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How to value toxic assets (part 4)

Okay.  First, a correction:  There is (of course) a market for CDOs and other such derivatives at the moment.  You can sell them if you want.  It’s just that the prices that buyers are willing to pay is below what the holders of CDOs are willing to accept.

So, here are a few thoughts on estimating the underlying, or “fair,” value of a CDO:

Method 1. Standard asset pricing considers an asset’s value to be the sum of the present discounted value of all future income that it generates.  We discount future income because:

  • Inflation will mean that the money will be worth less in the future, so in terms of purchasing power, we should discount it when thinking of it in today’s terms.
  • Even if there were no inflation, if we got the money today we could invest it elsewhere, so we need to discount future income to allow for the (lost) opportunity cost if current investment options generate a higher return than what the asset is giving us.
  • Even if there were no inflation and no opportunity cost, there is a risk that we won’t receive the future money.  This is the big one when it comes to valuing CDOs and the like.
  • Even if there’s no inflation, no opportunity cost and no risk of not being paid, a positive pure rate of time preference means that we’d still prefer to get our money today.

The discounting due to the risk of non-payment is difficult to quantify because of the opacity of CDOs.  The holders of CDOs don’t know exactly which mortgages are at the base of their particular derivative structure and even if they did, they don’t know the household income of each of those borrowers.  Originally, they simply trusted the ratings agencies, believing that something labeled “AAA” would miss payment with probability p%, something “AA” with probability q% and so on.  Now that the ratings handed out have been shown to be so wildly inappropriate, investors in CDOs are being forced to come up with new numbers.  This is where Knightian Uncertainty is coming into effect:  Since even the risk is uncertain, we are in the Rumsfeldian realm of unknown unknowns.

Of course we do know some things about the risk of non-payment.  It obviously rises as the amount of equity a homeowner has falls and rises especially quickly when they are underwater (a.k.a. have negative equity (a.k.a. they owe more than the property is worth)).  It also obviously rises if there have been a lot of people laid off from their jobs recently (remember that the owner of a CDO can’t see exactly who lies at the base of the structure, so they need to think about the probability that whoever it is just lost their job).

The first of those is the point behind this idea from Chris Carroll out of NYU:  perhaps the US Fed should simply offer insurance against falls in US house prices.

The second of those will be partially addressed in the future by this policy change announced recently by the Federal Housing Finance Agency:

[E]ffective with mortgage applications taken on or after Jan. 1, 2010, Freddie Mac and Fannie Mae are required to obtain loan-level identifiers for the loan originator, loan origination company, field appraiser and supervisory appraiser … With enactment of the S.A.F.E. Mortgage Licensing Act, identifiers will now be available for each individual loan originator.

“This represents a major industry change. Requiring identifiers allows the Enterprises to identify loan originators and appraisers at the loan-level, and to monitor performance and trends of their loans,” said Lockhart [, director of the FHFA].

It’s only for things bought by Fannie and Freddie and it’s only for future loans, but hopefully this will help eventually.

Method 2. The value of different assets will often necessarily covary.  As a absurdly simple example, the values of the AAA-rated and A-rated tranches of a CDO offering must provide upper and lower bounds on the value of the corresponding AA-rated tranche.  Statistical estimation techniques might therefore be used to infer an asset’s value.  This is the work of quantitative analysts, or “quants.”

Of course, this sort of analysis will suffer as the quality of the inputs falls, so if some CDOs have been valued by looking at other CDOs and none of them are currently trading (or the prices of those trades are different to the true values), then the value of this analysis correspondingly falls.

