Thursday, 2 April 2009

Subsidies in the PPIP

The non-recourse loans available to investors as part of Geithner's Public Private Investment Program have been criticized as unnecessary subsidies by Paul Krugman in the New York Times, Jeffrey Sachs in the Financial Times, and today by Peyton Young in another op-ed piece in the Financial Times. A few thoughts:

First, all three authors identify these subsidies as put options, but all three provide simple two-state numerical examples to illustrate the nature and potential magnitudes of these subsidies. They would improve the quality of the debate by attempting to use more realistic examples.

For example, using a simple Black-Scholes model with an implied volatility of 50% per year, I estimate that the 6:1 non-recourse leverage in the Legacy Loan program might increase the value of the loans by a bit more than 10% in the case of a one-year guarantee and a bit more than 20% in the case of a three-year guarantee -- a far cry from Sachs' estimate that taxpayers will "...overpay for banks’ toxic assets, perhaps by a factor of two or more." Of course, there are better models for this purpose than the Black-Scholes model, and Professors Krugman, Sachs, and Young could contribute more to the debate by at least trying to provide more realistic assessments of the values of these subsidies.

Second, the authors don't incorporate the fees that investors will be paying to the FDIC, the Treasury, and the Federal Reserve in at least partial payment for these put options. According to the Treasury Fact Sheet, in the case of the Legacy Securities program “Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral.” In addition, “Lending rate, minimum loan sizes, and loan durations have not been determined.” In the case of the Legacy Loan program, according to the Treasury term sheet, “The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.”

Just as haircuts, fees, and loan rates for home mortgages reflect the non-recourse nature of a mortgage loan, the haircuts, fees, and loan rates in the Legacy Securities and Legacy Loans programs can be set to reflect the non-recourse nature of the loans that are part of these programs. Until we know more about these fees, any judgment about the net magnitude of these subsidies is premature.

Third, the authors fail to comment on an important characteristic of the program that appears to work toward lessening the eventual liquidity in the secondary market for these assets. The investors in the PPIP will receive two assets when they invest: 1) the legacy assets, and 2) the put options provided by the non-recourse nature of the loans from the FDIC, Treasury, and the Fed. But it appears they'll have to relinquish the put options if they later wish to sell these assets in the secondary market.

If the value of the assets increases, the put options will lessen in value anyway, so in this case the issue may not be relevant. But if the asset values don't increase, in which case the put options would still have value, the inability to transfer these put options to subsequent purchasers would be expected to lessen the liquidity that otherwise would exist in the secondary market. Rather than increasing the liquidity of these legacy assets, the subsidies in the PPIP appear as if they might succeed only in a one-time subsidized transfer. Of course, even a one-time transfer may improve matters, but it does run contrary to the stated goal to enhance liquidity for these assets.

Fourth, the embedded put options present an accounting issue for the banks and their regulators. In particular, if assets are transferred from banks to the PPIP at values that reflect the put options provided by the non-recourse loans, should banks be able to use these higher prices to mark the value of similar assets? If so, the banks may be overstating the market values of their assets, which don't contain similar embedded put options. If not, at what prices should these banks mark these assets in light of the PPIP purchases?

At this point, I believe we'd all be better served if the debate focused on: 1) providing more precise estimates of the value of the put options, including fees paid by the investors, 2) the medium-term prospects for liquidity in the secondary market for these assets; and 3) the accounting and capital implications of observed PPIP purchase prices, which include puts for the buyers but not for the selling banks, which are very likely to retain some of these assets.

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