The Best Minds of My Generation

1) Though they didn’t use this language, I think The Economist hinted that the PPIP-gaming critics, including myself, are being a bit Glenn Beck Doom Bunker about their analysis. PPIP Doomsday Scenario XVII: Werewolf Congress! Ha! The Economist: “Given how absurdly bad those scenarios would be, and how the Treasury seems to be at least nominally interested in preventing them, I don’t know that it makes much sense to be accusing the government of bad dealings just yet.”

I’m rooting for Obama and his team. They have one of the hardest situations in the past half-century to deal with, and the stakes are very high – and I think they are up for the challenge. And up until recently, my thought was that these auctions wouldn’t clear, or not get enough money in order to make the banks solvent. However I am not hearing enough from the Treasury to be convinced yet that this isn’t a just a move to spin the assets around the banks once for a fee – and time is running out there.

I do think it is important for the critics to get their say early here, while the administration is still planning this out. If we are really going to go through with this at this scale we get one shot. There are a lot of ways, both overt and subtle, for the government to convey that they are serious about this not being gamed. I’d like to hear more of that from the key players – so far I have not heard much that is convincing me. The FDIC is really good at its job, but its job is not to be the SEC. It is not good at it. The SEC hasn’t been very good at being the SEC lately. Meanwhile digging every last drop of juice out of profit opportunities is exactly what Wall Street is good at – and we don’t want them having large incentives aiming their guns at the Treasury. As as the ever wise Interfluidity says:

It is worth noting that overcoming coordination problems so that diverse parties can collaborate on profitable ventures is precisely what the financial sector is supposed to be good at doing. Ideally, we would like the profitable ventures to be welfare-improving projects in the real economy, but there is little question that financial sector actors will gladly apply the same skillset to extracting transfers and rents when the opportunity presents itself. Attempts to regulate away intentional overbidding by cooperating parties will have to outwit some very clever professional deal makers.

2) Jeffrey Sachs:

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.

Citibank thereby receives $1 million for the worthless asset, while the CPPIF ends up with an utterly worthless asset against $850K in debt to the FDIC. The CPPIF therefore quietly declares bankruptcy, while Citibank walks away with a cool $1 million. Citibank’s net profit on the transaction is $925K (remember that the bank invested $75K in the CPPIF) and the taxpayers lose $925K. Since the total of toxic assets in the banking system exceeds $1 trillion, and perhaps reaches $2-3 trillion, the amount of potential rip-off in the Geithner-Summers plan is unconscionably large.

Good example, but as many people on the blogosphere are pointing out, Treasury is outlawing this: “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.” Whoops.

In the spirit of yesterday’s post, I want to use Enron’s Ricochet play as our Guiding Principle to get around this so-called legal constraint (pdf):

8. Ricochet

The definition of ricochet schedules or “megawatt laundering” provided in the Enron memos and (subsequently included in the Commission’ s Request for Admissions) is narrow in that it includes only one type of “ricochet” or “megawatt laundering”: i.e. exporting power from the PX to another entity, for a fee, in order to resell the same energy back into the ISO’s real time market. Under this scenario, if the energy was re-imported and resold back into the ISO market by a second entity, the ISO generally does not have the information to identify the schedules and transactions involved in such an arrangement.

Once you start thinking Enron… is it addictive.

So, A third party of ex-Citi executives, CitiJR, is given $6.50 by Citi to bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. This isn’t allowed by the so-called rules. However…

A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. Now the FDIC is stuck holding a bunch of assets it didn’t want for $50. Why doesn’t CitiJR rebundle those loans into new loans and sell them back to Citi for the FDIC? Maybe they can get $53 dollars in return – A gift! There’s a slight fee CitiJR has to charge Citi though – $6.50.

A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. So goes price discovery. CitiJR looks to be doing poorly, but there’s a ton of human capital there that is worth a lot of money, so CitiJR is open to a bid for a takeover. Citi, now doing pretty well, shows up, offering to buy the firm outright for a price, let’s say of $6.50.