Method 3. Borrowing from Michael Pomerleano’s comment in rely to Christopher Carroll’s piece, one extreme method of valuing CDOs is to ask at what price a distressed debt (a.k.a. vulture) fund would be willing to buy them at with the intention of merging all the CDOs and other MBSs for a given mortgage pool so that they could then renegotiate the debt with the underlying borrowers (the people who took out the mortgages in the first place).  This is, in essense, a job of putting Humpty Dumpty back together again.  Gathering all the CDOs and other MBSs for a given pool of mortgage assets will take time.  Identifying precisely those mortgage assets will also take time.  There will be sizable legal costs.  Some holders of the lower-rated CDOs may also refuse to sell if they realise what’s happening, hoping to draw out some rent extraction from the fund.  The price that the vulture fund would offer on even the “highly” rated CDOs would therefore be very low in order to ensure that they made a profit.

It would appear that banks and other holders of CDOs and the like are using some combination of methods one and two to value their assets, while the bid-prices being offered by buyers are being set by the logic of something like method three.  Presumably then, if we knew the banks’ private valuations, we might regard the difference between them and the market prices as the value of the uncertainty.

Other posts in this series:  1, 2, 3, [4], 5, 6.

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How to value toxic assets (part 3)

Continuing on from my previous thoughts (1, 2, 3, 4) …

In the world of accounting, the relevant phrase here is “fair value.”  In the United States (which presently uses a different set of accounting requirements to the rest of the world, although that is changing), assets are classified as being in one of three levels (I’m largely reproducing the Wikipedia article here):

Level one assets are those traded in liquid markets with quoted prices.  Fair value (in a mark-to-market sense) is taken to be the current price.

Level two and level three assets are not traded in liquid markets with quoted prices, so their fair values need to be estimated via a statistical model.

Level two assets are those whose fair value is able to be estimated by looking at publicly-available market information.  As a contrived example, maybe there is currently no market for a particular AA-rated tranche of CDOs, but there are recent prices for the corresponding AAA-rated and A-rated tranches, so the AA-rated stuff should be valued somewhere in between those two.

Level three assets are those whose fair value can only be estimated by appealing to information that is not publicly observable.

These are listed in the U.S. Financial Accounting Standards Board (FASB) Statement 157.  In October of last year, the FASB issued some clarification/guidance on valuing derivatives like CDOs when the market for them had dried up.

Brad DeLong, in early December last year, was given a list of reasons from Steve Ross why we might not want to always mark-to-market (i.e. assume that the fair value is the currently available market price):

  • If you believe in organizational capital–in goodwill–in the value of the enterprise’s skills, knowledge, and relationships as a source of future cash flows–than marking it to market as if that organizational capital had no value is the wrong thing to do.
    • Especially as times in which asset values are disturbed and impaired are likely to be times when the value of that organizational capital is highest.
  • If you believe in mean reversion in risk-adjusted asset values, mark-to-market accounting is the wrong thing to do.
  • If you believe that transaction prices differ from risk-adjusted asset values–perhaps because transaction prices are of particular assets that are or are feared to be adversely selected and hence are not representative of the asset class–than mark-to-market accounting is the wrong thing to do.
  • If you believe that changes in risk-adjusted asset values are unpredictable, but also believe:
    • in time-varying required expected returns do to changing risk premia;
    • that an entity’s own cost of capital does not necessarily move one-for-one with the market’s time-varying risk premia;
    • then mark-to-market accounting is the wrong thing to do.

Other posts in this series:  1, 2, [3], 4, 5, 6.

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How to value toxic assets (part 2)

Continuing on from my previous post on this topic, Paul Krugman has been voicing similar concerns (and far more eloquently).  Although his focus has been on the idea of a bad bank (to which all the regular banks would sell their CDOs and other now-questionable assets), the problems are the same.  On the 17th of January he wrote:

It comes back to the original questions about the TARP. Financial institutions that want to “get bad assets off their balance sheets” can do that any time they like, by writing those assets down to zero — or by selling them at whatever price they can. If we create a new institution to take over those assets, the $700 billion question is, at what price? And I still haven’t seen anything that explains how the price will be determined.

I suspect, though I’m not certain, that policymakers are once more coming around to the view that mortgage-backed securities are being systematically underpriced. But do we really know this? And how are we going to ensure that this doesn’t end up being a huge giveaway to financial firms?

