Agents Looting FDIC while cranking the Vol.

I want to add another layer to the Geithner Put Model I created yesterday, but I’m going to try to keep it accessible to non-finance people, so bear with me if you know what volatility is already. We took a binomial distribution, very common in credit quality events, and projected some scenarios with it. The model looked like this:

We found a neat development – when the hedge fund bids the expected value, it makes a profit. This should be surprising. If you expect a box to have $5 in it, and you pay $5 for the box, you shouldn’t expect to make any money. However when the hedge fund pays what it expects to be in the asset, it makes a tidy profit (see “Bid = E[x]” below); that profit is the value of the Geithner Put option, the hockey stick like light blue line poking out above. That is worth real money, and it is transfered to the hedge fund.

Interfluidity brings up a great point:

But notional “moneyness” is not the only thing that determines the value of [this FDIC put] option. In particular, options are most valuable when the assets that underlie them are very volatile. In order to limit the degree to which banks maximize the value of the deposit insurance option at the taxpayers’ expense, banks are supposed to submit to onerous, intrusive regulation that limits the riskiness, the volatility of the assets they can purchase.

Under the Geithner plan, the government will extend its non-recourse option to investors without preventing them from “swinging for the fences” on risk in order to extract value from the option. On the contrary, the government is insisting its loans be used to purchase assets that have already proved themselves unsuitable for purchase by a regulated entity, by virtue of being volatile and difficult to price. It’s as if an insurance company that ordinarily refuses to cover homes in hurricane states suddenly offered policies only to purchasers looking to build homes on Gulf-coast barrier islands.

Normally the government should prevent banks from taking on too much volatility, as it tends to steal money from the FDIC. I’m going to phrase it another way. As an old professor used to say: “You have trouble if your model is wrong, and you have trouble if your model is right.” One problem for us is that the hedge funds have no idea how to value these assets. We have a whole other problem if they know how to value them very, very well. What? Why?

Let’s say that the hedge fund can pick its portfolio it is going to invest in. Let’s also say that the hedge fund is good, real good, and always bets the correct value of the asset. However this tends to lead to no profits. So what can it do to make a major profit? Turn up the volatility!

Volatility is also called the standard deviation, and it is a measure of the variance of a portfolio; to use non-math language, how “wacky” it is. The higher the volatility, the crazier it is going to be – some values may be very high, some may be very low. If the hedge fund wants to increase it, it does the equivalent of insuring the Gulf Coast homes Interfluidity mentioned – it seeks out the craziest, most volatile loans it can find. If the loans go really high, better for them, if they go really low FDIC is left holding the bag. As long as the fund whiz-kids know what they are doing, and how to price them, they’ll make $0 on the loan itself but a ton of money from the FDIC put.

Now options are increasingly valuable in volatility. The more volatility goes up, the more the option tends to be worth if you have them. Is it true of the the Geithner Put Option? If so how much? Let’s see. I take median held constant, and just increase the volatility, which increases the average and the tails. [Nerd talk: the median is exp(mu) and the mean is exp(mu+sigma*sigma/2); so by hold mu constant I can increase the mean, tails and vol against the median.] Here is the graph:

As you can see, the more volatility the hedge funds can stuff into their portfolio, the more valuable the Geithner Put becomes. This may be a feature, not a bug, of the Geithner Plan. Notice that very quickly, as we begin to increase the volatility, the FDIC put option becomes more valuable than the asset itself. The blue line is how much money they make. The green line is how much money they put up.

This goes to the principal/agent problem. We are hiring the hedge fund to make money in the banking market. However the hedge fund can make money in two directions – it can make money off banking assets by bidding correctly, and it can make money off the Geithner Put option by fudging around with the volatility numbers. And as we see above, it can make a hell of a profit off just the Geithner Put option by itself. So looting the FDIC may not just be a by-product of what the hedge funds are doing – it can be an active strategy they seek to maximize.

And if this sounds made up to non-finance people, the idea of hedge funds tweaking their volatility little points this way or that way, trust me – they are very into that, and very good at it. Meanwhile, small and medium sized banks that have acted responsibly are getting taxed to fill up the FDIC’s coffers. Making them easier to be bought out by these large zombie banks. To paraphrase Steve Albini, some of your local banks are already this fucked.