Kevin Drum asks a question about the numbers Nemo and I wrote:
But it’s a pretty important question that some financial engineering types should spend some more time on. If, in the end, the toxic waste gets overvalued by 10% or less, that’s not too big a deal. If it’s overvalued by 50%, it’s a disaster. Not only will taxpayers likely lose a lot of money, but no one outside the auction will have any faith in the prices. And since price discovery is one of the goals of Geithner’s plan, lack of faith would be disturbing indeed.
This is very valid. I played around with a toy model as a teaching tool for how options work in this case. I didn’t mean to imply a specific value for overbidding – but why don’t we try to answer this question? If I’m wrong, you don’t even know who I am anyway.
I’m going to continue to use the lognormal distribution. A lot of the binomial modeling (It’s either 30 OR 80) increases the volatility and doesn’t seem natural to an actual rough guess. I am not a mortgage-value modeler, and know little of how the distributions play out in practice. But then again, I just want a ballpark – is it closer to 10% or 50%? This distribution will be good enough.
This is still a very difficult proposition because (1) nobody knows what these assets are worth and (2) provided we know what it is worth on average, we can still make a lot of extra money, perhaps more than from the assets, from the put option from the FDIC – and that depends on the volatility. And we have even less of an idea of how volatile the assets are. The volatility will come from the mortgages themselves, and also unemployment and falling GDP. It can also be gamed.
So I’m going to suggest a 2×2 matrix. 2 values of assets, 2 volatility estimates. The real values will probably be somewhere in-between them.
Bad: Paul Krugman is right. These assets aren’t trading because they are worthless, and everyone knows it. The $1 trillion dollars in debt is actually only worth around $350 billion; this is what we set our average value to.
Good: Well, relatively good. Obama’s team is right – with some government backing, people’s risk measures go from too adverse to just right, and we realize the assets weren’t that bad all along. The $1 trillion dollars in debt is actually worth $600 billion, and this will be our average value.
Low: Unemployment decreases while never having gotten that high, GDP bounces back harder to make up for lost time, the regulators make sure that the hedge funds don’t game the process with the portfolio selections.
High: The opposite of Low happens.
Also: I’m going to assume a lower leverage on average (a lot of commenters said that was unfair) – let’s say on average the hedge fund pays 1/5th. Hedge Fund means both the Treasury and the Hedge Fund itself. They are damn good, so they know the distribution so they can bid to whatever value they like, and they bid to where, as wagster suggests, they receive a 12% return on their investments.
So what happens? With a trillion dollar notional, all dollars below are in billions:
This should be taken with a major grain of salt. However, looking at the range from the low ends to the high ends, we see the waste will be overvalued somewhere between 7-20%. I would say low-to-mid teens. FDIC will lose between $30 and $100 billions, which will be split between the hedge funds – remember they lost money on the asset itself! – and the banking sector. (Go ahead and add half the HF profits – which are from Treasury – back into the FDIC loses, if you want to think of the government as a single entity.) The over valuation isn’t as bad as I thought it would be, but the FDIC loses more than I expected.
Any quants out there have better clues?