On the 18th of January, he followed this up with:

What people are thinking about, it’s pretty clear, is the Resolution Trust Corporation, which cleaned up the savings and loan mess. That’s a good role model, as far as it goes. But the creation of the RTC did not rescue the S&Ls. The S&Ls were rescued by (1) having FSLIC seize them, cleaning out the stockholders (2) having FSLIC pay down enough debt to make them viable (3) reselling them to new investors. The RTC’s takeover of the bad assets was just a way for taxpayers to reclaim some of the cost of recapitalizing the banks.

What’s being contemplated now, if Sheila Bair’s interview is any indication, is the creation of an RTC-like entity without the rest of the process. The “bad bank” will pay “fair value”, whatever that is, for the assets. But how does that help the situation?

It looks as if we’re back to the idea that toxic waste is really, truly worth much more than anyone is willing to pay for it — and that if only we get the price “right”, the banks will turn out to be solvent after all. In other words, we’re still in Super-SIV territory, the belief that fancy financial engineering can create value out of nothing.

Tyler Cowen points us to this article in the Washington Post that describes the issues pretty well.  Again, the crux of the matter is:

The difficulty is that banks think their assets are worth more than investors are willing to pay. If the government sides with investors, the banks will be forced to swallow the difference as a loss. If the government pays what the banks regard as a fair price, however, the markets may ignore the transactions as a bailout by another name.

Tyler Cowen’s own comment:

If the assets are undervalued by the market, buying them up is an OK deal. Presumably the price would be determined by a reverse auction, with hard-to-track asset heterogeneity introducing some arbitrariness into the resulting prices. If these assets are not undervalued by the market, and indeed they really are worth so little, our government wishes to find a not-fully-transparent way to give financial firms greater value, also known as “huge giveaway.”

Right now it seems to boil down to the original TARP idea or nationalization, take your pick. You are more likely to favor nationalization if you think that governments can run things well, if you feel there is justice in government having “upside” on the deal, and if you are keen to spend the TARP money on other programs instead.

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How to value toxic assets

There should really be a question mark at the end of that title.  As far as I can tell, no-one really knows.

I mentioned yesterday that the US government has just given a guarantee to Bank of America against losses in a collection of CDOs and other derrivatives that BofA and the US government agreed were currently worth US$81 billion (the headline guarantee is for $118 billion, but $37 billion of that is cash assets that are unlikely to lose value).

Last November the US government did the same thing for Citigroup, but the numbers there were much larger:  US$306 billion.

The deal with Bank of America is a better one because the $81 billion of toxic assets had to be bundled with $37 billion of cash that will almost certainly create a (small) profit to partially offset any losses.

Nevertheless there is a general question of how they arrived at those numbers given that the market for those assets has dried up:  nobody is buying or selling them, so there aren’t any market prices to use.

The problem is hardly unique to America.  From today’s FT:

[M]inisters and regulators are examining loans already on banks’ balance sheets, which are becoming more impaired as the economy deteriorates. Concern about the eventual size of losses on them is one reason British banks have recently reined in lending.

Final decisions are not expected imminently from the Treasury. But Mr Brown has spoken recently of the problem of “toxic assets” on balance sheets, raising speculation that a “bad bank” solution will be adopted.

The prime minister has also said Britain is looking at different models. These include schemes whereby the government buys up bad assets in return for cash or government bonds; and schemes where banks keep the assets on their balance sheets but the government insures them against loss. The latter method was adopted by the US government this week to shore up Bank of America.

The Bank of England is moving towards the idea of a so-called bad bank, since private sales of bank assets are proving difficult or impossible. But it raises difficult questions: how should assets be valued; should gilts be issued for the purchases; or should money be created.

Mr Darling also notes that a US toxic asset relief scheme proved difficult to launch because of banks’ refusal to sell assets at a price ­acceptable to the government. Offering insurance against future losses on bad assets could prove more attractive.

