One: no. But as one who once designed a C++ class called “PPTPPPPLink”—a choice from which my programming career has never quite recovered—I feel Secretary Geithner’s pain. At least his latest acronyms no longer include words like “Troubled” or remind us of Star Wars villains.
And two: no. At least, not if by “work” you mean “convert our rapidly-disintegrating Rube Goldberg machine into a healthy, stable and productive financial system.” Perhaps this comes as a surprise to you. But probably not.
But a more interesting question is: will the Geithner plan achieve its intended results?
Obviously, the PPIP is a bandaid, not a reboot. Its goal is not to create perfection. Its goal is to stop the hemorrhage. Will the artery finally clot, this time? If you know the answer, you can either make a lot of money, or at least avoid losing one. At least if you’re the sort of fellow who can raise $500 million from your friends at the Palm Beach Country Club. I’m afraid the truth will not help the skells raise any quarters, though. Ah, change.
Unfortunately, my answer is: I don’t know. I can guess, though, and I will.
Let’s start by looking at one common misconception about the Geithner plan. Perhaps by clearing it up we can take our first step toward some small enlightenment.
The misconception I have is that the Geithner plan (and its predecessors in the department of liquidity-enhancing Star Wars villains, from MLEC to TALF) represents a subsidy to the hedge funds and other fat cats who may, or may not, participate in it. The essential Steve Waldman has battered this issue much, most recently here.
One can argue this point, if one is willing to finesse the word subsidy. But for me, a program is not a subsidy unless it can turn loss into profit. This the PPIP cannot do.
If the word subsidy attracts you solely on the basis of its negative connotations, fine. I am happy to admit that the PPIP is a black, reeking horror. And I wouldn’t be surprised if its designers agree. Surely at least they consider it the least of many possible evils.
But, at its bottom, the PPIP is a government loan facility. By definition, no loan can render an insolvent balance sheet solvent. You cannot borrow your way to profitability.
So, as a fairly typical example of the misconception, The New Yorker’s Surowiecki writes:
In fact, it’s essentially the same kind of subsidy that the entire U.S. banking system has depended on for the last seventy-five years. What are FDIC-insured bank deposits, after all? They’re non-recourse loans to banks. You deposit money with a bank—that is, you lend it your money. The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it’s invested.
First, Surowiecki seems confused about the difference between a non-recourse loan and a loan guarantee. The FDIC’s loan guarantee can be seen as a free option, but this option is a gift not to the bank, but to the “depositor.” (I find “deposit,” an English word which connotes the act of putting something somewhere and leaving it there, a dubious euphemism for a zero-term loan—hence the quotes.) The same is true for the PPIP loan guarantee.
A simpler way to model this transaction is that the “depositor” or PPIP bondholder lends to USG, whose credit rating is perfect thanks to its ability to print dollars, and USG then lends to the bank. If the bank fails, USG eats the loss and takes the assets—like any financial intermediary. This accounting interpretation produces exactly the same results. And it involves no funky instruments, just bog-standard vanilla loans.
Again: the PPIP is a loan from USG. Since USG can print infinite dollars, it can loan infinite dollars. But since a loan is neutral on the balance sheet, it is not a subsidy in my doxology.
So—second—consider Surowiecki’s phrasing:
The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it’s invested.
I have seen this explanation a million times. The usual implication is that this represents a one-way bet—a typical case of Wall Street’s practice of “socializing loss, privatizing profit.” And perhaps it does, but not in the obvious sense.
In the obvious sense, the outcomes for the PPIP playa are exactly the same as in any leveraged investment. The most our playa can lose is everything he puts in. Duh. If you make an investment leveraged at 10 to 1, and that investment goes down by 10%, you lose all your money. If it goes up by 10%, you double your money.
This is not a subsidy. It is normal finance. It is true whoever is providing your leverage financing—Goldman Sachs, USG, or your Uncle Ernie. It is true whatever your asset is—Florida swampland, gold, or frozen-concentrated orange juice. The most you can lose is all your money. Again: duh. For what investment is this not true?
While I am not a fund manager, I am quite confident that there is no shortage of leverage for collateralized loans, whatever the asset, on Wall Street today. The cause of deleveraging is not a shortage of leverage, i.e., of prime brokers willing to lend against collateral. While it’s true that many of the “toxic assets” are one-off securities for which establishing a market price is not just a matter of a ticker query, this is why the big boys make the big bucks. Moreover, the spiral of deleveraging has affected quite a few assets which are continuously quoted.
The cause of deleveraging, and of course its result as well, is falling asset prices. More on this in a moment. But suffice it to say: no one at Treasury is stupid. They know this.
So what were the designers of the PPIP thinking? How is this machine intended to work? I was not, of course, in the room, but I am no dummy myself and I think I have it figured out. While my guess is that the PPIP, like its predecessors, will not operate correctly as designed, (a) I could be wrong; and (b) it could produce the desired result through unintended means.
