Former Head of Structured Products at UBS: Game Theory Exposes Toxic Asset Plan As Fraudulent

I wasn't very interested in reading yet another exposé on Geithner's toxic asset plan until I saw who the author was: James Keller, the former head of structured products at UBS.

A structured product is basically a pre-packaged investment strategy which is based on derivatives or other items. Derivatives are the core "toxic asset" of the big banks.

Keller presumably understands financial markets, toxic assets and game theory quite well. And he is calling Geithner's toxic asset plan "fraudulent.

In an essay entitled "Game Theory Exposes PPIP As Fraudulent", Keller writes:

The Public-Private Investment Program (PPIP) is intended to ... create an incentive for investors to pay $90 for a bet that is only worth $50. It is bad economics and bad public policy and it is probably fraudulent. Congress should act pre-emptively to halt Treasury Secretary Tim Geithner’s latest scheme...

Many commentators have pointed out the obvious: that the PPIP is another welfare program for the big banks, funded by the taxpayer.

It is interesting because the legislation governing the FDIC does not allow it to take expected losses above its capital base, and that capital base is now just $30 billion. Against a $500 billion PPIP, it only requires a 6% overpayment to wipe out the FDIC’s capital.

The New York Times’ Andrew Ross Sorkin pressed the FDIC’s Shelia Bair on this point and she apparently claimed that the accountants “signed off on no net losses.” But we are now in zero sum territory. There are only the assets, the banks, and the government. The windfall to the banks is offset by the expected loss to the government. Convincing one’s accountants that a transaction with a high expected loss has no expected loss is fraud...

The accountants for the FDIC were convinced that the loans would be purchased at a fair price because they would be sold through an auction mechanism. But if every bidder in the auction has the same incentive to overbid, it is no longer a fair auction. A naïve accountant might equate “auction” with “fair” and ignore the distortion built in to the process.

Jeffrey Sachs did a fine job pointing out that the incentive is actually to massively overbid, and perhaps even collude. Paul Krugman pointed out that the plan is a “disguised way to subsidize purchases of bad assets.” Josef Stiglitz commented that Geithner’s plan “only works if the taxpayer loses big time.”...

It is disturbing that the Treasury Secretary’s long awaited plan to solve the toxic assets dilemma relies on an overly contrived scheme to obscure its risk to the taxpayer. Either the disguise is intentional or it has not occurred to the Secretary that the plan jeopardizes the soundness of the FDIC. Neither answer is acceptable.