“The other problem is that the banks haven’t asked us to do this yet,” said one government official. “We would be asking the banks to give us a load of crap and they’d say to us: ‘What are you going to pay us then?’”

The credit crisis will not end until we know which banks are solvent and which are not, and we won’t know that until we know the value of those CDOs.  Despite the fact that they can’t sell them, banks are loath to write them off completely.  Also from the FT today:

With speculation growing that the government will be forced to stage another bank rescue, the prime minister told the Financial Times he had been urging the banks for almost a year to write down their bad assets. “One of the necessary elements for the next stage is for people to have a clear understanding that bad assets have been written off,” he said.

Speaking amid mounting market concerns that banks face further heavy losses, Mr Brown said: “We have got to be clear that where we have got clearly bad assets, I expect them to be dealt with.”

Is it just me, or do you get impression that we’re watching a very expensive game of chicken here?

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The (latest) bailout of Bank of America

Bank of America is being handed a butt-load of cash:

Bank of America will on Friday receive $20bn in fresh capital from the US government and a guarantee on most of a further $118bn of potential losses on toxic assets.

The emergency bail-out will help to cushion the blow from a deteriorating balance sheet at Merrill Lynch, the brokerage BoA acquired earlier this month.
[…]
The package is on top of the $25bn BoA received from Tarp funds last October, and underscores the depth of the financial difficulties affecting the world’s leading banks.

At this point, BofA has received US$45 billion in hard cash and – more importantly, to my mind – a guarantee against US$118 billion of CDOs and related assets that they hold, many of them from their takeover of Merrill Lynch.

I don’t really want to get into whether bailouts in general are worthwhile, or if this one in particular is worthwhile. What I want to rant about is the nature of this bailout and in particular, that guarantee.  It’s been done in a manner highly similar to the one given to Citigroup last year, so my criticism applies to that one as well.

Here is the joint Press Release from the US Federal Reserve, the US Treasury Department and the FDIC.

Here [pdf] is the term sheet for the deal with Bank of America.

The guarantee is against a pool of assets broken down as:

  • US$37 billion worth of cash assets
  • US$81 billion worth of derivatives (i.e. CDOs and other “troubled” assets)

Profits and losses for the pool will be treated as a whole. The fact that one third of the pool is cash (and cash equivalents) will have been insisted upon by the US government because they will almost surely generate at least a minor profit that will offset losses in the derivatives.

In the event of losses on the pool as a whole, BofA will take the first US$10 billion of losses; the US Government will take the next US$10 billion of losses; and any losses beyond that will be split 90/10: the US government will take 90% of them. That gives a theoretical maximum that the US government might be liable for as 10 + 90%*(118-20) = US$98.2 billion.  In all likelihood, though, the cash assets will hold or increase their value, so the maximum that the US government can realistically be imagined to be liable for is 10 + 90%*(81-20) = US$64.9 billion.

But kicker is this: There was no easy way for them to arrive at that number of $81 billion. The market for cash is massively liquid (prices are available because trades are occurring), so it is easy to value the cash assets. The market for CDOs, on the other hand, is (at least for the moment and for many of them, forever) gone. Unless I’m mistaken, there are no prices available to use in valuing them. Even if there were still a market, CDOs were always traded over-the- counter, meaning that details of prices and volumes were secret.

Instead, the figure of US$81 billion is “based on valuations agreed between [BoA] and the US [Government]” (that’s from the term sheet).

I want to see details of how they valued them.

When TARP was first envisaged and it was suggested that a reverse auction might take place, the rationale was for “price discovery” to take place. The idea – which is still a good one, even if reverse auctions are a bad way to achieve it – is that since nobody knows what the CDOs are really worth, confusion and fear reign and the market drys up. Since nobody can properly value banks’ assets, nobody can tell whether those banks are solvent or not.

The generalised inability to value CDOs remains, and will continue to remain, a core issue in the financial crisis.

