An idea for the 'toxic waste' problem
But these assets have a kind of information asymmetry problem. The bank says, "How about $1 million for this asset." The buyer says, "I'll give you $50,000." The bank says, "Why so little?!" The buyer says, "I don't believe you that it's worth $1 million!" The bank says, "Well, we paid this gentleman in a suit over here to put an AAA price tag on it! Of course it's worth $1 million!" And the buyer says, "Yeah right" and walks away. The idea is that the bank knows more than the buyer about these assets, so the mere fact that it is trying to sell them is a signal that you shouldn't buy them at all. This is kind of like the lemon car problem: if you don't trust the used car salesman, the fact that he is selling the car at all is a red flag.
But what if the banks had to do the following thing. They parcel out all their mortgage-related securities into bundles. At that point, some public and some private parties (or perhaps partnerships somewhat similar to those envisioned by the Geithner plan) say how much they'll pay per bundle. The trick is that only some bundles can be sold, but they all have to be sold for the same price, and furthermore, the order of choosing is the following: first the government picks its bundles, then the private investors pick theirs, and then the bank keeps the rest.
This would create an immensely powerful incentive for the banks to create bundles of precisely equal value: since they go last in picking the bundles, they had better make them all identically valued. This is like splitting cake between two kids: you have the first kid cut the cake, then the other kid choose the first piece. This makes the first kid very, very careful to cut equal pieces.
So if the bank made unequal bundles, then the private parties and public parties would underbid, take the most valuable ones, and leave the trash for the bank. The government's leverage works like this: it relies on the private participants to set price, but it goes first in picking. Perhaps it simply picks at random. Then the private party is incentivized to bid an accurate price -- if it bids too much (on the theory it'll just grab the sweet bundle), the sweet bundle may simply disappear. (Competition is intended to make the bids not be too small.) The leverage is that the government buys 10 bundles for every 1 bundle private parties buy.
In terms of cake, this works like this: the bank has the cake, we want to give them a fair price for the cake to reduce the uncertainty in their balance sheet. The problem is, no-one will buy a piece of cake because they're worried that some pieces have no filling, and the bank knows how to cut slices with no filling, and will just sell you those. So the market for cake freezes. Furthermore, the cake is simply too big for anyone to buy up the whole thing, which would ensure that they don't get cheated. The government could buy the whole cake, but has no idea what it should pay. So what we do is make the bank cut 16 slices of cake, then ask private parties to bid for the right to get two or three slices. The government then buys 10 slices at the market price. The government picks 10 slices at random. The private parties get their pick of another two or three, and the bank selling cake gets the remaining couple.
As a side benefit, now that there's an agreed-upon price for these slices, a) the bank can write down whatever losses it took on the cake, b) it just got a fat roll of cash, c) it can now sell it's own slices on the market as bundles, or re-bundle the remaining assets and repeat the trick.
This would undoubtedly leave some banks bankrupt. (It is analogous to the 'stress test' that's been proposed by the Treasury.) Those can be taken over and basically nationalized and dealt with. Those who survived to tell the tale would have accurate balance sheets that counterparties could trust, and credit in theory would be available.
The bottom line? Taxpayers are exposed to the same risks and getting the same performance from their portfolio as the hedge funds and private equity that bought the bundles from the banks. Even if bank employees who have inside information quit and join the hedge funds to cheat, the fact that the government picks first and at random, and that the banks go last, leaves very powerful incentives for the banks to make the bundles as even as they know how. ¶ 11:11 PM
Tuesday, March 24, 2009
So there's a problem with our banks. They have assets that are troubling them. They're troubling because they are illiquid, resulting in a lock-up of credit and a general mistrust in each other's ability to pay. If you think the other bank has a 1% chance of failing tomorrow, letting them hold your money is crazy.
But these assets have a kind of information asymmetry problem. The bank says, "How about $1 million for this asset." The buyer says, "I'll give you $50,000." The bank says, "Why so little?!" The buyer says, "I don't believe you that it's worth $1 million!" The bank says, "Well, we paid this gentleman in a suit over here to put an AAA price tag on it! Of course it's worth $1 million!" And the buyer says, "Yeah right" and walks away. The idea is that the bank knows more than the buyer about these assets, so the mere fact that it is trying to sell them is a signal that you shouldn't buy them at all. This is kind of like the lemon car problem: if you don't trust the used car salesman, the fact that he is selling the car at all is a red flag.
But what if the banks had to do the following thing. They parcel out all their mortgage-related securities into bundles. At that point, some public and some private parties (or perhaps partnerships somewhat similar to those envisioned by the Geithner plan) say how much they'll pay per bundle. The trick is that only some bundles can be sold, but they all have to be sold for the same price, and furthermore, the order of choosing is the following: first the government picks its bundles, then the private investors pick theirs, and then the bank keeps the rest.
This would create an immensely powerful incentive for the banks to create bundles of precisely equal value: since they go last in picking the bundles, they had better make them all identically valued. This is like splitting cake between two kids: you have the first kid cut the cake, then the other kid choose the first piece. This makes the first kid very, very careful to cut equal pieces.
So if the bank made unequal bundles, then the private parties and public parties would underbid, take the most valuable ones, and leave the trash for the bank. The government's leverage works like this: it relies on the private participants to set price, but it goes first in picking. Perhaps it simply picks at random. Then the private party is incentivized to bid an accurate price -- if it bids too much (on the theory it'll just grab the sweet bundle), the sweet bundle may simply disappear. (Competition is intended to make the bids not be too small.) The leverage is that the government buys 10 bundles for every 1 bundle private parties buy.
In terms of cake, this works like this: the bank has the cake, we want to give them a fair price for the cake to reduce the uncertainty in their balance sheet. The problem is, no-one will buy a piece of cake because they're worried that some pieces have no filling, and the bank knows how to cut slices with no filling, and will just sell you those. So the market for cake freezes. Furthermore, the cake is simply too big for anyone to buy up the whole thing, which would ensure that they don't get cheated. The government could buy the whole cake, but has no idea what it should pay. So what we do is make the bank cut 16 slices of cake, then ask private parties to bid for the right to get two or three slices. The government then buys 10 slices at the market price. The government picks 10 slices at random. The private parties get their pick of another two or three, and the bank selling cake gets the remaining couple.
As a side benefit, now that there's an agreed-upon price for these slices, a) the bank can write down whatever losses it took on the cake, b) it just got a fat roll of cash, c) it can now sell it's own slices on the market as bundles, or re-bundle the remaining assets and repeat the trick.
This would undoubtedly leave some banks bankrupt. (It is analogous to the 'stress test' that's been proposed by the Treasury.) Those can be taken over and basically nationalized and dealt with. Those who survived to tell the tale would have accurate balance sheets that counterparties could trust, and credit in theory would be available.
The bottom line? Taxpayers are exposed to the same risks and getting the same performance from their portfolio as the hedge funds and private equity that bought the bundles from the banks. Even if bank employees who have inside information quit and join the hedge funds to cheat, the fact that the government picks first and at random, and that the banks go last, leaves very powerful incentives for the banks to make the bundles as even as they know how. ¶ 11:11 PM
