In my last post, I compared the US and the EU approach to the post-2008 banking crisis, suggesting that Europe perpetuates the zombie state of its banks. Here are relevant extracts from Chapter 7 of my forthcoming Global Minotaur:
With a little help from my friends: The Geithner-Summers Plan
If Crises are the future’s laboratories, the chief experimenters who try out different ‘treatments’ play a central role in the outcome. Following the Crash of 2008 such experiments shaped its aftermath; what I called bankruptocracy. No better example can be had of these audacious experimental methods than the famous Geithner-Summers Plan.
Failure pays
Nothing perseveres like privilege’s determination to reproduce itself. During the Global Minotaur‘s days Larry Summers (President Clinton’s Secretary of the Treasury) gave the green light to the complete deregulation of Wall Street. At the time Timothy Geithner was his Undersecretary. So, who was to be summoned to clean up the mess they had a major hand in creating when President Obama came to power eight years later? Summers and Geithner of course! The explanation? Who else could be trusted with such a big job and all the privileges it brought to its bearers? Once capitalism grows sufficiently complex, failure pays. Every crisis boosts the incumbent’s power because they appear to the public as the only good candidates for mopping up the mess. The trouble is that the ‘solutions’ implemented by the original creators of the problem create even more centralisation and complexity which, in turn, further boosts the culprits’ indispensability…
The Geithner-Summers Plan started life in February 2009 and constituted President Obama’s $1 trillion package for saving the banks from the worthless CDOs in which they were drowning. The problem with an asset that no one wants to buy is that it has no… price. The honest thing to do would have been to force the banks to write the CDOs off as bad investments. But if their did that, their losses would greatly exceed their assets and all banks would have to file for bankruptcy.
One solution would be to have the taxpayer, or the Fed, ‘buy’ these ‘assets’ at made up prices that would be just high enough to prevent across the board bank failures. This what Secretary Paulson had in mind, albeit never secured enough money from Congress to implement. So, after the change of government, the ball fell in Geithner’s and Summers’ court. And they decided that they would try something new out; a brilliant idea that would create a marketplace for these defunct CDOs and save the taxpayer the cost of bailing the banks out, again.
Their idea was simple: To set up, in partnership with banks, hedge funds, pension funds etc. a simulated market for the toxic CDOs that would yield simulated prices which could, then, be used to re-write the banks’ accounts. Here is how it was meant to work: Suppose Bank B owns a CDO, let’s call it c, that B bought for $100, of which $40 was B‘s own money and the remaining $60 was leverage (i.e. a sum that B somehow borrowed in order to purchase c). B‘s problem is that, after 2008, it cannot sell c for more than $5. Given that its vaults are full of such CDOs, if it sells each below $60, it will have to file for bankruptcy, as the sale will not even yield enough to pay its debt of $40 per CDO (i.e. a case of negative equity). Thus, B does nothing, holds on to c, and faces a slow death by a thousand cuts as investors, deterred by B‘s inability to rid itself of the toxic CDOs, dump B‘s shares whose value in the stock exchange falls and falls and falls. Every penny the state throws at it to keep it alive, B hoards in desperation. Thus, the great bail out sums given to the banks never found their way to businesses that needed loans to buy machinery or customers that want to finance the purchase of a new home. And this made a bad recession worse.
Enter the Geithner-Summers Plan which created an account, let’s call it A, that could be used by some hedge or pension fund, call it H, to bid for c. Account A would amount to a total of, say $60 (the lowest amount that B will accept to sell c at) as follows: Hedge fund H contributes $5 to A and so does the US Treasury. The $50 difference comes in the form of a loan from the Fed.[1] The next step involves the hedge or pension fund, our H, to participate in a government organised auction for B‘s c; an auction in which the highest bidder wins c.
By definition, this auction must have a reservation (or minimum) price of no less than $60 (which is the minimum B must sell c for if it is to avoid bankruptcy). Suppose that H bids $60 and wins. Then B gets its $60 which it returns to its creditor (recall that B had borrowed $60 to buy c in the first place) and, while B loses its own equity in c, it lives to profit another day. As for hedge fund H, its payout depends on how much it can sell c for. Let’s look now at two scenarios; a good and a bad one for H.
In the good scenario case, hedge fund H discovers that, a few weeks after it purchased c for $60 (to which it only contributed $5), its value has risen to, say, $80, as the simulated market begins to take off and speculators join in. Of that $80, H owes $50 to the Fed and must share the remaining equity ($30) with its partner, the US Treasury. This leaves H with $15. Not bad. A $5 investment became a $15 revenue. And if H purchases a million of these CDOs, its net gain will be a cool $10 million.
In the case of the bad scenario, H stands to lose its investment (the $5) but nothing beyond that. Suppose, for instance, that it can only sell CDO c, which it bought for $60 using account A, for $30. Then, H will still owe $50 to the Fed on a revenue of only $30. Normally, it would be $20 out of pocket (as would the Treasury). However, the $50 loan by the Fed to H is what is known as a non-recourse loan; which means that the Fed keeps the money from H‘s sale of c but has no way of getting the rest of its money (the $20 of outstanding loans) back from H.