Suppose that the true value of BoA’s CDOs is US$51 billion. At some point, we will collectively realise that fact. The market will become (at least semi-)liquid again and the prices will, at least approximately, reflect that value. But since the BoA and US government had agreed that they were worth US$81 billion, it will technically look like a $30 billion loss and so will trigger the US government handing $19 billion (= 10 + 90%*(30-20)) to BoA and unlike the $45 billion in direct capital injection, the government will get nothing in return for that money.

Therefore, BofA had an enormous incentive to game the US government. No matter what they privately believed that their CDOs were worth, they would want to convince the Treasury that they were actually worth much more.

The US government isn’t entirely stupid, mind you. That’s why the first $10 billion in losses accrue to BoA. That means that for the money-for-nothing situation to occur, the agreed-upon valuation would need to be out by over $10 billion. On other hand, that means that instead of telling a little white lie, BoA has an incentive to tell a huge whopper of a bald-faced lie in convincing the Treasury.

That is why I want to see details on how they valued them.

Felix Salmon thinks that both Citigroup and Bank of America should be nationalised:

[N]either institution is capable of surviving in its present form much longer. [Hank Paulson and Tim Geithner] should embrace the inevitable and just nationalize the two banks.
…
[T]his isn’t a bank run: Citi and BofA aren’t suffering from liquidity problems. They have all the liquidity they need, thanks to the Fed. The problem is one of solvency: the equity markets simply don’t believe that the banks’ assets are worth more than their liabilities.

The problem being, as I explained above, that nobody knows what the assets are really worth and the market is simply assuming the worst as a precautionary measure.

I’m not yet convinced that they should be fully nationalised. I just don’t think that the government should put itself in a situation where it promises to give them money for nothing in the event that their private valuation turns out to be too high (i.e. the market is correct in believing that they’re worth bugger-all).

Barry Ritholtz wants to know why the heads of Citi and BoA are still there:

Like Citi, the B of A monies are a terrible deal for the taxpayer — not a lot of bang for the buck, and leaving the same people who created the mess in charge.

Organ transplant medicine understands certain truths: You do not give a healthy liver to a raging alcoholic, as they will only destroy the organ via their disease/bad judgment/lifestyle.

In this, I agree with him entirely.

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Individually sub-rational, collectively rational (near equilibrium)

Alex Tabarrok has had an interesting idea.  It’s short enough to quote in its entirety:

Rationality is a property of equilibrium. By this I mean that rationality is habitual and experience-based and it becomes effective as it becomes embedded in the rules of thumb and collective wisdom of market participants. Rules of thumb approximate rational decision rules as market participants become familiar with an economic environment. Individuals per se are not very rational; shift the equilibrium enough so that the old rules of thumb no longer apply and we are likely to see bubbles, manias, panics and crashes. Significant innovation is almost always going to come accompanied with a wave of irrationality. When we shift to a significant, new equilibrium rationality itself is not strong enough to tie down behavior and unmoored by either reason or experience individuals flail about liked naked apes – this is the realm of behavioral economics. Given time, however, new rules of thumb evolve and rationality once again rules but only until the next big innovation arrives.

It seems appealing to me on a first read, but there are plenty of questions to go with it.

There is a language difficulty here.  On one level, an equilibrium is defined by the actions of everybody aggregating to demand and supply in any given instant, so we are always in an equilibrium by definition.  On another level, an equilibrium is a deeper, fundamental attractor that (at least in the short run) exists independently of people’s choices.  In what follows, I will call the first “where we are” and the second “the attractor”.

Why would agents use rules of thumb instead of making decisions on a fully-rational basis?  Is it just because they aren’t entirely rational people (not very satisfying) or are there constraints that induce a fully rational individual to use rules of thumb?

Under what market mechanisms do the individually sub-rational agents aggregate to collectively rational decision-making when we are close to the attractor and – potentially – to collectively irrational decision-making when we are far away from the attractor?

