Banks as Bidders and Sellers; Financial Nostalgia

So according to the FT, it appears that the banks selling assets will also be able to bid on each other’s assets.

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.

The plans proved controversial, with critics charging that the government’s public-private partnership – which provide generous loans to investors – are intended to help banks sell, rather than acquire, troubled securities and loans.

I brought this up when the plan was first released, via a marginalrevolutions’ post in that link, but the idea seemed so absurd that I didn’t mention it in any subsequent posts. It is apparently staying, and we need to consider what this will do to the process.

I was out at “Debaser Night”, a 90s-music dance party in San Francisco, with some friends. A riot grrl rock cover band opened, followed by lots of great singles. I was getting a bit nostalgic. A friend of mine, who used to be on an energy trading desk back in the early 2000s, was listening to me talk about the government plan. He couldn’t believe what I was telling him about letting the banks that are selling auctions also bid on them. In the middle of my explanation, he had his own wave of nostalgia: “Man does that bring back memories….”

Before we go there, what will happen with these banks when they can bid on each other’s assets? Let’s do a thought exercise. Let’s say you are a bidder for Bank A. You know your banking asset is worth $50, and you also know the asset Bank B has is worth $50. You call your buddy up, the trader at B, and make a deal. Happens all the time. You go to bid, and you bid $80 for B’s asset. Then you wait. If B doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your asset – $80 from B. You have each bid up each others assets and traded them. And now the government is screwed. Let’s chart out that payment:

Yup. Bad news. Bank A pays $6.50 for its new asset because of the leverage , and it loses all of that. It also loses the $50 from not having the asset anymore. However it gains $80, net profit – same as Bank B. The government has paid $73.50 for a $50 asset, twice. (See previous for how the levered non-recourse loan turns into a put option.) We tend to call this collusion if you and I did it.

So why did my energy trading friend get all nostalgic? “Because what you are telling me brings back some great memories from what Enron was up to back in the day. All of us energy traders back then watched with our jaws on the floor. 2000 was a hell of a year.”

It is August, 2000. Let’s say you are a trader for Enron. You know your energy in California is worth $50, and you also know the energy that Reliant Energy has is worth $50. You call your buddy up, the trader at Reliant, and make a deal. Happens all the time – you even have a nickname for it, The Daisy Chain Swap. You go to bid, and you bid $80 for Reliant’s energy. Then you wait. If Reliant doesn’t come through, you are screwed out a lot of money. And hey, isn’t this wrong? Well, you are pretty sure one of those Rubin-protégé government whiz-kids has given someone who knows someone you know a wink-wink about this. You take a drink, steady the nerves. Then, the bid comes back for your energy – $80 from Reliant. You have each bid up each others assets and traded them. And now the government is screwed, because it has to pay you $80. Let’s chart out that payment:

You can go ahead and replace an Enron subsidiary for Reliant in that example, as I did in the chart. Enron did, and the banks are probably going to now. My friend was very excited telling me all the strategies Enron deployed – “Forney Perpetual Loop”, “Ricochet”, “Ping Pong”, “Black Widow”, “Red Congo”, “Get Shorty”, the whole works – and how all of them will be reliable guides for gaming the legacy asset market here. Buy assets high, write them down, then pay back with “fees.” Got it. Create SIV to bid up the profits. Brilliant.

What is really exciting, from the evil point of view, is the idea that we are going to get to see one giant, massive, Enron Death Star put into play:

that's no moon

that's no moon

The Death Star strategy (yes, they called it that) was where Enron would take a fee for relieving a congested market of its excess supply by moving it elsewhere. Just like our legacy assets! There are too many of them, it is clogging up trade, let’s get them to someone else who wants them. However Enron would just move the energy in a circle, collecting a fee for not doing what it was supposed to. As their memo famously said, they are paid “for moving energy to relieve congestion, without actually moving any energy or relieving any congestion.” And, it appears, that the large banks are gearing up to do just that; with the Geitner Death Star that they’ll just be collecting a large fee to run them in a circle, without actually moving any of them off their collective books. For old time’s sake, I hope they route their loan bids through Oregon and then Utah before putting them back right where they started.

Mind you that was the electrical grid of California – this appears to be at the scale of the entire financial market. In case you are wondering, traders out there are licking their lips to try and find ways to game this even better than Enron. It appears the public will get to invest in these vehicles too. Direct Democracy in the 21st century means that all of us get to take part in collusion and ripping off taxpayers – we are the ones we’ve been waiting for!

I’m not the biggest Enron junkie – else I would have seen this connection sooner. If any people who know their playbook of strategies want to leave a comment with a move that could be made by the PPIP bidders, I’d be much obliged. And please, tell your representatives to keep the selling banks and their subsidiaries from bidding. I’m still hoping this part is a bad dream…

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36 Responses to Banks as Bidders and Sellers; Financial Nostalgia

  1. Bagsnatcher says:

    Thank you for good reading and an excellent blog You can get even more nostalgic if you’d wish for it. In the words of old “Ben Kenobi” (and the paratroupers) This is what I envisaged long ago:

    The World – Mark to Market value please!
    BankA (with a small wave of the hand) “You don’t need to see our valuations”
    The World – we don’t need to see any valuations!
    BankA “These are not the assets you are looking for”
    The World – These are not the assets we are looking for!
    BankA “You can go about your business”
    The World – Go about your business now!
    BankA “Carry on”
    The World – Carry on!! Carry on!!