First, let’s review what makes a “toxic asset” toxic.
The prices of any asset X, whether stock, bond or Kewpie doll, is set by supply and demand. But in the Anglo-American financial system, which was invented by God and is so perfect that it has worked the same for over 300 years, banks practice a practice called maturity transformation. MT lets lenders who want to lend at a short or even zero term (such as bank “depositors”) fund loans of a long term (such as mortgages). (“Fractional-reserve banking” is a special case of MT.) Thus, demand for X is magically transmuted into demand for Y.
I.e.: MT creates demand for long-term loans. I.e.: MT raises the price of long-term loans. I.e.: MT lowers the interest rate on long-term loans. I.e.: if MT breaks for any reason, the price of long-term loans falls sharply, and the interest rate rises. This is a “bank run,” “liquidity crisis,” etc., etc., etc.
In a world without MT—i.e., one in which 30-year borrowers are funded by 30-year lenders—a cluster of bad loans (such as NINJA loans to impecunious strippers) would simply result in proportional haircuts to the original lenders.
But when 30-year borrowers are funded by zero-term lenders, falling loan prices force the maturity-transforming bank to sell more loans, receiving present cash with which to meet its zero-term commitments. This lowers the price of these loans, and so on—creating the feedback loop that is the basis of the bank run.
“Toxic assets” are toxic because they are at the business end of a bank run. In a “normal” market, the default risk of a loan can be calculated by comparing its yield to the yield of a risk-free security, such as a Treasury bond, of the same term. The spread between these yields can be assumed to represent the market’s estimate of the probability that the loan will default.
In a bank run, this formula produces nonsense, because it is comparing apples to oranges. The market for toxic assets is simply a different market than the market for Treasuries. The latter contains new demand from maturity-transforming banks. The former does not.
Thus the yield on Treasuries is around 3%, whereas the yield on “toxic assets” excluding default risk (i.e., the yield on an imaginary risk-free toxic asset) is probably something like 20%. The only buyers of toxic waste at the moment are the most patient “vulture” investors. The carcass-to-vulture ratio is quite high, and getting higher. Ergo: supply and demand, baby.
The goal of the various liquidity restoration plans, including PPIP, is to break down the partition between these markets, creating a flood of gigantic profits as sea levels equalize. We are now ready to look at how PPIP is supposed to work.
PPIP is essentially a bank-run-proof leverage facility. The key to PPIP is the difference between PPIP and an ordinary margin loan. As we’ve seen already, the risk-return profile of a PPIP investment is generally no different from that of an ordinary leveraged investment. There is a difference, though, and the difference is in the details.
An ordinary margin loan is a zero-term loan, like a bank “deposit.” Unlike a bank “deposit,” it is completely safe for the lender, even without an FDIC guarantee, because it is continuously marked to market. If you lever up at 10 to 1 to buy an asset on Tuesday, and that asset falls 10% on Wednesday, your broker will instantly and automatically sell the asset to repay the loan. The lender is left with all his money. You are left with squat. (If bank “deposits” worked this way, there would be no such thing as a zombie bank—Citi would be rotting peacefully in the grave.)
So, if you use an ordinary margin loan to lever up and buy toxic assets, and the asset price continues to dive, two things happen. One: you lose all your money, instantly. Two: the asset is sold, putting it back on the market and further depressing the price.
PPIP attacks this in two ways.
First, the PPIP loans are long-term. When you use a normal, zero-maturity margin loan to leverage collateral, say at 10 to 1, you are betting that the price of your asset will never drop by 10%. When you use a PPIP loan, say of 10-year maturity, to leverage collateral, you are betting that the price of the asset will not have dropped by 10% at the end of 10 years. Big difference!
The PPIP leverage can withstand short-term fluctuations; the standard margin loan cannot. Thus, it is not at all unreasonable for Treasury to hope that PPIP will attract buyers who are not, at present, ready to make leveraged bets on dodgy mortgage-backed securities.
Second, if the worst comes to worst and the toxic assets have not recovered even after 10 years, PPIP does not dump them back onto the market. It sells them to Uncle Sam, who buys them with his magic printing press. Thus, there is no feedback-loop spiral of asset dumping, as in the classic bank run.
(By the way, using the phrase “taxpayer dollars” to describe expansion of the Fed’s balance sheet is a horrific abuse of both good English and good accounting. Sorry, Americans: USG does not need your dollars. It can print its own without any trouble at all. It taxes you simply because otherwise, everyone would be too rich, and prices would go up. In other words, the purpose of taxation under a fiat-currency regime is not to finance government expenditures, but to minimize monetary dilution, thus defending the currency as an effective medium of saving.)