What form of decision rules do the sub-rational (rule of thumb) agents use?  Could we say that agents use taylor-series approximations around the point they believe to be the attractor, with the exact location of the attractor being uncertain?  If so, would it be interesting to imagine that simple agents use first-order (i.e. linear) approximations and sophisticated agents use second-order (quadratic) approximations?

What is the source of uncertainty?  With my example in the previous paragraph, why doesn’t everybody instantly know the new location of the attractor and adjust their rules of thumb accordingly?

How do agents learn?  Could we bypass this question by proposing that agents update their understanding of where the attractor is in a manner analogous to firms setting prices in the Calvo pricing (i.e. a fixed percentage of agents discover the truth in any given period)?

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Negative interest rates on US government debt and Brad DeLong (Updated)

The interest rates on US government debt has turned negative (again) as a result of the enormous flight to perceived safety.  I guess they’ll be able to fund their gargantuan bailouts more easily, at least.

Brad DeLong has written a short and much celebrated essay (available on Cato and his own site) on the financial crisis and (consequently) why investors currently love government debt and hate everything else.  I’ll add my voice to those suggesting that you read the whole thing.  Here is the crux of it:

[T]he wealth of global capital fluctuates … for five reasons:

  1. Savings and Investment: Savings that are transformed into investment add to the productive physical — and organizational, and technological, and intellectual — capital stock of the world. This is the first and in the long run the most important source of fluctuations — in this case, growth — in global capital wealth.
  2. News: Good and bad news about resource constraints, technological opportunities, and political arrangements raise or lower expectations of the cash that is going to flow to those with property and contract rights to the fruits of capital in the future. Such news drives changes in expectations that are a second source of fluctuations in global capital wealth.
  3. Default Discount: Not all the deeds and contracts will turn out to be worth what they promise or indeed even the paper that they are written on. Fluctuations in the degree to which future payments will fall short of present commitments are a third source of fluctuations in global capital wealth.
  4. Liquidity Discount: The cash flowing to capital arrives in the present rather than the future, and people prefer — to varying degrees at different times — the bird in the hand to the one in the bush that will arrive in hand next year. Fluctuations in this liquidity discount are yet a fourth source of fluctuations in global capital wealth.
  5. Risk Discount: Even holding constant the expected value and the date at which the cash will arrive, people prefer certainty to uncertainty. A risky cash flow with both upside and downside is worth less than a certain cash flow by an amount that depends on global risk tolerance. Fluctuations in global risk tolerance are the fifth and final source of fluctuations in global capital wealth.

In the past two years the wealth that is the global capital stock has fallen in value from $80 trillion to $60 trillion. Savings has not fallen through the floor. We have had little or no bad news about resource constraints, technological opportunities, or political arrangements. Thus (1) and (2) have not been operating. The action has all been in (3), (4), and (5).

As far as (3) is concerned, the recognition that a lot of people are not going to pay their mortgages and thus that a lot of holders of CDOs, MBSs, and counterparties, creditors, and shareholders of financial institutions with mortgage-related assets has increased the default discount by $2 trillion. And the fact that the financial crisis has brought on a recession has further increased the default discount — bond coupons that won’t be paid and stock dividends that won’t live up to firm promises — by a further $4 trillion. So we have a $6 trillion increase in the magnitude of (3) the default discount. The problem is that we have a $20 trillion decline in market values.

Some people have criticised Brad for his characterisation of the liquidity discount, suggesting that he has confused it with the (pure) rate of time preference.  I don’t think he is confused.  Firstly because he’s a genuine expert in the field and if he’s confused,  we’re in big trouble; and secondly because the two concepts are interlinked.

The liquidity discount is that an inability to readily buy or sell an asset – typically evidenced by low trading volumes and a large bid/ask spread – reduces it’s value.

The pure rate of time preference is a measure of impatience.  $1 today is preferred over $1 tomorrow even if there is no inflation. [Update: see below]

The two are linked because if you want to sell assets in an illiquid market, you can either sell them at a huge discount immediately or sell them gradually over time.  The liquidity discount is (presumably) therefore a monotonically increasing function of the pure rate of time preference for a given level of liquidity.