In short, if things work out well the fund managers stand to make a net gain of $10 from a $5 investment (a 200% return) whereas if they do not they will only lose their initial $5. Thus, the Geithner-Summers Plan was portrayed as a brilliant scheme by which the government encouraged to hedge and pension fund managers to take some risk in the context of a government designed and administered game that might work; one in which everyone wins – the banks (who would have rid themselves of the hated CDOs), the hedge and pension funds that would make a cool 200% rate of return, and the government which would recoup its bail out money.
It all sounds impressive. Until one asks the question: What smart fund manager would predict that the probability of the good scenario materialising is better than around one third?[2] Who would think that there is more than one chance in three that the duff CDO would sell for more than $60, given that now no one wants to touch the toxic CDO for more than $5 now? Who would participate in this simulated market? Committing $1 trillion to a program founded on pure, unsubstantiated optimism seems quite odd.
Were Tim Geithner and Larry Summers, two of the smartest people in the US administration, foolhardy? Of course not.[3] Their Plan was brilliant but not for the stated purpose. While its stated purpose was to motivate hedge and pension funds to buy the banks’ burnt out toxic money, the CDOs, a closer look, as we just saw, reveals that prudent hedge and pension fund managers would not play any part in it. So, did Geithner and Summers not know that? Of course they did. Who, then, did they count on to bid for the banks’ toxic derivatives, if the hedge and pension funds were certain to stay away? The ground-shattering answer is: The banks themselves!
Here is what was really intended (and, unsurprisingly, happened): Consider Bank B again. It is desperate to get CDO c off its balance sheet. The Geithner-Summers Plan then comes along. Bank B immediately sets up its own hedge fund, H’, using some of the money that the Fed and the US Treasury has already lent it in a previous bail out. H’ then partakes of the Plan, helps create a new account A’, comprising $100 (of which H’ contributes $7, the Treasury chips in another $7 and the Fed loans $86) and then immediately bids $100 for its very own c. In this manner, it has rid itself of the $100 toxic CDO once and for all at a cost of only $7, which was itself a government handout![4]
It was a devilish plan for allowing the banks to get away with figurative murder. However, the significance of the subterfuge in the Geithner-Summers Plan goes well beyond its ethical or even fiscal implications. The Paulson Plan that preceded it was a crude but honest attempt to hand cash over to the banks no-questions-asked. In contrast, Geithner and Summers tried something different: to allow Wall Street to imagine that its cherished financialisation could rise Phoenix-like from its ashes on the strength of a government-sanctioned plan for creating new derivatives; new forms of private money underwritten by taxpayers’ public money.
In essence, the administration allowed the Global Minotaur‘s staunchest and ugliest handmaiden to make a mighty come back after the beast’s fall from grace. It was only one move of many that politicians made along a path which, ironically, led them to their own disempowerment. By arming the hand of the bankrupt banks, they deprived themselves of any serious room for effective policy making. Once Wall Street’s powers had been restored, politics lost its capacity to rein in the ongoing Crisis.
Europe’s version of the Geithner-Summers Plan
Europe’s Crisis, which comes into its own in the next chapter, has its own special peculiarities. However, it is instructive to take a quick look at the incredible hold that the toxic derivatives had over the imagination of European institutions. In a continent that was, purportedly, scornful of American-sourced CDOs, it is fascinating to find that, when the European Union (EU) decided to create a loan facility for its fiscally stressed member-states (e.g. Ireland, Portugal, Spain), it found its inspiration in the structure of the dreaded CDOs.
In May 2010 the EU created a so-called Special Purpose Vehicle (SPV). Its purpose to borrow on behalf of solvent eurozone countries and lend to the rest who had been frozen out of the money markets, thus avoiding defaults on state debts that would have decimated the banks which, in turn, had loaned large amounts to these states.
The SPV, later named EFSF (the European Financial Stability Facility), was meant as a temporary fund. As the euro crisis deepened, it was decided that it would evolve, by 2013, into a permanent institution called EFSM (the European Financial Stability Mechanism). The idea was to borrow, on behalf of the eurozone, €440 billion to be lent to the illiquid, and possibly, insolvent members-states.[5]
Two features of the EFSF make it a fascinating example of bankruptocracy. The first feature, into which I delve in the next chapter, is that the EFSF is raising money to bail out not Ireland, Portugal etc. but Europe’s failing banks. The second feature, which is more pertinent here, is that the EFSF is borrowing money by issuing toxic eurobonds. That is, bonds that are structured in a manner identical to the errant CDOs of yesteryear.
Recall how Wall Street’s CDOs bundled together slices of different mortgages (prime and subprime ones), each bearing different interest rates and default risks. And, moreover, that the mix was truly toxic, or explosive, because if one slice within a given CDO went bad (e.g. Jack defaulted on his loan), that increased the risk of a default by the next slice (e.g. Jill would default because her chances of losing her job, and defaulting, increased when Jack lost his job and home).