A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. CitiJR however, still has around $2.50 in working capital left over from this disaster at that point; Citi sells them some selected assets for that $2.50 that turns out, lo and behold, to be worth $9. Lose some, win some!

A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. Citi is very impressed with CitiJR’s keen analytical minds, and wants to bring them in to do some consulting work. They offer them a generous $0.50 per consultancy project, and they have 13 of them lined up to go.

A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50….

Honestly, those four took me 90 seconds. And I’m not even very good at that stuff – wait till the lawyers get involved. If you have your own, please leave them in the comments. Right now there’s offices full of the best minds of my generation, paid handsomely, who will all get hundreds of millions of dollars if they can figure this one out. And they are putting in the overtime…

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13 Responses to The Best Minds of My Generation

  1. Chris Marino says:

    Mike, I think I might be part of the Doom Bunker crowd as well. You don’t even have to assume the worst in people, or that laws are going to be broken (although I suspect some will be). You only have to look at the objectives of the program: Remove toxic assets and provide capital to banks. Success will be measured by this, not by ferreting out corruption and/or fraud.

    Defenders say that similarly egregious frauds are possible with all kinds of transactions, but what they fail to recognize is that those frauds hurt the banks. With PPIP, fraud will help them. There’s a bit of an incentive problem here….

    Finally, its been said on other blogs, but it worth repeating here. No fraud or collusion is necessary to game the system. If you own enough of a banks debt, you can make huge gains on that asset if you over-bid enough for that banks toxic assets.

    Here’s some quick arithmetic:

    Bank debt trades at 70. Toxic asset worth 50, but sold for 70. Huge windfall (+20 capital injection) reduces risk pushing debt up to 75. Lost 5 on asset (50% equity of 70/7 levered asset), but made it back on the debt.

    Buy a ton of the debt, maybe levered 10:1 and you’re golden. Literally.

    Not sure what it would take to move their debt price, but as you say, they’ve got the best and brightness working on these kinds of strategies. Last I checked these banks were levered ~20:1 or more, so a little extra capital could really move the needle.

    No fraud, no collusion. In fact, each participant can pursue this strategy independently without the risk of defection. Not to mention the irrefutable fact that the debt truly is more valuable in a better capitalized bank. The higher priced debt really is the fair price. That asset is safe.

    Does anyone think PIMCO isn’t large enough to unilaterally execute such a strategy? Does anyone think that Treasury wouldn’t applaud such an outcome? In fact, I’m struggling to find anyone that would make a fuss over this outcome? Congress? Maybe, maybe not. FDIC, perhaps, but they’d be all by themselves. They’d be drowned out by the cheering and back-slapping going on among the politicians, bankers and investors (PPIP and bank bond/shareholders). I can practically hear Geithner on Meet the Press right now: “See, we were right all along. It was a liquidity problem, not a solvency problem. The assets were severely underpriced and our plan worked just as it was designed’

    Krugman’s head asplodes.

    Everyone wins, bank, PIMCO, even other bank debt holders. The only looser is the taxpayer.

  2. dismalist says:

    I keep hearing about taxpayers being on the line for all this, but I just don’t see how this is going to happen. When exactly is the bill going to arrive and how could any of the taxpayers every pay for it? I think when people start paying their taxes with their Bank of America credit cards to pay for the Bank of America bailout the lunacy of what is going on will come full circle. The way I see it the financial system is currently busy eatings itself, with America watching on like an attentive waiter thinking it’s in its best interest to provide it with all the salt and pepper it might need.

    *Well, guess I’m one of the bunker crowd, but then again I have been for some years now so I’m not just doing it to be trendy. While I hear other people talking about whether the market has bottomed I’m trying to figure out the chances of the U.S. global hegemony collapsing.*

  3. Jacob says:

    Ooh, this looks like fun. Let me try! (Admittedly, these are a bit more uncertain or illegal, but I’m not so good at these things).

    A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. However, in the meantime, the deferred compensation they already held in the form of Citi stock and options has appreciated by…$6.50.

