Geithner's Option Solution to Toxic Assets
Geithner's put-writing plan creates the right incentives for private investors.
Investing Specialists
The details of the Financial Stabilization Plan are as clear as mud to me, and the raspberries from the financial markets when Treasury Secretary Timothy Geithner described the plan means I'm not alone in my confusion. However, one characteristic of the plan did perk up my ears, and that is the government's willingness to backstop asset values.
Understanding the Mess
First, some groundwork on the situation in financial markets. Assets are assets. Assets are not liabilities. Assets are not toxic. If someone gives you a handful of tickets for this week's lottery, would you throw them away? If someone handed you, for free, a mortgage and told you it was worth somewhere between zero and $0.35 on the dollar, would you refuse to take it? An asset is an asset, and a distressed asset is just an asset with very high uncertainty around the long-term value. It still has a value greater than zero, that is why it is an asset.
What makes an asset "toxic" is the inability of the owner to hold it. When you park a bunch of highly uncertain assets on the balance sheet of a bank with leverage, you amplify the uncertainty of the pool of assets. The fact that a bank owns the asset only amplifies the problem. If the uncertainty is high enough that you begin to question if the value of the bank remains above zero, then the bank's solvency becomes uncertain. At that point, the uncertainty becomes self-reinforcing. Because nobody trusts the bank, nobody will loan money to the bank or trade with the bank as a counterparty, and the bank fails. Therefore, it is the location of the asset on a leveraged balance sheet, and worse yet, a bank balance sheet, that makes the asset toxic. For Citigroup (C), Bank of America (BAC), J.P. Morgan Chase (JPM), Wells Fargo (WFC), or even Goldman Sachs (GS), the more cash on their balance sheets, the less likely they are viewed as insolvent, so having these highly uncertain assets on their balance sheets makes them conserve cash and resist lending, which is the whole problem in the first place.
The Geithner Put
Amid the lack of details in Geithner's plan to resolve this problem, the concept of backstopping the assets and limiting losses could have a powerful effect that can be understood through option analysis. By limiting losses on private investment, Geithner's plan would take the downside risk off of the private investor's hands. Limiting downside risk is simply a government agreement to write a free put option on each asset purchased.
If you take an asset, and add a free put option to the original asset, you've turned that asset into a call option. In simple terms, if you get to keep the upside on an investment, but have limited exposure to the downside, your net exposure is only the upside, and the upside of an investment is the payoff of a call option. By splitting the upside from the downside and turning an asset into a call option by writing a put, the government is dramatically changing the incentives of asset buyers.
The key difference between pricing a bondlike asset (like mortgage loans) and pricing an option on those assets is the impact of uncertainty on the valuation. For a bondholder, the more uncertain the value of the bond and the cash flows, the less desirable the asset. However, an option operates exactly in reverse. The more uncertain the value of the upside, the higher that upside might be, so the more valuable the option. Think about it this way, the more distressed the asset, the greater the potential rise in value but the more likely the decline in value. If you take that decline out of the picture, the most distressed assets have the greatest potential rise in value, making them most desirable. Turning highly uncertain assets that are undesirable into highly uncertain options that are desirable has the ideal effect, it makes the most risky assets the most valuable ones. The Geithner put would drive private investors toward the most distressed assets, doing a great deal to clean up bank balance sheets. The most distressed assets might become overpriced, but that is a secondary effect. Further, the taxpayers will foot the biggest burden as investors maximize the value of that free put the government is writing, but obsessing over the small cost of the overvalued put loses the forest of fixing the financial system for the trees of political pandering.
Asset or Portfolio
An interesting nuance of the Geithner put-granting strategy is whether the government writes the put on each individual asset purchased by private investors or on each private investor's portfolio. By backstopping each asset, there is no question that investors will look for the riskiest assets in assembling their portfolio. However, if the government backstops the portfolio, investors may try to construct the riskiest portfolio possible, rather than the riskiest individual assets. My vote would be to backstop each asset; it will have the most straightforward incentive for private investors.
So, go for it, Tim; write those put options. There is no more clear way to sop up the most distressed assets. Don't dawdle though, time is of the essence.
If you are interested in exploring options as an investment vehicle, and Morningstar's unique approach to using fundamental research to invest in options, I encourage you to download the Morningstar Guide to Option Investing.
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