Wha? The Banks don't have to honor the auctions (Geithner plan and price discovery)

[Kurt_and_Hunter]

One of the chief defenses of the Geithner plan is that though it won't be super effective it represents an advance in the much needed process of price discovery on the obscure and unpredictable assets that weigh down bank balance sheets.

If that were true it would indeed be useful. But since the entire price discovery framework is based on paying people to offer prices they would never offer if you were not paying them to do so it's kind of silly. BUT at the very least it offers a framework that will result in sales at "market" prices, right? Even that is better than nothing.

Whoops! Not so fast... Here is the process. Banks contact the FDIC to offer assets of the bank's choosing for auction. This is entirely voluntary on the part of the banks. All that stuff about how this will allow examination of the banks' assets is nonsense. The FDIC already knows everything there is to know about these banks assets except how they will perform, which nobody knows. And there is no aspect of the Geithner plan that compels any bank to disclose anything whatsoever. Turning things over to the FDIC for auction is voluntary on an asset by asset basis.

But even that might lead to some sort of pricing which is better than nothing.

So imagine my surprise to read that the banks do not have to sell at the auction price. After the auction is held the bank can go through lot-by-lot and pick which offers the feel like accepting.

This makes the term "auction" something of a fraud. Auctions are unique because "acceptance" (as in "offer and acceptance") has already happened. Once the auction begins the seller has accepted an offer yet to be determined. All parties agree to that in advance. In an unreserved auction if the crown jewels are hammered own at $5.00 then somebody got the crown jewels for $5. In a reserved auction there is a secret minimum bid, the "reserve", known to the auctioneer and the consignor, but not the bidders. But it is still set before the fact. The seller cannot (legally) change the reserve during the auction. Any bid that hits the reserve constitutes a sale... not an offer, a SALE.

But it turns out that these Geithner "auctions" are not even reserved... they are not auctions at all! They are just solicitations of bids with no obligation to accept any bid at any price. The seller looks over the bids after the fact and decides whether he feels like accepting any of them.

Worst... price discovery frame-work... ever.

Gaming the Legacy Loan Auctions

I finally got a chance to read through the PPIP plan in detail. I noticed one curious point: under the program as announced, auctions for the legacy loans do not appear to be binding on the contributing entity.

The Process for Purchasing Assets Through The Legacy Loans Program: Purchasing assets in the Legacy Loans Program will occur through the following process:

Pools Are Auctioned Off to the Highest Bidder: The FDIC will conduct an auction for these pools of loans. The highest bidder will have access to the Public-Private Investment Program to fund 50 percent of the equity requirement of their purchase.

Financing Is Provided Through FDIC Guarantee: If the seller accepts the purchase price, the buyer would receive financing by issuing debt guaranteed by the FDIC. The FDIC-guaranteed debt would be collateralized by the purchased assets and the FDIC would receive a fee in return for its guarantee.

This is quite odd, since, if I read it correctly, it turns the entirety of the program into a put option for participating banks. That is, they could identify certain assets, put them up for auction seemingly risk-free, check the result, and reject anything below their internal valuation without any further capital contribution.

The structure, which seems to be confirmed by the term sheet (”Once a bid(s) is selected, the Participant Bank will have the option of accepting or rejecting the bid within a pre-established timeframe”), amplifies the lemons problem that Simon and James mention in their LA Times op-ed. If the plan revolved around binding auctions, a temporary market for the toxic assets could develop while investors make government-guaranteed “probing” bets on the precise toxicity of the assets for sale. If banks wanted the auctions to recur instead of being a one-time event (perhaps to sell a larger or more diverse set of loans), they might mix in some good assets with the bad ones. This move would assuage concerned investors and probably make it easier for the banks to get approval from their regulators for the particular sale. Investors who were smart/lucky enough to win the good assets with bids below their “worth” to the bank on a medium-term basis would then get to profit from their decision. Other buyers would want to follow suit, at least until the point in time when they would expect a bank to cash out on any previously established confidence with a large offer of only toxic securities that would earn a lot of money even in the absence of future auctions.

By contrast, if banks can selectively reject bids, they could offer an enticing mix of good and bad assets (say, 50/50) and then accept only the ones that grossly overpay for the bad ones. That is, they would get full power to exclude intelligent, accurate price setters from the auction process, undermining the efficacy of the program to an even greater extent than adverse selection would in a committed-sale context. Of course, it is not clear whether the current setup is objectively worse than the repeated-game lure-and-hook scenario, but the question is worth considering.

http://baselinescenario.com/2009/03/29/gaming-the-legacy-loan-auction/

[Kurt_and_Hunter]

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