Monday, July 27, 2009

Why Jamie Dimon is Wrong!

It's been a long time since my last post. I gave up on the Obama administration because of their lack of leadership. In what seems a stunning fit of hubris, they have marched on to healthcare reform, while financial regulation still remains undone.

Today's FT article "If we can't raise rates for the guy who pays late, everyone is charged more." by Saskia Scholtes left the basic assumptions underlying that statement unquestioned. I dashed off a letter to the FT editor in haste this morning, but in the event it doesn't get published, here are my thoughts.

This is what Mr. Dimon would like to have us believe, of course. It is true considering that they have issued credit cards to people who shouldn't have them in the first place, and who, therefore, represent default risks. Chase would not make money from a customer who pays off bills promptly at the end of each cycle. They would much prefer a customer who maintains a continuous balance, i.e., someone who is essentially unable to pay off his or her credit card expenses each month. That's the juicy customer who pays the high interest that Chase charges. By extension, it would be eminently conceivable that a person who maintains a constant balance, with little effort, turns into a person whose balance keeps growing unsustainably. Now, I ask you, is Chase incapable of distinguishing good risks from late payers and defaulters? I hardly think so. By including "everyone", which they do essentially by force, by constantly mailing credit card offers, Chase and other credit card issuers are buttressing this specious argument. Is a credit card something "everyone" should have? No more than a home loan, I'd assume.

Stepping back for a grander view, is it hard to see why the securitization market has created asset-backed securities out of credit-card receivables? On the one hand, there is a hungry investor class of monied people looking for ever greater returns on their investments. On the other, there is the working class, who might conveniently be lured with credit cards to spend money they cannot easily repay, and then bilked with exorbitantly high interest rates and late fees in order to generate these sought after returns. Issuers like Chase are the enablers of this abuse of credit cards, which are essentially ingenious devices of efficiency and convenience in a modern economy. And for this enablement of wealth transfer, they require a rather large cut of the spoils, and are willing to spend millions lobbying Congress to allow them to aggressively market products through mailers, charge usurious rates that may be changed arbitrarily at any time, deny bankruptcy protection to their clients, and to fight any attempt at meaningful regulatory reform.

Thursday, May 14, 2009

The Matrix Reloaded By Goldman...

They did forget to tell you a minor detail in "The Matrix". It is controlled by Goldman Sachs. No, but really, I'm just adding to my list of Goldman alumni that have conflicts of interest while serving in governmental positions.

This is stale news from last week and the week before that - sorry, but I couldn't get to posting this in time... Last week, Stephen Friedman was all over the news - he's an ex-Chairman of the Goldman Sachs Group, who was a Director of the New York Fed and bought Goldman Sachs shares several times after the financial crisis hit, and while he was a director, and last week, he resigned following news coverage of his situation. This was the original WSJ article that broke the story, and this subsequent WSJ article reported his resignation.

Outrageous stuff. Anyway, this post at Muckety has an interactive diagram that shows the links between the various parties and this blog post by Reality Lenses excerpts the thread of logic from the WSJ article to make it more compact.

Sunday, May 10, 2009

Catching Up on Mothers' Day...

Last week was a rather busy week for news.  I'm an FT subscriber, and several interesting items in this week's FTs caught my eye.  Since I do have a full-time day job, I'll expand on them as time permits.  Here are the highlights:
  • Monday, May 4:  Buffett hits out at stress tests

    Warren Buffett criticized the Obama administration's stress tests on the grounds that of the 19 banks tested, 15 are small enough to be taken into receivership by the FDIC, and so, do not have the same impact as the remaining 4.  For the same reason, he concluded that applying a uniform test to all 19 banks (more precisely, bank holding companies) was not a useful exercise - the 4 largest ones are different from the remaining 15 and also from each other.  The official test results can be found here.  It's not apparent who the 4 Buffett refers to are, since their market capitalizations are now much smaller than they were before the crisis.  The FT article explicitly named just Bank of America and Citigroup, but I assume Buffett is referring to Bank of America, Citigroup, Wells Fargo, and JPMorgan Chase.