Similarly with the EFSF bonds issued, for example, for lending to the Irish state which, in December 2010, came to verge of bankruptcy, having failed to find the money to repay, as promised, its private banks’ debts. The EFSF loans for Ireland were raised from the money markets by the EFSF on the strength of guarantees issued by the remaining 15 eurozone states, in proportion to their GDP (17 member-states minus Greece, which had already been frozen out of the marketplace in May of 2010, minus Ireland). The total sum raised was then cut up in small ‘packets’, each containing a slice that was guaranteed by Germany, another slice by France, another by… Portugal. Now, given that each country had different degrees of creditworthiness, each was charged a different interest rate. Lastly, these ‘packets’ were sold off as bonds, mostly to Asian investors and Europe’s own (quasi-bankrupted) banks.
Now, suppose what happens if Portugal too is forced to exit the money markets, just like Greece and Ireland did before. One reason why this may well happen (if it has not happened already, by the time you are reading this), is the very fact that Portugal, already on the verge, was just forced to borrow, at high interest rates, on Ireland’s behalf! Speculators may well buy CDSs, that will pay them if Portugal defaults, and the rise in the price of these CDSs may push the interest rates Portugal must pay for new loans to a level that is unsustainable. Thus, Portugal goes to the EFSF cap in hand!
The EFSF will then have to issue new debts, on behalf of the remaining eurozone countries, to help Portugal. This means that, with Portugal out of that group, a greater burden will be shared by the 14 countries remaining to guarantee the EFSF’s bonds. How will markets react? By focusing immediately on the new ‘marginal’ country: the one that is currently borrowing at the highest interest rates within the EFSF in order to loan the money to Greece, Ireland and, now, Portugal: Spain! At once, Spain’s own interest rates will rise until Madrid is also pushed out of the markets. Then there will be 13 countries left to borrow of EFSF’s behalf and the markets will focus on the newer ‘marginal’ country. And so on, until the band of nations within the EFSF is so small that they cannot bear the burden of total debt on their shoulders (even if they wish to).
In the next chapter I employ the metaphor of a group of stricken mountaineers, held together by a single rope, and falling off the mountain’s face one after the other until the strongest members also fall, unable to withstand the weight of all the rest. Seen through this prism, the EFSF’s brief begins to look desperate. Its bonds have bundled together different kinds of guarantees (offered by each individual state) in ways that remain woefully opaque. This is precisely how the CDOs came to life prior to 2008, featuring two deadly sins:
First, structuring the EFSF bonds like the CDOs that caused such problems for the world economy seems, at the very least, careless. One immediate repercussion of its CDo-reliance is that the EFSF must borrow €440 but only hand over loans worth at most €250. The remaining €220 billion must sit idly by gathering dust! Why? Because investors know that the bonds they are buying are toxic and will only buy them if the EFSF keeps a lot of money on hold to repay them in case of a default by Portugal or some other eurozone member-state. It is, in short, a highly inefficient way of pooling debts.
Secondly, this type of political intervention, just like the Geithner-Summers Plan in the United States, not only absolved the principle of CDOs (and by extension its Wall Street progenitors) but, more importantly, allowed banks, insurance companies, hedge funds etc. to create new forms of private money. Like the Crash of 2008 had never happened! In the United States, we already saw how the Geithner-Summers Plan created new derivatives and, thus, pumped new private money, underwritten by good old public money, into Wall Street. In Europe, something equally sinister occurred.
When it became clear that EFSF-style interventions to bail out countries like Greece and Ireland would be financed by toxic eurobonds, and given that the markets were not convinced for one moment that they would, in the end, effectively deal with these states’ solvency issues, banks and hedge funds grasped with both hands the opportunity to turn the uncertainty about the euro into another betting spree. This is precisely what they did: They took out bets, in the form of CDSs, against European member-state bonds (e.g. Greece’s, Ireland’s, Spain’s, Italy’s). In the end, both the toxic EFSF eurobonds and this voluminous output of fresh CDSs constitutes a new round of unsustainable private money generation. When the latest pile of private money turns to ashes too, as it certainly will, what next for Europe?
[1] The Treasury’s equity contribution of the $5 would actually come from something called TARP (the Troubled Assets Relief Program) whereas the Fed’s $50 would come from the FDIC (the Federal Deposit Insurance Corporation founded by the New Dealers, as part of the Glass-Steagall Act of 1933, in order to guarantee to depositors their saving in case of a bank failure). The Geithner-Summers Plan set aside $150 billion for TARP, $820 billion for FDIC and expected the private sector (hedge and pension funds) to chip in $30 billion of their own money.
[2] If the good scenario materialises, H‘s net equals $10. If the bad good scenario materialises, H’s net returns are -$5. The ‘distance’ between these two numbers is $15. Should it take part in this simulated market gain? Simple calculation suggests that H stands to gain only if the probability of the good scenario is better than the possible loss ($5) divided by that ‘distance’.
[3] Henry Kissinger reportedly once said that Summers “…ought to be given a White House post in which he was charged with shooting down or fixing bad ideas.”
[4] Moreover, if by some miracle its subsidiary H’ can sell c for more than $100, it will stand to gain an extra sum.
[5] The plan was that the EU’s own budget would chip in another €60 billion and the IMF a further €250 from the IMF, bringing the total package up to €750 billion.