Minor update:

A more correct illustration of the pure rate of time preference would be to say:

Suppose that you could get a guaranteed (i.e. risk-free) annual rate of return of 4% and there is no inflation.  A positive pure rate of time preference says that $1 today is preferred over $1.04 in a year’s time.

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Oops …

Well, what do you know?  The US government is (almost certainly) going to buy troubled assets after all, starting with those of Citigroup.  CalculatedRisk has been on top of it [1,2,3,4].  The last of those links contains the joint statement by the Treasury, Federal Reserve and FDIC:

As part of the agreement, Treasury and the Federal Deposit Insurance Corporation will provide protection against the possibility of unusually large losses on an asset pool of approximately $306 billion of loans and securities backed by residential and commercial real estate and other such assets, which will remain on Citigroup’s balance sheet. As a fee for this arrangement, Citigroup will issue preferred shares to the Treasury and FDIC. In addition and if necessary, the Federal Reserve stands ready to backstop residual risk in the asset pool through a non-recourse loan.

In addition, Treasury will invest $20 billion in Citigroup from the Troubled Asset Relief Program in exchange for preferred stock with an 8% dividend to the Treasury. Citigroup will comply with enhanced executive compensation restrictions and implement the FDIC’s mortgage modification program.

Here is a summary of the terms of the deal, with a fraction more detail:

Size: Up to $306 bn in assets to be guaranteed (based on valuation agreed upon between institution and USG).

Deductible: Institution absorbs all losses in portfolio up to $29 bn (in addition to existing reserves) Any losses in portfolio in excess of that amount are shared USG (90%) and institution (10%).

USG share will be allocated as follows:
UST (via TARP) second loss up to $5 bn;
FDIC takes the third loss up to $10 bn;

Financing: Federal Reserve funds remaining pool of assets with a non-recourse loan, subject to the institution’s 10% loss sharing, at a floating rate of OIS plus 300bp. Interest payments are with recourse to the institution.

A couple of points:

  • The US government isn’t immediately buying US$306 billion of crappy assets.  It’s guaranteeing that the value of them won’t fall too much further.  If they do, then they’ll buy ’em.  It will be interesting to see how much of this guarantee is actually called into force.
  • Notice that only US$20 billion is attributable to TARP, while the rest is entirely new.  That is presumably to make sure that the US government can continue to stand by it’s recent promise to not ask for congressional approval for the last US$350 billion available under that program.  On the other hand, I suppose it’s also likely that they want to keep the TARP money for direct capital infusions; that is, for actual money spent now rather than taking on risk.
  • To put the US$20 billion of new money into perspective, Citigroup’s market capitalisation as of Friday was US$20.5 billion.
  • It’s that “on valuation agreed upon between institution and USG” that troubles me.  Part of the reasoning given for TARP in the first place was for “price discovery” (through reverse auctions).  There was plenty of criticism of that policy, but the goal of discovering the true value of all of these assets is a noble one.  This bailout of Citi will now involve private negotiation between Citigroup and the US government to determine their value for the purposes of the guarantee.  That’s a bloody awful way to do it.
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Bush does the right thing

The US$700 billion Troubled Asset Relief Program, otherwise known as the mother of all pork, did have one redeeming feature:  It came in tranches.  The first US$350 billion were directly accessible (some of it needed a signature from the president), but the last US$350 billion needs congressional approval.  With just 10 weeks to go in his Presidency and every company big enough to hire a lobbiest bashing on the doors for a piece of the action, George W. Bush has done the right thing:  He’s deciced to not ask for the last 350.  If soon-to-be-President Obama wants to tap it, it’s up to him.