    A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. They also buy Citibank common stock at $3.00/share that has an expected value of, say, $9.50/share if and only if Citi sells its $50 assets at $80. Sure enough, two years later they lose their $6.50 but the share price moves to $9.50.

    A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. Citi generously extends a line of credit for operating expenses, which CitiJR uses to pay its employees bonuses totaling…$6.50. CitiJR promptly goes bankrupt and defaults on the loan.

    A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50, but not before reasoning that the assets ought to be just like AIG CDS contracts that were worth full face value, so the $80 bid actually means an immediate $20 accounting profit on a face value of $100. So they charge their investors a relatively high 2.5% management fee of $100 AUM and and 20% of $20 profit, $6.50. Natch, Citi’s funds of funds desk invests clients’ money in CitiJR.

  4. Murph says:

    Citibank sells credit protection (CDS) on its toxic assets (which pays $6.50 in the event of default) for $0.01 to… anybody, really… say Rick Astley. If the assets drop, Rick’s covered by the CDS – he’s even. If the assets appreciate, Rick’s rolling. Zero cost, upside-only.

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  6. Tom Lindmark says:

    Is this the best that the “best minds” of your generation can devote themselves to?

  7. B. Mull says:

    A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. Coincidentally they hold some bonds at GM, which the government has decided to honor for $9.

    Remember that the government and the taxpayer are like corporation and shareholder, and we all know how that goes…

  8. Taunter says:

    I’m with Jacob on this one – it’s the easiest and quickest payoff:

    CitiJR bids $80 for an asset worth $50. Separately, CitiJR2 takes a levered position in C options with a strike price of $6 (vs. current trading price of $3).

    CitiJR calls CNBC to announce that it was “lucky” to have been able to get the junk for the low price of 80 cents – look at the great stuff the Treasury is making them give away, lucky we got there before the smart money! Pandit goes on to follow up, says that it’s a shame Treasury made him sell at 80, of course the stuff is worth par, but the good news is that it was on the books for 50, and Citi will show a huge gain.

    Baghdad Tim sees this in DC and goes on to deny that he made anyone sell anything, and insists that we see this as a sign of the robustness of the Administration’s strategy; this is really just a liquidity crisis, which he has solved.

    C spikes, CitiJR2 sells its stock, everyone hangs out. In a few years CitiJR declared bankruptcy and no one notices.

  9. Keith - Hermosa says:

    Here’s what Joe Sixpack American doesn’t get. Smart people, people whose job and fun are derived from being creative love doing this. It’s not even the money really. It is the rush of crushing the system. Americans and especially “News” reporters are always shocked when they hear of plans to run circles around the law. But that is what bored brains do. They find out what the can’t do, and they do it, or at least they mentally plan how they would do it. They look at what a criminal has done, and try to figure out how to best it. I guarantee there are scores or hundreds or thousands of people on Wall Street who have literally said “You thought Enron was a good scam? Wait till they see this.”

    And the public and Time magazine and USA Today are all just shocked. The fact is that none of those people are in the same league. And when you base an entire society not on mutual achievement, but on grabbing and piling money, this is what you get. When you put criminals in the White House for 8 years the rules are off.
    The best brains are not curing cancer or advancing science. The best brains are creating Ponzi Schemes and crushing the government.

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  11. PghMike says:

    Really, all you need to assume is that people in the finance world think “If it’s legal, and it makes us money, then it’s OK.”

    That’s how they’ve always thought. That’s how lawyers in general think. Only a fool would expect that a legal method to pump hundreds of billions of dollars out of the Treasury into various bankers’ hands won’t get used.

  12. Full Stop says:

    Did I miss this one?

    A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50. Just before declaring bankruptcy, CitiJR sells the assets back to Citi for $20. Citi turns around and sells them for $50 on the market and hires back CitiJR’s management ‘team’ as highly paid consultants.

  13. B. Mull says:

    A third party of ex-Citi executives, CitiJR, bid $80 for assets worth $50. Sure enough, two years later they lose their $6.50.

    On the bright side CitiJR managed to re-sale the strongest of the assets and earned $25 before going bust.

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