More on the Geithner Put

There are three parts to the government’s plan:  A “stress test” and new capital injections for the banks; a “public-private investment fund” (“P-PIF”); and an expansion of the TALF to $1 treeellion.

Let’s focus on the P-PIF for a moment.  Although the details are not yet announced — because they are making this up as they go — there is already cause for concern.  As JPMorgan’s analysts say:

It should be noted that this plan’s so-called private sector pricing of assets would be directly related to how much leverage the P-PIF extends to private investors.  The greater the share of non-recourse lending extended to investors, the higher will be the new “market” price for assets.  The dilemma that first surfaced last September — the higher the price the greater the support for the banking system, but also the greater the risk for taxpayers — is not resolved by the P-PIF but is instead transformed into a decision about how much leverage the P-PIF will provide to investors.

This is a very important point, so I am going to belabor it.  My apologies if this insults your intelligence.

Let me go back to my earlier example:  Suppose some bank is holding 10 bad assets, one of which is likely worth $100 and the rest of which are likely worth zero.  (And it is unknown which is good and which are bad; that will only become clear in the fullness of time.)  Now suppose Mr. Private Equity comes along and offers to purchase all of the 10 assets for $50 apiece, using $5 of his own capital and $45 borrowed from the P-PIF.

If these loans are non-recourse — which every report suggests they will be — then what is the likely outcome?  9 of the 10 assets wind up worthless, and on each of them Mr. Private Equity loses his $5 and the public loses $45.  The remaining asset turns out to be worth $100, so Mr. Private Equity repays the $45 loan, recovers his initial $5, and pockets $50 in profit.

Thus the final result is that Mr. Private Equity put up $50 to earn $5.  That is a 10% return; not bad.

Meanwhile, the taxpayers are out $405.  ($5 of which went to Mr. Equity, and $400 of which went to the banks.)

I say again:  The most important question is who will pay for the losses that have already happened.  And I can pretty much guarantee it will not be the private equity folks…

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