The Bush administration told congressional aides it won’t ask lawmakers to release $350 billion remaining as part of the $700 billion U.S. financial- rescue package, people familiar with the matter said.
…
The Treasury Department has committed $290 billion, or about 83 percent of the total allocated so far in a program Congress enacted last month to inject capital into a wide spectrum of banks and American International Group Inc. The U.S. invested $125 billion in nine major banks, including Citigroup Inc. and Wells Fargo & Co. and plans to buy an additional $125 billion in preferred shares of smaller lenders.
…
Paulson told the Wall Street Journal today he is unlikely to use what remains of the package, estimated at $410 billion, unless a need arises.

“I’m not going to be looking to start up new things unless they’re necessary, unless they make great sense,” Paulson said. “I want to preserve the firepower, the flexibility we have now and those that come after us will have.”

Update: I don’t mean to suggest that the money shouldn’t be spent. Maybe it should. Professor Krugman, for one, might argue that it ought to be spent as part of a stimulus package. I just think that it’s correct for Bush to pass on deciding how to spend it. His moral authority as an economic leader was gone some time ago. Paulson’s flip-flopping, even if what he has moved to is the better plan, demonstrates the same for him. America will – I suspect – benefit from being forced to take a breather in their cries for help. Let the new team think about the whole mess carefully and then take up the responsibility handed to them.

Another update: The anonymous authors at Free Exchange aren’t so sure it’s a good idea:

It is, in effect, calling time-out on the rescue until Barack Obama is sworn in, and even then there will be a delay while funds are requested and authorised. Meanwhile, Congress has all but decided not to pursue a stimulus bill during the lame duck session. The legislature is taking up discussions on an automaker bail-out, but given resistance to a rescue among Republicans and conservative Democrats, it seems clear that any bill signed into law during the lame duck will be quite weak.

Now, Ben Bernanke will remain on duty right through the inauguration. There’s still an executive branch, and there are still plenty of international policy makers working to stabilise the global financial system. But in a very real sense, America is going to coast on its current economic policies for the next two (and in practice, three) months. I’m not sure this is a good idea, particularly given the critical nature of the holiday shopping season. By all accounts, consumers are locking up their piggy banks at the moment. A disastrous shopping season will probably mean a wave of post-holiday failures among retailers, which will, in turn, mean lay-offs (as well as pain for exporters to America).

Yes, it’s only three months, but three months is a long time for people and businesses struggling to pay bills. And if the economic situation deteriorates over that span, then the government may well feel pressured to pass a much larger and more expensive stimulus package in the spring.

I’m not convinced.  I do note that, as Paul Krugman points out, it’s difficult to have too large a fiscal stimulus in this environment.  I also think that we might benefit from backing off a little bit and abandoning the idea that America and the world at large can somehow escape the recession.  It needs to sink in.

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Power proportional to knowledge

Arnold Kling, speaking of the credit crisis and the bailout plans in America, writes:

What I call the “suits vs. geeks divide” is the discrepancy between knowledge and power. Knowledge today is increasingly dispersed. Power was already too concentrated in the private sector, with CEO’s not understanding their own businesses.

But the knowledge-power discrepancy in the private sector is nothing compared to what exists in the public sector. What do Congressmen understand about the budgets and laws that they are voting on? What do the regulators understand about the consequences of their rulings?

We got into this crisis because power was overly concentrated relative to knowledge. What has been going on for the past several months is more consolidation of power. This is bound to make things worse. Just as Nixon’s bureaucrats did not have the knowledge to go along with the power they took when they instituted wage and price controls, the Fed and the Treasury cannot possibly have knowledge that is proportional to the power they currently exercise in financial markets.

I often disagree with Arnold’s views, but I found myself nodding to this – it’s a fair concern.  I’ve wondered before about democracy versus hierarchy and optimal power structures.  I would note, however, that Arnold’s ideal of the distribution of power in proportion to knowledge seems both unlikely and, quite possibly, undesirable.  If the aggregation of output is highly non-linear thanks to overlapping externalities, then a hierarchy of power may be desirable, provided at least that the structure still allows the (partial) aggregation of information.