  2. DiverCity says:

    Won’t matter if we complain, yell, stomp, gripe, whine, cry, holler, scream, ad infinitum, ad naseum, cause the fix is in. They will do what they do, and the TP’s will suffer. The only way to right this sinking ship of state is to hit the reset button and begin anew.

  3. William Todd says:

    Does the President have any clue that he could be building Enron Death Star 2.0? Does he realize what he’s up against? This is a Ponzi scheme that puts Bernie to shame.

  4. William Todd says:

    Also check out http://www.morenewmath.com for the following apropos gem:

    Ponzi Scheme = ROI – R – I

    Brilliant!

  5. 4best4worst says:

    Great post.

    I am left wondering if judgement day will be after the first half-trillion is exhausted and most of the assets have moved from bank A to bank B and vice versa, how the congress will justify approving more funds to continue this game for the trillions of toxic assets that will still need to be shuffled….

    Don’t take me wrong, I suspect they will find a way….I mean, we all know this first round is the beginning of the greatest theft in history, and I see nothing getting in the way so far….

    Maximus
    http://4best4worst.wordpress.com/

  6. fiftycent says:

    first thing i thought of when i contemplated how this would actually work was the whole iru swap scheme of wcom, qwst, lvlt, et al in the same era. brought back memories. ebbers and nacchio both yelled at me back then for “not understanding accounting.” those were the days. and that’s all i have to say about that.

    oh yeah, and i am un chien andalusia.

  7. Chris Marino says:

    Citibank as Enron will become a common meme before we know it.

    ‘The Smartest Guys in the Room’ is a great read and chronicles many of the financial engineering aspects of Enron’s rise and fall. It goes into lot of the details of the trading strategies executed that exploited CA’s baroque electricity/transmission regulations (many of which were drafted by Enron lobbyists). Beyond the surreptitious activities around trading, SPE, SIVs and the like, were aggressive petitions to the SEC that enabled them to mark to market their trading gains. Historically, these were not allowed, but after the ruling which characterized Enron as a trading Co, they were allowed to MTMyth.

  8. abraham says:

    No, it won’t help if we just complain and yell and stomp and gripe and whine and cry and holler and scream again. But it will help if we start shooting and blowing shit up. Won’t it?

  9. Anal_yst says:

    I’m moving to Guatemala, that’s it, its settled. Any idea where to find the ventilation shaft with the “self-destruct” button on this sucker?

  10. me says:

    We know they will do it… so how we can play it in the stock market ?? which stocks will move and in what direction when this robbing starts ?

  11. boondoggle says:

    Mike–

    Do you think this Geithner Death Star will end just like the Enron Death Star – the complete collapse of the companies involved, except for the subsequent nationalization of the banks? Or will they laugh all the way to the bank? If the big banks are indeed sharpening its own guillotine, then Geithner is more deviously diabolical than we are giving him credit for.

  12. rootless-e says:

    seems to be built on a rather tenuous chain of extrapolations from what Blair said.

  13. DiverCity says:

    @ abraham:

    Yes. That’s one way to hit the reset button. The clowns in Congress and the Executive Branch are probably tone deaf to anything else. Think “V for Vendetta.” Even though some complain that “V” is a leftist screed, one could perhaps be forgiven the hope that persons of all stripes who are cognizant of the massive wealth transfer we’re seeing might work together along those lines.

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  15. grant hart's ghost says:

    Was Geithner listening to Husker Du’s New Day Rising back in his college days? Because the PPIP gaming possibilities are straight from How to Skin a Cat:

    We are starting a cat ranch and taking one hundred thousand cats
    Each cat will have twelve kittens a year
    The catskins will sell for thirty cents each
    One hundred men could skin five thousand cats a day
    We could be dealing a profit of over ten thousand dollars
    But what should we feed the cats?
    We will start a rat ranch next door with a million rats
    The rats will be twelve times faster than the cats
    So we can have more rats to feed each day for each cat
    But what should we feed the rats?
    We will feed the rats
    The carcases of the cats
    After they have been skinned
    Now get this!
    We feed the rats to the cats and the cats to the rats
    And get the catskins for nothing
    We feed the rats to the cats and the cats to the rats
    And get the catskins for nothing

  16. Awake says:

    Good analysis, but there is one point you left out-

    It doesn’t matter what the bank thinks the asset is “worth” (in this case $50). It matters what the bank has it marked at currently.

    Snagging a bid for $80 on an asset that is worth $50 doesn’t make a whiff of difference if you are barely solvent with it marked at $90. You need $90.