  • Tuesday, May 5: Obama squares up to corporate America for fight over tax havens

    Basically, the Obama administration is targeting profits of foreign subsidiaries of US corporations in the following 3 principal ways: (i) At present, a US multinational is allowed to deduct expenses incurred by a foreign subsidiary against its US tax liability, while deferring tax payment on that same subsidiary's income until it is repatriated.  The new rules will allow deductions to be claimed only in conjunction with the repatriated income, so that both occur in the same period.  (ii) The second change is to revise a complex system of foreign tax credits claimed against US tax liabilities.  Foreign tax credits make a US corporation appear more profitable by lowering its tax rate, although the same tax is paid by its foreign subsidiary.  (iii) The last item is a revision of the rules for reporting of fund transfers between a US corporation and its foreign subsidiaries that will expose more income to taxation.  Kudos to the administration on this.  It is time to level the playing field so that multinationals do not gain any advantage over mom-and-pop entrepreneurs and smaller companies from engaging in tax arbitrage.

    The administration has already heard a predictable chorus of opposition from several fronts:  (i) The National Association of Manufacturers called the proposal "disastrous".  (ii) John Castellani, Business Roundtable president said, "It is the wrong idea, at the wrong time for the wrong reasons."  (iii) Consulting companies, like Ernst & Young, Deloitte & Touche, etc. have entire desks devoted to tax arbitrage.  Naturally, Clint Stretch, a tax partner at Deloitte, said the proposal rested on "a continuing belief that there's a substantial pot of money in the international tax rules ... a pretty tired idea".  Well, if there wasn't, he wouldn't be a tax partner now, would he?  (iv) Silicon Valley also voiced concerns.  I think it would be fine for Microsoft to pay the estimated $2.2 billion in taxes resulting from this reform.

    In honor of Mothers' Day, I can think of something similar mom might have said:  "Eat your broccoli!"  If the proposal wouldn't raise taxes, which is its very goal, we would not be hearing any opposition to it.  That we are, implies that it has found its mark.

  • Wednesday, May 6: Subprime groups spent $370m to fight regulation

    The Center for Public Integrity, a non-profit investigative journalism organization, released a study showing that the top 25 originators of subprime mortgages, most of which are now bankrupt, but were either owned or financed by banks including Citigroup, Goldman Sachs, Wells Fargo, JPMorgan Chase, and Bank of America, spent almost $370 million in Washington over the past 10 years on lobbying and campaign donations to ward off tighter regulation.  This essentially is the official finding that confirms what I wrote in my very first post with which I started this blog.

  • Wednesday, May 6: Stringent rules set on bail-out repayment

    US regulators apparently want to banks to prove that they can issue debt without FDIC insurance.  Some banks have been asked to increase their equity, i.e., lower their debt-to-equity ratio.  It is a bit hard to understand how they would do both.  Increasing equity, whether by new issuance, or conversion of preferred stock or debt to equity, would be dilutive to current shareholders.  Issuing new debt would increase the debt servicing load, which I think ought to be reduced.

  • Wednesday, May 6: Heads of $63bn collapsed money market fund charged with fraud

    Getting a bit personal here, I lost money from a "stable value" money market fund breaking the buck.  Turns out the fund owned $785 million in Lehman debt which became worthless.

  • Thursday, May 7: Decade of gold sales has cost Europe's central banks $40bn

    Interesting article, noting that over the past 10 years, European central banks sold 3,800 tonnes of gold, while China's central bank bought 659 tonnes.  The European banks sold at the lows, and now gold has appreciated from $287.55 an ounce on January 6, 1999 to $903.50 an ounce on May 6, 2009.

  • Friday, May 8: Treasury yields soar after poor bond auction

    Apparently, this is because equities now offer greater returns thanks to the recent rally.  And this is the US Treasury we're talking about.  I can't imagine how the TARP-beneficiary banks would do in fulfulling the new requirement (cf., May 6 above) to issue debt without the FDIC guarantee.  Yields would have to be higher still, and this would impose a greater debt service load on the banks.

