Bond Market Bingo

Today Treasury Secretary Tim Geithner unveiled his plan to save the financial system. The response has been predictable: bankers and Wall Streeters love it, normal people don't understand it, and a sliver of taxpayers with the fortitude to check it out are outraged.

Count me among the latter.

The deal breaks down like this: The government will lend, at minuscule interest rates, several hundred billion dollars to qualified investors who wish to bid on the many insolvent banks' "toxic assets" (In its "fact sheet," the Treasury calls them "legacy assets"). In addition, the government will come in with its own equity investment, partnering with the private money guys. The ratio breaks down like this:

80-85 percent borrowed taxpayer money; 13-16 percent taxpayer cash investment; 3-5 percent private equity = Profits.

The taxpayer loans will be paid back only if the assets bought with the money can be sold at a profit, which the taxpayers and the private investor will share, at about 80-20.

The amount of real private money demanded by Geithner is shockingly small. Basically, investors in the deal will be receiving a 20 percent equity stake for only a 3 to 5 percent investment, all of it backed by sweetheart government financing that effectively leverages the private equity at breathtaking levels. The "private partners" will, in effect, enjoy a 33-to-1 leverage ratio on their upside, with no downside risk. The proposed deal is stunningly similar to the one given to George W. Bush when he invested in the Texas Rangers.

Bush invested about $150,000 and made about $15 million on that deal. Heh heh.

So what's in it for us taxpayers? The stated reason for this whole business is to "get the banks lending again."

But if we taxpayers lend rich guys hundreds of billions to buy the bad bank loans, why not just have the government itself make the loans needed for productive businesses? Why not cut out the middlemen?

The answer: Those middlemen are "the system" Geithner is trying to save.

The system we're saving is not the It's a Wonderful Life system of mortgages for normal people. That system died in the 1980s. The new system is akin to a big casino where rich people get to bet using poor folks' money. That's the system we're saving.

That's why the chatter all weekend about how these "private investors" were worried about how the government might allow populist anger to stain their ties, and might later tax them, or might limit their "executive pay" and all that nonsense.

As the New York Times noted, Obama's people want it known that these rich people are not like the others. They're our friends:

This is the kind of talk that strains credulity. And it opens up another possibility—the horrifying possibility that Obama and Geithner don't know what they're doing.


On reflection, the simplest assessment of Geithner's proposal is that it's designed to shift potential blame from the government. If they rope in these "private investors," and those investors set the prices, then no one can blame the government for overpaying for crap. It's not about the money; it's about shifting the responsibility: political risk arbitrage, in which Geithner and co. pledge $1 trillion of your and my money in order to receive a mere $30 billion of so-called "private capital," which will act as a fig leaf.

Whether Geithner knows what he's doing or not, the result of this kind of deal is predictable. Blogger Mish Shedlock calls the plan a


Assets can appear to be more valuable than they really are, especially when a lot of borrowed money is flooded into a given market. What Geithner is doing, then, is reinflating the asset bubble—at least temporarily. "I seldom agree with Paul Krugman," Shedlock writes. "Yet I am essentially in agreement with Krugman on Geithner's bailout plan."

For months

The Times

' Paul Krugman has suggested we nationalize the insolvent banks like Sweden did in the 1990s or like, well, the United States did with the S&Ls in the 1980s. That deal still gave sharpies a load of money, but it didn't put them in the driver's seat like Geithner's new plan would.

"This is more than disappointing,"

"In fact, it fills me with a sense of despair."

The central error in Obama/Geithner's thinking, says Krugman, is their contention that the "toxic assets" are actually worth much more than the 25 cents or 32 cents on the dollar that has been offered so far. In fact, goes Geithner's theory, the "bad assets" are actually so not-bad that, if they were valued correctly, the banks would have no problems.

Krugman doesn't talk about this, but the error underlying Geithner's theory (if, indeed, he has a theory besides "don't blame me") is the idea that these mortgage-backed securities (MBS) are backed by actual mortgages on actual houses. It's true in some cases. But as

, it's not true in many, many others, because there are these things called "synthetic MBS"—which are simply betting slips. They are derivatives of the real MBS, and they're backed by nothing at all.

The ratio of synthetic MBS to real MBS is unknown. But there is probably several times as much synthetic crap out there as there is real crap, judging by the

at stake.

Felix Salmon at



explains Synthetic Bonds for Dummies.

The important thing he doesn't talk about (someone in the comments got it) is that synthetics introduce a bit of counterparty risk that is not present in the real bond. Until recently, everyone discounted this risk. Today—as AIG has taught us—it's paramount.

So this bailout is not about getting you a better mortgage, and it's not even about getting banks out of trouble. It's about making the counterparties like AIG whole.

Geithner is trying to solve the counterparty risk problem created by the compulsive gamblers. Krugman seems to overlook this; he is puzzled by Geithner's continual re-pitching of this same plan:

Indeed it is. But it looks completely logical once you realize that the "system" they're proposing to save (with your money and mine) is the very system of crazy, non-productive casino gambling that made the mess we're in.

Pissed off yet?

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