are substantial but not unlimited. A program that requires more than that needs to deal with the likelihood of opposition from most of the Party of No's representation plus other politicians capable of detecting that another dip into public funds for the financial services industry, however necessary, is likely to rival plague for popularity. At least as frightening as the problem that the "stress test" is window dressing is the likely size of the caucus who'd vote against an expanded bailout were the evidence of necessity delivered by the ghost of Ayn Rand herself. In fact, I'd say that right now there's no way a bailout expansion would pass.

That seems to put a premium on cleverly engineering a plan to the aforementioned resources. That may be observationally indistinguishable from a lack of boldness.

Duff and Phelps, which tends to be the rating agency you go to if S&P or Moody's won't rate you highly enough, provides a convenient evaluation table (p. 22 of this report) for the marvelous negotiating techniques and acquisition skills of the previous Administration.

Since the current Administration is now threatening to continue with the same effort, any cause for optimism is sadly misplaced.

(h/t Joseph N. DiStefano)

Update: DOLB
I apologize if Ken minds me adding this, but Elizabeth Warren talked about exactly this last night on Rachel Maddow's show.

Visit msnbc.com for Breaking News, World News, and News about the Economy

I was pontificating earlier today about how many of the now-unemployed Financial Services workers were, in a previous life, engineers of one stripe or another, and if we're going to be doing things with the stimulus bill such as re-engineer the power grid, some of them may well decide to return to their previous life. And with a 60% increase in the number of people unemployed since May of 2007, there should be some decent competition.

Leave it to my old friend Terry Bisson to completely undermine that argument:

I think the big Wall Street bonuses are a fine idea.

Without them, Wall Streeters will all look for other jobs. Do we really want these greedy incompetent clowns building our houses, teaching our children or driving our cabs?

Dr. Black graciously asks:

Am I the only to whom it's occurred that monetary policy through the banking channel (as opposed to, say, actually dropping money from helicopters) is only likely to be effective if banks are pretty good at allocating capital efficiently, and recent history tells us that the existing set of clowns in charge completely suck ass at this?

No. In fact, this is one of the better reasons for advocating spending (fiscal) solutions over monetary ones. The monetary ones haven't worked, because the skillset to make them so does not currently exist sufficiently in the financial community.

Or, as someone once observed, we have thirty major banks. What we don't have are thirty bankers to run them.