  • Friday, May 8: US banks must add $74bn in equity

    US regulators ordered 10 of the largest US banks to add a total of $74bn in equity following the stress tests.

  • Saturday, May 9: US banks claim line softened on $74bn test cash

    The government has given US banks assurances that they will not be required to raise the $74bn in equity, if earnings over the next six months exceed regulators' forecasts.  This is reminiscent of how Paulson and Bernanke handled Bear, Lehman and AIG:  Bail out for Bear Stearns; sorry, Lehman; okay again for AIG.  A flip-flop in just a day, based on earnings over a single six-month period.  You have to wonder:  Do these folks know what they're doing?

  • Friday, April 24, 2009

    Have the Banks Won?

    Last Tuesday, April 21, 2009, a hearing of the Joint Economic Committee was chaired by Congresswoman Carolyn B. Maloney.  It was entitled "Too Big to Fail Or Too Big to Save?  Examining the Systemic Threats of Large Financial Institutions."  Please find the testimony of the invited experts - Nobel Laureate Prof. Joseph Stiglitz of Columbia University, Prof. Simon Johnson of MIT (author of The Quiet Coup, The Atlantic, May 2009) and Thomas M. Hoenig, President of the Federal Reserve Bank of Kansas City - at the link above.

    Their testimony indicates that so far, the answer is yes.  Who, you may ask, is their opponent?  Who have the banks won against and what have they won?  The banks have won against the administration and you, the tax payer.  What they have won so far is the capitulation of the administration and your money to recapitalize themselves and ensure their survival.  It's not entirely final yet.  Speaker Nancy Pelosi has expressed interest in having investigative hearings of the type chaired by Ferdinand Pecora in 1932 following the crash of 1929.  As Prof. Stiglitz testified, we need to emerge from the crisis with a new financial system that is more resilient to systemic failure.  To do so, we need to understand how we got here.

    Both the Clinton and the Bush administration held the view that US capital markets and the US financial industry was a source of innovation (in finance) and consequently, an enabler of the engine of entrepreneurship and the vitality of the US economy.  In the 1980s, financial engineering brought mathematicians to Wall Street, giving new-fangled products the aura of academic legitimacy.  Thus, in addition to money and power, Wall Street projected intellectual superiority onto the executive and legislative branches of government.  The revolving door between Goldman Sachs and past administrations is indicative of the sway that Wall Street has held over government.  The current administration is comprised of people who are also similarly under the sway of the financial industry, some of whom (Larry Summers and Timothy Geithner for example) were directly imported from past administrations.

    In 2008, after several previous failures (Long-Term Capital Management or LTCM in 1998 and the bursting of the dot-com bubble in 2000 to name just two,) banks managed to convince the Bush administration that systemic failure was imminent without government handing them a bailout.  Congress appropriated $700 billion towards the TARP in a hurry, with Ex-Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke holding a gun to their heads.  Paulson and Bernanke made adhoc decisions with a lot of back-room dealing, which is now coming to light (cf., The Atlantic, April 23, 2009.)  From a psychological perspective, it should seem obvious that intervention usually tends towards preserving the status quo, which at that point, has typically proven to be unsustainable already.  As research shows, government intervention usually results in prolongation of the crisis.  Every whiff of a crisis has resulted in the Fed flooding dollars into the system.  The side effects of intervention are usually opacity in pricing and an increased possibility of inflation.

    Thanks to the TARP, banks are currently pretty well collateralized in the US.  The issue is not about whether they are collateralized, but rather about how they are collateralized.  Collateral comes in primarily two forms - debt and equity.  Banks are excessively collateralized by debt instead of equity.  Banks are using TARP monies to service their debt, i.e., paying interest on it, which has allowed them to continue operating a failed business model.  What needs to happen for banks to be restored to good health is for the creditors to take at least partial losses and assume an ownership stake in the banks, by converting some of the outstanding debt to equity.  Creditors are resisting this as well, via influence peddled by K Street, and pushing the problem onto the backs of taxpayers.  It is entirely odd that the administration has not pushed back on this, since this merely postpones the denouement.  If the business model does not bring in revenues, as it surely won't, given that the financial industry is doomed to shrink, more bailouts will be required to service the unending debt.  This will eventually require raising taxes.

