Alice in Bankland

In a world awash in acronyms, PPIP is just another side show in the rodeo. It stands for Public/Private Investment Partnership. Who cares? Except this innocuous sounding scheme, hatched by Obama’s financial czar Larry Summers and Treasury Secretary Tim Geithner had the potential of further bankrupting the American taxpayer in an effort to re-inflate the banking bubble. The plan involved doing quadruple by-pass surgery to balance sheets of superbanks, but with a twist. In this operation, the risk was not to the patient (the banks) nor to the surgeons (The Fed and the Treasury) but to the person who pays for the insurance (the public). But you don’t have to worry about it any more. The plan died on the table before the operation began.

Still it’s instructive to pull this apart as a stark reminder that the fantasy economy remains in la-la land. Here’s what happened. After the music stopped, the banks ended up with trillions in toxic assets. So many trillions, that many of Americas largest banks, even though they had huge assets, had even huger losses. They were close to insolvency or maybe even way over the line. We will never really know. But it all depends on how you tally the balance sheet. If you want to live to play another day, you do anything you can to pretend the losses really don’t exist. To do that, you must somehow hide the toxic assets from the balance sheets. Then you hope like hell something substantial will magically happen to erase them.

PPIP was that white night, created by the government just for that purpose. The government and the banks have a similar MO. For the banks, it’s more important to create a quarterly report that will maintain the illusion of prosperity than to peck away at the slow plodding work of long term viability. And the government has exactly the same agenda.

This is how it was supposed to work: The banks would remove the troubled assets from their balance sheets and put them up for auction. The auction price would be paid thusly: 7.5% from private investors, 7.5% from government (taxpayer) funds, and 85% from a loan from the FDIC. If the assets prove to be worth more, the private investor and taxpayer portion could pay out at 2:1, 3:1, even 4:1. They would then pay out the FDIC loan. If it turns out to be a bust, everyone walks away from the table with nothing and the FDIC owns the mess.

What’s wrong with this picture? The FDIC is ultimately backstopped by the taxpayer, so, in this highly leveraged investment, (weren’t we supposed to quit those?) the private investor has 7.5% of the risk and the taxpayer has 92.5% of the risk, but for the same potential payout.

A sucker’s deal all the way. In fact, with this set up, there is a very real risk of the private investor over bidding, since the risk is so small the potential reward so great. According to financial expert Peyton Young, “the more aggressively investors compete in bidding for these assets, the worse off the taxpayer will be”.

So the bank walks away with a good payout on their previously almost worthless toxic assets. Oh, sorry, we are calling them “legacy” assets now. Another nice perk for the banks is that they would get transaction fees as both the buyers' and sellers' agents. The banks liked the idea so much they lobbied to be able to bid on the assets themselves, essentially buying back their own assets at pennies on the dollar. According to Joe Wiesenthal of the Business Insider, “Having no shame, the only way the PPIP appeals to them is if they can use it for straight up money laundering.” Plenty of other highly regarded economists publicly expressed shock, including Nobel economist Paul Krugman, former World Bank chief Economist Joseph Stiglitz, and former IMF Chief Economist Simon Johnson.

But a funny thing happened on the way to the operating table: The patient got cold feet. A number of things substantially changed between idea and implementation. One problem was pegging an actual value for these hard to price assets. That would make it very difficult for the banks to pretend the assets were worth much more, and also would expose thier hand to other players. Also, the banks were able to raise billions in private capital, reducing the need to unload assets. Mostly because private investors were realizing the government would do anything, risk any amount of money, to make sure the superbanks came out smelling like a rose.

Instead of this meltdown punishing the big banks for engaging in foolishness, and rewarding the smaller banks who didn’t, it is exactly the other way around. Mostly the bailed out banks survive and smaller banks don’t because in this plan, winners and losers are chosen by the government. Competition in the banking sector is reduced, and the big banks remain “too big to fail”. You talk about your “moral hazard.” The incentive to step back from the brink of excessive risk is gone.

Another thing was the reversal of the “mark to market” rule. Under this rule, banks had to mark their assets as being worth what the current market would pay for them. That was great in good times, because it bloated the balance sheet in the banks favor. When times got bad, they lobbied heavily to reverse the rule. The worry was that the toxic assets' fall in value would reveal the Banks to be the hollow shells they really were. The rule was changed in March. Now, the banks could value the assets at whatever they felt they would fetch in some rosy future. With those pesky toxins not dragging down the books anymore, the banks were actually reporting profits.

PPIP is not officially dead. Instead it’s bobbing about in what one pundit called, “a Monty Python moment.” Critics of the plan say the banks can too easily game the system from both ends. Banks don’t like it anymore because they are afraid the bidding will reveal the real sorry truth about the “legacy” assets. Even investors worry that the rules would be changed mid-game if the public realized how crazy the whole thing was.

And in a world where no one really wants to face the painful reality that the delusional bubble we called prosperity isn’t likely to return any time soon, and certainly not by efforts like PPIP, this is what passes for reality.

Doug Friesen
6/16/09