From the headlines of the Wall Street Journal: “Banks Aiming to Play Both Sides of Coin — Industry Lobbies FDIC to Let Some Buy Toxic Assets With Taypayer Aid From Own Loan Books (subscription required, but Calculated Risk has an excerpt). I thought the headline had to be a mistake until I read the article.

To recap: The Public-Private Investment Program provides subsidies to private investors to encourage them to buy legacy loans from banks. The goal is to encourage buyers to bid more than they are currently willing to pay, and hopefully close the gap with the prices at which the banks are willing to sell.

Allowing banks to buy their own assets under the PPIP is a terrible idea. In short, it allows a bank to sell half of its toxic loans to Treasury – at a price set by the bank. I’ll take this in steps.

Assume that a bank has a portfolio of loans on its books at $100 and that, when held to maturity, those loans will turn out to be worth $90. In the absence of any transaction, it will end up losing $10.

First, imagine the bank is buying these loans from itself with no government support. Let’s say it decides to pay itself $80. Obviously this does nothing – no cash has changed hands, and the bank still has the toxic loans. It might take a $20 “loss” today, but it will gain $10 by holding those loans to maturity, so its net loss is still $10.

Second, imagine that the bank creates an investment fund where its own money is matched dollar-for-dollar by Treasury money. If the fund buys the loans from the bank at $100, then the fund will eventually lose $10. That loss will be split between the bank and Treasury, so now the bank’s net loss is only $5, because the other $5 of losses is absorbed by Treasury. Conversely, if the fund pays less than $90 for the loans, the gains will be split with Treasury, so the bank’s net loss will exceed $10. If it pays exactly $90, then the bank is no better or worse off than before the transaction.

In other words, it’s exactly the same as if half of the loans were sold to Treasury, with the bank holding onto the other half. From the bank’s perspective, it wants the price to be as high as possible.

Third, imagine that the equity in the investment fund is split evenly between the bank and Treasury, but it is leveraged up to six-to-one by a loan that has an FDIC guarantee. This has the effect of capping the bank’s downside if the loans do really badly. The guarantee wouldn’t kick in if the loans end up being worth $90, but let’s say they end up being worth $70. Now if the fund pays $90 for the loans, that is about $6.50 of bank money, $6.50 of Treasury money, and $77 of FDIC-guaranteed loan. So the bank loses $6.50, Treasury loses $6.50, and the FDIC loses $17. With no transaction, the bank would have lost $30.

The third scenario is the PPIP.

So if banks are allowed to buy their own loans, they will have the incentive to overbid for those loans. As long as the price they pay exceeds the eventual value of the loans, they will come out ahead, even without the loan guarantees. This is bound to close the gap between buyers’ bids and sellers’ reservation prices – by ensuring that at least one buyer (the bank) will bid more than the reservation price set by the seller (the bank). And the way these investment funds are set up, the private equity partner – the bank – will be the one deciding how much to bid; the whole point of these “partnerships” was to get the government out of the business of valuing assets. In short, since the government doesn’t have the expertise necessary to guard the henhouse, we’ll let the fox do it.

Do you think this is so crazy it couldn’t possibly be what the banking lobby is asking for? Consider this:

[Norman R.] Nelson proposed to the FDIC that banks be allowed to control as much as half the capital in a buyers’ group. In some cases, he wrote, “the selling bank should be able to participate as the only private-sector equity investor.”

(Nelson is general counsel of the Clearing House Association, a trade group representing ten of the world’s largest banks.)

The blather being spouted in support of this self-dealing is so blatantly disingenuous it makes you wonder if this is some sort of joke.

“Banks may be more willing to accept a lower initial price if they and their shareholders have a meaningful opportunity to share in the upside,” Norman R. Nelson . . . wrote in a letter to the FDIC last month.

Um, no. Participating as buyers will only ensure that banks will be motivated to overpay. If they think that the price is too low, they would prefer to just hold onto the asset – especially now that the stress tests have made clear that no bank will be forced to liquidate assets under pressure.

“Bankers see it as a win-win,” said Tanya Wheeless, chief executive of the Arizona Bankers Association, which has urged the FDIC to let banks buy their own assets through PPIP.

That’s absolutely true – for them, that is.

Towne Bank of Arizona plans to sell some of its soured real-estate loans into PPIP and wants to profit from the program. “We think it would be attractive to our shareholders to be able to share in whatever profits there are from the venture,” said CEO Patrick Patrick.

It seems like this proposal is too extreme for some people in the banking lobby to support; neither Scott Talbott of the Financial Services Roundtable nor Edward Yingling of the American Bankers Association was quoted.

You would think that the government would slap down this idea in a second. But here’s the FDIC spokesman on the issue: “It’s an issue that’s been raised and an issue we’re aware will need specific guidelines.”

Now, even if banks aren’t allowed to buy assets directly from themselves, there are still reasons to be worried. If you think of the banking sector as one big entity, then it’s obviously in the interests of that entity to buy assets from itself exactly as described above – only with Bank A buying from Bank B and Bank B buying from Bank A (or more complicated permutations as required). In other words, there is a massive incentive to collude. Now, collusion is illegal. So the question is whether the banks can get themselves into an equilibrium where they all overpay for each other’s assets – thereby benefiting everyone – without actually conspiring to do so. This is like when one airline raises prices and immediately every other airline follows suit – there’s nothing illegal about it, even though the end result is the same as if they had colluded.

But let’s not make it easy for them. If this proposal has any chance of going anywhere, then Tim Geithner or Sheila Bair should come out and reject it right now.

By James Kwak