    The so-called stress tests are proving to be a thorn in both the industry's and the administration's sides.  Results will not be credible if everyone passes.  Yet the most likely bank to fail is Citibank, which is "too big to fail," and if it is officially known to have failed the stress test, that could engender a tailspin in financial stock valuations.  We will see how the administration deals with this dilemma.  The results are due in the next week or two.

    For those of you invested in the market currently, you should know about a Bloomberg article informing us that insider selling is at its highest level since 2007.  The recent rally definitely seems to have run into strong headwinds.  For disclosure sake, I am out of the market entirely, and have been for a while.  The outlook is negative for a simple reason:  Even if economists exclusively ran the country, they would have a fairly tough time getting us out of this mess.  With politicians involved, I can only conclude that our chances of making it are dimmer.  For perspective on historical returns and the likelihood of reaping investment returns in the current environment, read this article published in July 2008, and also a more recent article published today.  Of course, if we did have proper recognition of the full scope of the problem, and a solution that does not attempt to return us to status quo ante, things may turn out to be very different in the coming years.  However, the odds are stacked against it.

    Moving on, let's think about how our financial system could be made more resilient.  What are some of the things we want from our future financial system?
    • If you have an institution that is "too big to fail," it poses systemic risk, and therefore, should be broken up.  This amounts to enforcing anti-trust laws against financial institutions.  So far, however, banks have been able to resist this.  Paul Krugman in his New York Times blog has called for splitting up banks into low-risk (aka boring) banks that serve as financial utilities, and high-risk entities that are more speculative.
    • The financial industry must inevitably shrink.  This means more job losses in New York, and a reduction in its clout in Washington.
    • Some have called for labeling of financial products akin to consumer product labeling with buyers being provided information on the risks associated with the products.
    • Transparency in accounting is paramount.  Banks have pushed for suspension of mark-to-market accounting.  On March 10th, Ben Bernanke suggested there should be some leeway in interpreting the rules.  Perhaps this will convince the already skeptical creditors and public that banks are indeed solvent.
    • Finally, we need to eliminate the conflict of interest that is so rife in the industry and in government.  In emerging economies like India and most of the poorer rest of the world, we would tend to call this corruption.  Here in the US, we indulge ourselves with euphemisms like "lobbying." 
    We need to understand that a public company's CEO is a shareholder's fiduciary.  If a company is going down, its CEO would most likely not hasten its demise by admitting that fact openly.  A CEO will necessarily attempt to make the company survive and protect shareholders from loss.  What we need is for stakeholders to be true to their interests, which should be divergent.  A conflict of interest arises when multiple parties serving as fiduciaries to counterparties with divergent interests find their own interests converging or when a single party serves as a fiduciary to multiple counterparties with divergent interests.  We need excellent analysts to discover what the CFO is trying to finesse through on the balance sheet and income statement.  This is also why we need short-sellers - for the same reason that we need vultures to pick the flesh of carrion - to enable, as Joseph Schumpeter put it, "creative destruction."

    Sunday, April 19, 2009

    Adolescent Boys Don't Like Rules

    Just a quick note on a blog entry by Andrew Sorkin in the New York Times of April 17, 2009, following my last post:  Liddy has a sizable stake in Goldman Sachs, even though he is doing his AIG job for a salary of $1 per year.  The stench of conflict of interest is becoming unbearable.

    Yesterday, I watched a rerun of The Panic of 2008, a forum held at George Washington University on April 4, 2009, on C-Span.  Its subtitle was "Causes, Consequences and Proposals for Reform: Roundtable on the Significance of the Panic."