So: do I think PPIP will work—as in, achieve its goal of taking the toxic assets off the bank balance sheets and restoring them to ruddy good health? Well, it is certainly not impossible. But no, I don’t think it will work. There are three big problems.
One, PPIP has a long row to hoe in generating enough demand for the toxic waste for the banks to be willing to sell. Banks do not want to sell their toxic assets at the vulture-investor bid, because holding these assets at non-market prices allows them to pretend to be solvent. If the market price is 30 and PPIP demand can get that up to 50, a zombie bank that needs 85 for any kind of solvency will not sell.
Now, one way in which PPIP could work is if banks find a way to use it to buy assets from themselves. If they can bid 90 for their own assets held at 95, PPIP is simply a cover for the obvious solution, which is for the Fed to just buy all the toxic assets from the banks, at prices congenial to the latter. However, I don’t expect this to happen, because this type of Enron scammery normally happens in the absence of public scrutiny. The PPIP could easily work by turning into a fraud, but USG winks at fraud only when no one is looking. Now and for the foreseeable future, the stadium lights are on. I’d be quite surprised if anyone major tries anything funny.
Two, remember our original point: leverage cannot turn losses into profits. If asset prices rise, PPIP investors will make money hand over fist. If they remain durably depressed, as in Japan, PPIP investors will lose their entire investment. If investors anticipate this result, they will not participate in PPIP. If investors do not participate in PPIP, asset prices will remain depressed—absent some more generous program.
Toxic assets tend to be collateralized loans themselves, and the collateral is generally real estate. Falling real-estate prices create defaulting loans. But since all real-estate is bought with loans, we see the vicious circle again. Asset-price deflation has its own momentum.
As the suction of deleveraging feeds through the economy, more and more assets enter the toxic category. Thus: expanding supply. Thus: falling price. PPIP must push uphill against this brutal, unrelenting gravitational suckage. Not an easy task.
Three, the vicious circle is not at all irrational. It is actually quite sensible.
Doug Noland, whose Credit Bubble Bulletin has been reporting on the impending disaster since Jesus was a little boy, calculates that the US economy needs about $2 trillion a year of new lending just to stay in the same place. This is obviously a seat-of-the-pants guess, but it sounds about right to me. Thus all the noise from the great and the good about “restarting the flow of credit,” etc., etc., etc.
If we separate the economy into two consolidated balance sheets—A, the balance sheet of the government and the banking industry; B, the balance sheet of all other industries and households—we feel it is perfectly normal for B to borrow more and more money, every year, from A. But is it?
In fact, when this “flow of credit” ceases, the result is described as a “recession.” And it is certainly quite painful. And when the flow reverses—that’s real pain.
Now: imagine you were considering investment in a business, and that business had borrowed two trillion dollars last year. Or two billion dollars. Or two million dollars.
There are two possibilities. One, the business is in an expansion stage, and is creating equity with negative cashflow. It has a “burn rate.” But it is using this money to make productive long-term investments which will, in time, reverse this and produce a profit.
Two: the business is a dog. It is losing money. It needs to be liquidated or at least restructured. Woof! Sorry, Old Yeller. The time has come to say hello to Mr. Smith and Mr. Wesson.
Which is it? There is no way to know. However, if we discover that the same business has been borrowing money every year, in the same way, for the past decade, we probably have our answer. If it has been bleeding for the past quarter-century… b ehold: Exhibit A.
In this interpretation, the United States, as a whole, is a money-losing operation. The fact that the dollar is a fiat currency has allowed us to disguise this, because fiat currency is essentially equity, and equity can always be diluted. So our losses are funneled into a hemorrhage of new shares, in the classic equity death spiral of the dying corporation. But since USG, unlike most dying corporations, is sovereign, the game can continue indefinitely.
The difference between capitalism and socialism is the difference between profit and loss. It’s not just that money-losing businesses lose money. They also produce crappy goods and services. Once disconnected from the need to make a profit, they lose the tension that makes them perform. There is only one way for a string to be taut, but all kinds of crazy ways for it to be slack.
Nor is the US unique. If there is an economy in the world that does not run a trade deficit with the future, so to speak, I do not know of it. The fact that we think of continuously increasing debt levels as normal is a measure of the 20th-century detachment from reality. Reality just called—it wants its money back.
This structure is especially interesting when juxtaposed with the fact that there are less than 2 trillion actual dollars in the world (M0). How can a company be capitalized at $50 trillion, when its customers have less than $2 trillion to spend? Because the Fed can create new dollars, both explicitly by expanding its balance sheet, and implicitly by issuing formal or informal loan guarantees.
And it does. At least in normal times. But these are not normal times. Owen Glendower could call spirits from the vasty deep. Did they come, when he called? Not as I recall.