    So the “ponzi cycle” you have laid out above only works if the asset is currently marked at 50. And, I would argue that anything that has already been marked down to 50% of par is less likely to completely wipe out the government/taxpayers loan (remember, the “private investor” still eats the first 1/6th of losses), except for the stuff that is literally, completely worthless. Which may be what ends up getting sold via this program.

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  19. Mike says:

    I’d like to thank everyone for not pointing out that the first picture has a $2 addition error in it (carrying the one – the bane of financial engineering). Cursed charts-made-into-jpgs I don’t want to fix, nor can since I deleted the powerpoint slide.

    Thanks all for reading – stick around if you are finding it interesting.

    To repeat what fifty said, I am un chien andalusia!

  20. bob says:

    Is there even a prohibition on self-interested bidding in the plan? It would seem like there is plenty of room for a bank to, e.g., covertly pay their own agent (1.1 X) to bid (X times gov’t leverage) for their own assets.

  21. Dave says:

    If you pay $6.50, lose the $50 asset and gain $80, you’re up $23.50, not $24.50. Similarly the gov’t is *only* down $47, not $49.

    Looks like Geithner’s plan won’t be so bad after all. Phew. What a relief ;)

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  24. skopros says:

    don’t repeat…it’s chien andalou

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  26. Joseph Somsel says:

    Here’s a piece I did on Amory Lovins’ phoney-baloney concept of “negawatts” and how Enron used the “Death Star” gambit to rob us Californians.

    http://www.energypulse.net/centers/article/article_display.cfm?a_id=488

    Sure sounds like the current Administration has taken this to new heights!

    Thanks for the financial enlightenment.

  27. NoDiv4 says:

    It won’t just be Citi that is willing to overpay for its own assets with govt money, but a PPIP investor will be incentivized to buy shares of citi (or all together) as well as over paying for assets. So preventing citi to do it doesn’t eliminate someone from doing it because they have the same incentives.

    Think of it, you put in a $1 billion in PPIP, it’s matched by treasury levered and you go and pay 100 cents on the dollar for citi legacy assets. You also buy $1 billion out of the money call options on Citi. The success of the auction restores citis solvency and the stock soars, your options are worth 100′s of billions and write down the PPIP assets to zero and FDIC takes 95% of the loss.

    Set it up offshore so you don’t get taxed at 95%.

  28. Pingback: The Geithner Death Star. [JHoward]

  29. Murph says:

    Bob there is a prohibition against bidding on your own assets: “Private Investors may not participate in any [public private investment fund (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.”

    That’s why they’ll bid on each other’s assets, or use proxies.

    Khan Academy had an interesting way they can game it: Sell super-cheap CDS on their own toxic assets to a hedge fund, with upside value on default equal to the equity investment that the hedge fund will put up for the assets! That provides incentive for the hedge fund to take a flyer on the assets, as it’s a free call…

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  31. Taunter says:

    This is fantastic. Good to see someone else both realized the scams that can be pulled and understands the fine tradition of naming crooked SPVs after Star Wars characters:

    http://tauntermedia.com/2009/03/23/gaming-the-system/

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  33. Ellen1910 says:

    Back in the day — S & L crisis day, that is, it used to be called “trading a dead horse for a dead cow.”

  34. SameGameInCanada says:

    Interesting article and familiar, yes. You see, this is how we have been propping up our insolvent banks in Canada. The scam works as such:

    We have only five major banks here and a few small regionals. All are effectively insolvent, yet trade at at very high levels, with a couple (RBC and TD) occasionally in the top 10 in NA by market cap.

    When capital ratios get out of whack, regulators issue a notice that more Tier 1 capital is required. In Canada we have what is called a “bought deal” where the underwrite agrees to buy the issuers offering at a set price and redistributes the deal. Sounds risky, but the risk is mitigated by having only five banks. You buy my shares, I’ll buy yours. Due to inflated prices, share issues are simple. effectively nothing changes as the banks are constantly swapping each other’s toxic paper amongst themselves. Each bank issues shares pretty much monthly, with some going to the trough every two weeks, if markets dictate. One of the banks issued shares twice in the week before Christmas! Yet, the sheeple keep buying shares due to the dividends (funded by taxpayers) and the belief that our banks, which are now global in nature, are somehow immune from the global financial crisis.

    To top it off, the Feds have pumped in close to 200B into the banks, which is quite large, considering it is 1/12th the size of the US economy. Yet, after massive bailouts and the constant swapping of shares, the banks have been able to to perpetuate the myth that Canada has a better banking model!! Even the Prime Minister has been going on an international speaking tour, lauding our banking model. In reality, our banks truly are too big to fail, with a foreign takeover (not currently allowed) the only potential cure for the mess, were international investors interested in the true situation.

  35. Rototillerman says:

    4best4worst wondered how they will get Congress to approve additional funds… don’t forget that it is the FDIC backing the loans! That’s the evil beauty of it… there’s no other logical reason for the FDIC to be in this game, except as the reason that they will have to go to Congress “to save deposit insurance” when it all blows up… again.

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