    It was painful to watch Dennis Berman, Money & Finance Deputy Bureau Chief of the Wall Street Journal, hem and haw around the need for regulation.  He began by referencing an article in The Atlantic issue of May 2009, by Simon Johnson, former Chief Economist of the IMF, called The Quiet Coup, which he said, explained that Wall Street in a quiet coup has taken over the reigns of government.  In his very next sentence, he redacted himself by saying "Now that doesn't mean that a sharp turn to regulation is necessarily the answer."  I was wondering to myself, "Is this man blind, or is he just saying it to sound intelligent and balanced?"

    The idea that Wall Street firms would engage in socially responsible financial behavior without regulation has been proven false repeatedly as I outlined in my post of March 24th.  Wall Street firms are carnivorous, they are apex predators like sharks in the economic food chain.  Left unchecked, they are likely to use every legalistic maneuver to make money, or if not, at least create the illusion that they are making money, so that their stock prices go up.  When they run afoul of the law, as they have, they settle out-of-court, without admitting or denying wrongdoing.  We have indeed devolved from a nation of respectable conservative businesses to one of opportunistic operators.   So, yes, Wall Street firms are like adolescent boys.  They don't want to be stifled by rules.  Government needs to be a parent and ground them for some time.

    When Jamie Dimon, CEO of JPMorgan Chase Bank, and Lloyd Blankfein, CEO of Goldman Sachs, say they would like to return the TARP monies loaned them by the government, they are counting on making the public believe that by doing so, they will have annulled their obligations to the government.  That is far from the truth.  A week after Lehman Brothers collapsed, Goldman Sachs and Morgan Stanley turned themselves into bank holding companies (cf., this WSJ article) with some alacrity, so that they would be more easily able to be acquired, merge with or acquire smaller banks with FDIC-insured deposits.  It also potentially allows them to avoid using mark-to-market accounting, and instead classify assets as "held for investment" as banks do.  Even if the TARP funds were returned, bank holding companies receive the backing of the FDIC, which relies on using tax payer monies as collateral.  So, while these cowboys posture about how they don't need the government, you, the public, should know that it's a red herring.  I'm reminded of Immanuel Kant's famous quotation, "Out of the crooked timber of humanity, nothing straight was ever made."

    Tuesday, April 14, 2009

    Goldman Sachs A Winner Again!

    Wow, how do these guys do it?  Or as a not-so-proud alumnus, I should say, "How do we do it?"  It is absolutely amazing what Goldman Sachs gets away with.  Please read the following.  I don't want to rehash some excellent reporting:
    • The New York Times article by William Cohan
    • Floyd Norris' (also a New York Times reporter) blog