The Fed can create new dollars, by the quadrillion. It could buy every slice of pizza on the planet for a hundred dollars each, and abolish the IRS in the bargain. But will it? As we see above, the Fed’s mission is to lend, not buy. And it seems to be having a bit of trouble in doing that. If PPIP fails, does it have the political power to take the next step and straight-out buy toxic waste? With “taxpayer dollars?” I am not sure—not sure at all.
USG can also emit dollars via deficit spending. At present, via the wonders of “quantitative easing,” it is selling bonds for dollars to fund its deficit, then buying those bonds with printed dollars. Net effect: spending printed money. But how much money is USG really capable of injecting into the economy, via all its lightbulb-changers, roof-caulkers and Iowa piglet museums? It’ll take a lot of lightbulbs, even the most sophisticated and environmentally pure, to replace all those home-equity cashouts from 2006.
USG is simply an senescent state. It is so vast, ancient and sclerotic that it has great difficulty in accomplishing the most basic function of government: wasting money. If it cannot continue to produce dollars and spread them around broadly, the spiral of deleveraging continues. Asset valuations that look reasonable in the light of M0 are the only possible backstop.
And if USG can muster the energy to hemorrhage money, it diverts more and more of its productive resources toward the point of the bleeding, and gradually turns into the Brezhnev-era Soviet Union. In case you have difficulty translating “Brezhnev” into English, the word you are looking for is “Dilbert.” Non-profitable businesses become process-oriented, ineffective, and generally insufferable for employees and customers alike. To say nothing of shareholders!
If both these outcomes seem unattractive, perhaps it’s time to consider Plan M. (M—for Moldbug.) I feel it’s essential to accompany all such destructive criticism with a positive proposal, even just a summary. It’s always nice to end on an up note.
The goal of Plan M is to shut down our present financial system and replace it with one that is healthy and stable, preserving relative valuations in a way that is fair to everyone and doesn’t interfere with anyone’s life or work.
A healthy, stable financial system has two main characteristics.
One, it uses a hard currency—one with a fixed or naturally restricted supply. An example of the latter: gold. An example of the former: the numbers from 0 to (24—1).
Two, it exhibits balanced lending—maturity-matched banking. For every private-sector borrower of $X at term T, there is a private-sector lender of $X dollars at term T. I believe this is what is known as a “free market.” Financial intermediaries diversify risk by aggregating loans, but do not systematically violate this constraint. Interest rates at every term are set by this equilibrium, producing a stable yield curve which shifts only with real supply and demand.
The catch is that to convert our present 300-year-old Anglo-American Frankenstein into a healthy, stable financial system, a complete shutdown and reset is required. USG is no more capable of this procedure than I am of jumping to the moon, but we can still talk about it, I hope.
To reset: consolidate all financial securities and their collateral, including real estate, onto the Fed’s balance sheet, at the present market price. The Fed buys all stocks, all bonds, all houses, all commercial real-estate, etc. Automated appraisal tools, à la Zillow, can be used for unique assets. If you own a home, your mortgage becomes rent and your equity becomes cash.
The result is a 14- or 15-figure M0 that includes all former financial assets. Corporate debt disappears, because it becomes debt from the Fed to itself. Same with mortgage debt. If it is necessary to buy votes, unsecured personal loans can be forgiven. Otherwise, they are debts to the government—tax liabilities, essentially.
And all the toxic assets cancel, because they were held by banks whose stock is acquired, and owed by homeowners whose home has been acquired. Again, the Fed owes itself nothing.
Outcome: the citizens of America are sitting on a giant buttload of cash. The Fed is sitting on a giant buttload of real assets. A giant auction is held. Eternal Bolshevism is averted, and life returns to normal. Only better, I suspect.
This dollar pool can either be fixed, producing an ultra-hard fiat currency, or mapped to the nation’s gold reserve. While the former is economically optimal, the latter has numerous political advantages.
Mapping 105 dollars to Fort Knox will produce a much higher gold price than the current value. This is a feature, not a bug. It has the usual effect of currency devaluation, i.e., stimulating economic activity. But the stimulus does not become addictive, because the currency is now hard and will stay that way. There is also a Keynesian effect in which gold mining absorbs a large number of now-unemployed workers. While the production of currency does not create goods and services, from a political perspective it never hurts to get disgruntled people off the street. Gold holders also win big, but they win big in the right way: by being right.
And, of course, a hard gold standard is self-enforcing, whereas a fixed money supply is not that hard to un-fix. Given the 20th-century experience with virtual money, I suspect that it may be another century or two before the snake can tempt Eve again. As Mark Twain said, a cat who sits on a hot stove will never sit on a hot stove again—or a cold stove, either.
While Plan M (which I’ve been proposing for, oh, about the last year and a half) is politically inconceivable, it is an economic no-brainer. At least to me. If you agree, perhaps you should consider what can be done about the political obstacles. America certainly has no shortage of lampposts.