The “Geithner Put”

NY Times: Bank Bailout Plan Details

In the end, Mr. Geithner largely prevailed in opposing tougher conditions on financial institutions that were sought by presidential aides, including David Axelrod, a senior adviser to the president, according to administration and Congressional officials.

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He resisted those who wanted to dictate how banks would spend their rescue money. And he prevailed over top administration aides who wanted to replace bank executives and wipe out shareholders at institutions receiving aid.

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The Fed will use its balance sheet to provide the financing, and the Federal Deposit Insurance Corporation might provide guarantees to investors who participate in the program, which some people might call a “bad bank.”

If the Plan involves convincing private equity firms to take “first loss” position on the assets they purchase, and merely limits their downside with some form of insurance, does that make it a good deal for the taxpayer?

Well, let’s see.  Suppose some insolvent bank, like Citigroup or Bank of America, has 10 mortgages or MBSes or CDOs.  Now, nobody knows what any of these things is worth.  Most of them are worth nothing, but some of them are probably worth something, depending on who defaults on what.  Suppose, just for the sake of example, that each of these toxic assets has a 10% chance of being worth $100 and a 90% chance of being worth zero.

Obviously, a rational investor would pay at most $100 for the entire pool of 10 assets, or 10 cents on the dollar.

Now, suppose the D.C. branch of Goldman Sachs the U.S. Treasury comes along and offers to insure every one of these investments to the tune of $45 for any private equity firm who purchases the entire pool for $50/asset.  In other words, the private equity firm is in “first loss” position on each asset to the tune of $5, while Team Timmay is on the hook for the remaining $45.

Since one of the assets is probably worth $100 and the other nine are probably worth zero, the private equity firm expects to make $50 on one and lose only $5 on each of the remaining nine, for an expected profit of $5 on their $500 investment.  (Which they can lever up via the Fed, if the NYT is to be believed.  Not to mention that this is just an illustrative example…)

Meanwhile, the taxpayers expect to pay insurance to the tune of $45 * 9 = $405.  Thus, despite private equity being in “first loss” position, the most likely result is for the private firm to profit even as the taxpayers get hosed.

Scale these numbers up by millions or billions to get an idea of the degree to which you are about to get fleeced.

Of course, I could be wrong.  I am just guessing.  But if this is right, how many people will actually understand that this is what is happening?

Mission Accomplished.