    • I'm not a conspiracy theorist.  I'm a rationalist who believes there's no such thing as coincidence.  Here's a short history:
      • July 3, 2006:  Henry M. Paulson leaves his position as CEO of Goldman Sachs to be sworn in as the US Secretary of the Treasury
      • July 2006-March 2008:  Paulson and bailout-buddy Ben Bernanke downplay the subprime crisis as largely contained in numerous appearances before the Congress and the media
      • November 14, 2007:  John Thain, former COO of Goldman Sachs, leaves his position at the head of NYSE to become the CEO of Merrill Lynch - he changed NYSE from a non-profit board to a publicly traded company, and acquired Euronext NV - his departure comes at a crucial time for NYSE, given that it has still to digest its acquisition
      • March 17, 2008:  The proverbial excrement hits the cooling blades: Paulson lets Bear Stearns collapse - CDOs now have a chance of being priced for real, rather than being marked-to-model
      • September 15, 2008:  Paulson lets Lehman collapse after refusing Richard Fuld, CEO of Lehman, a $45 billion bailout;  Ken Lewis, CEO of Bank of America, agrees to buy Merrill Lynch
      • September 16, 2008:  Paulson takes control of AIG, fearing the systemic risk of a potential collapse, and providing $85 billion in initial bailout monies
      • September 26, 2008: Paulson "taps" ex-Goldman Sachs board member (2003-08) Edward Liddy to replace Robert Willumstad as the CEO of AIG
      • September 28, 2008:  Goldman Sachs says New York Times article by Gretchen Morgensen, detailing a $20 billion exposure to AIG, is seriously flawed - For an analysis, try this.  The right question to ask is not:  "Will Goldman fail if AIG does?"  It is "Will Goldman benefit if AIG does not fail?" 
      • October 6, 2008:  Paulson appoints a Goldman alumnus investment banker Neel Kashkari as Interim Assistant Secretary for Financial Stability, to oversee the administration of TARP
      • October 14, 2008:  Paulson meets with the big bankers and makes them an offer they cannot refuse - "Take the TARP money or else..."  By 6:30pm, all bankers have signed on the dotted line, setting in motion the biggest government intervention in US banking history since the Depression
      • November 10, 2008:  Paulson ups the bailout for AIG to a total of $150 billion, and subsequently, to $173 billion
      • December 17, 2008:  Ken Lewis, CEO of Bank of America, flies to Washington DC to back out of the Merrill Lynch deal.  Paulson and Bernanke stick it to the polite North Carolinian: "Your signature or your brains on that paper please..."
      • January 9, 2009:  Citigroup announces the resignation of its Chairman, Robert Rubin,  ex-Secretary of the Treasury under the Clinton administration
      • January 16, 2009:  Bank of America announces a 4Q2008 loss of $2.4 billion
      • January 17, 2009:  Merrill Lynch announces a 4Q2008 loss of $10 billion
      • January 22, 2009:  John Thain announces his resignation from Bank of America, after Bank of America's digestion of Merrill Lynch sours, taking with him a severance payout valued at $160 million
      • January 27, 2009:  Attorney General of New York, Andrew Cuomo, subpoenas John Thain and Bank of America's Chief Administrative Officer J. Steele Alphin, to investigate the accelerated payout of Merrill Lynch bonuses
      • February 24, 2009:  John Thain ducks out of Attorney General Andrew Cuomo's downtown Manhattan office after handing over the names of the Merrill bonus recipients, who collectively received $3.6 billion
      • March 18, 2009:  Goldman Sachs defends the $12.9 billion it received from AIG
      • March 26, 2009:  Congress demands a probe into AIG use of bailout monies
      • April 13, 2009:  Goldman announces 1Q2009 earnings of $3.39 a share - who could blame them for wanting to forget December 2008?

      • It will be interesting to see how the Obama administration, which has thus far believed in proper accounting, like putting the cost of the Iraq war on the US balance sheet, reacts to Goldman's latest maneuver.  Will they be able to make Goldman explain exactly what it did with the $12.9 billion it received from AIG?  I certainly hope so.

        Thursday, March 26, 2009

        A Closer Look at Geithner's PPIP or Public-Private Investment Plan

        In this post, I'm going to work out an example of how the Geithner plan might work.  I got the inspiration from Jeffrey Sachs' excellent article in today's Financial Times, "Obama's Bank Plan Could Rob the Taxpayer."  Nevertheless, I'm going to talk myself through his example to make sure I understand it, so that you can understand it as well.  Hopefully, we might understand it well enough to be bidding on some of those so-called toxic assets.

        Okay, let's begin with the government's motivation.  Geithner wants to incent investors to buy toxic assets off the banks, so that a bank will have a clean balance sheet once all its toxic assets are sold off. Geithner indicated that the terms of the plan - the lending rates, loan sizes, and durations - are yet to be determined.  The PPIP fact sheet says that for each dollar of private capital, the US Treasury will put up one dollar of equity capital, and in addition, the FDIC will provide up to 6-to-1 debt-to-equity financing (or 6 dollars of debt capital for each dollar of equity capital) via the expanded TALF or Term Asset-Backed Security Loan Facility.  This means for each dollar of private capital, the government through the Treasury and FDIC will put up one equity dollar plus twelve (6 x 2 equity dollars) debt dollars, for a total of 13 dollars in financing.  This amounts to roughly 93% financing.  Thus, the government will provide up to 93% uncollateralized financing towards the purchase of toxic assets, implying that investors will have to put up 7% financing themselves.  How will this work?  Let's imagine ourselves as the investors.

        Uncollateralized financing implies that an investor interested in buying a toxic asset will get a loan from the US government towards the purchase of the asset, without having to put up any collateral.  If the investor defaults on this loan, the government gets nothing back.  In Treasury-speak, this is called a non-recourse loan, i.e., there is no recourse for the lender, i.e., the Treasury, if the borrower defaults.  Assume the government loan carries no interest.  This assumption would favor the government's chances of success by making its plan even more attractive to potential investors.

        How Investors Will Fare

        Now, let's imagine a toxic asset called Bad Investment Fund, ticker symbol BIF.  BIF has a face value of 1 million dollars, but what price should we reasonably pay for it?  This is what we need to work out as investors.  Let's say we analyze the pool of bad loans underlying BIF, and conclude that based on the characteristics of individual borrowers in the pool, we have a 20% chance (technically, probability) of being paid off fully, i.e., getting a million dollars.  However, because the borrowers in this pool are so terribly in over their heads, there is an 80% chance that if we owned BIF, we would get paid only 200,000 dollars.  A reasonable (technically, risk-neutral) investor would pay the probability-weighted average payoff for this asset.  That is, s/he would compute a reasonable price to pay as:

        Risk-Neutral Price (BIF)
        = (20%)($1,000,000) + (80%)($200,000)
        = $200,000 + $160,000
        = $360,000

        Fair enough?  Well, okay why did we multiply the payoffs by their probabilities?  If the payoffs were equally likely, we could just have used a simple average.  But because they are not, we need to take a weighted average, by weighting the payoffs by their probabilities.  This is like saying: "After taking all possible scenarios that may unfold in the future into account, we will pay a price that averages all those future scenarios."  This gives you an idea of why we might use the term "risk-neutral" or "risk-adjusted" to describe this price.  We have priced the asset to account for the risk inherent in any future scenario unfolding, i.e., we are indifferent or neutral to the risk inherent in a particular scenario.

        Okay, but wait.  Under the PPIP, we won't be paying for the asset entirely ourselves.  The government will provide us an unsecured loan to the tune of 93% of the asset's value.  Let's look at how we would compute the risk-adjusted price in this situation.

        Let x be 1% of the price we, as investors, pay for this asset.  We contribute 7x or 7% of the price paid.  The government gives us a loan for 93x or 93% of the price paid.  The price is 100x.  Now, let's value the asset under the two scenarios in question.

        Scenario 1:  With 20% probability, the asset pays off in full.  We would receive $1,000,000, of which we have to pay back our loan, 93x, to the government.  We would therefore compute the payoff to investors as ($1,000,000 - 93x).

        Scenario 2:  We would only receive $200,000 and owe the government the 93x we borrowed.  Given that $200,000 is less than the fair value of $360,000, it would be fair to assume that $200,000 is less than the 93x loaned to us by the government.  Thus, the government would recover $200,000 out of the 93x that it loaned to us as investors, and the payoff to us would be zero.

        As investors, our risk-neutral price would be the probability-weighted average payoff under these two scenarios as usual.

        Risk-Neutral Price Under PPIP (BIF)
          = (20%)($1,000,000 - 93x) + (80%)($0)
        = (20%)($1,000,000 - 93x)

        Making a Profit

        Knowing what we know thus far, how do we turn a profit by investing in a toxic asset?  The way this plan is intended to work is that investors put up 7x and the government puts up 93x. This sets a practical limit on the value of x.  Since 100x = $1,000,000, x could never be more than $10,000.  That is, our own contribution would never exceed $70,000.

        Since we know the risk-neutral payoff, and we put up 7x, we can compute our profit as:

        Profit Under PPIP (BIF) = (20%)($1,000,000 - 93x) - 7x

        Therefore, our percentage return would be:

        Percentage Return Under PPIP (BIF) = Profit (BIF) x 100 / 7x

        So, let's imagine that we put up any amount less than $70,000.  Let's decide to pay 7x = $28,000 ourselves (so that x is $4,000).  We can get a government loan for 93x, which works out to $372,000.  The total price naturally would be $400,000 = 100x.  So we submit a bid of $400,000, and it is accepted by the government.

        Thus, under the terms of government financing, it would be reasonable to bid $400,000 for an asset whose risk-neutral price is actually $360,000!  If our analysis is indeed correct, and there is truly a 20% chance of being fully paid and an 80% chance of recovering $200,000 only, our risk-neutral price would be the weighted average payoff over the two scenarios, as we computed before:

        Risk-Neutral Price Under PPIP (BIF)
        = (20%)($1,000,000 - $372,000) + (80%)($0)
        = (20%)($628,000)
        = $125,600

        That is, we would have invested $28,000 and made a profit of $97,600 = $125,600 - $28,000.  This would amount to a tidy government-subsidized expected return of ($97,600 x 100.0 / $24,000) = 349%.

        Okay, so as investors, we would make out like bandits assuming we could analyze the underlying pools correctly to determine all of the modalities of failure and the recovery amounts and their associated probabilities.

        But this is quite a big assumption to make.  If, instead, our analysis had informed us instead that there is a 40% chance of being fully paid and a 60% chance of recovering $300,000, and it turned out that the real probabilities were 20% for being fully paid, and 80% of recovering only $200,000 instead of $300,000, would we end up losing money?

        Firstly, the new assumptions would imply a new risk-neutral price:

        Risk-Neutral Price (BIF)
          = (40%)($1,000,000) + (60%)($300,000)
        = $400,000 + $180,000
        = $580,000

        Now to what we, as investors, should pay under the new scenario.

        Risk-Neutral Price Under PPIP (BIF)
          = (40%)($1,000,000 - 93x) + (60%)($0)
          = (40%)($1,000,000 - 93x)

        However, given the higher risk-neutral price, we may bid higher than before.  Let's assume we pay 7x = $49,000, so that x = $7,000, and the government puts up 93x = $651,000, so that the total bid amounts to $700,000.  Once again, we're overbidding the risk-neutral price of the asset.  Our expected payoff assuming a 20% probability of full recovery and 80% probability of recovering $300,000 would be:

        Risk-Neutral Price Under PPIP (BIF)
        = (20%)($1,000,000 - $651,000) + (80%)($0)
        = (20%)($349,000)
        = $69,800

        Thus, we would have invested $49,000 and made a profit of $20,800 = $69,800 - $49,000.  In terms of return, we would have had a return of ($20,800 x 100 / $49,000) = 42%, even after being wildly off the mark in our analysis.  Because the government is bearing most of the risk, it is tilting the game in favor of investors.

        How the Government Will Fare

        Let's now take a look at how the government will fare in this grand bargain, assuming the first set of failure scenarios, i.e., 20% full recovery, 80% recovery of $200,000.  From the government's perspective, their expected payoff would be calculated as:

        Government's Expected Payoff Under PPIP
        = (20%)($372,000 - $372,000) + (80%)($200,000 - $372,000)
        = (20%)($0) + (80%)(-$172,000)
        = -$137,600

        That's an expected loss of 37%, not a profit.  In this particular situation, the best case for the government is that it recovers its loan fully.  Any chance of having a failure scenario unfold tilts the equation towards a loss for the government.

        Will the PPIP Lead to Price Discovery?

        Since investors are not actually buying the toxic assets entirely with their own capital, the PPIP will not lead to price discovery.  Investors' bids will have no relationship to the price paid for the asset eventually.  The government would accept the bid that has the highest amount of private capital, and then determine how much additional dollars it would add in to pay "fair" value for the asset.  To do this, the government would need to model the asset value itself.  If it paid "fair" value, the banks would be no better off than before.  That is, they would remain undercapitalized and that would trigger an FDIC review of their Tier I Capital requirements.

        Who Benefits from the PPIP and Who Pays

        Assuming things work as explained above, who benefits from this plan?  The money from the winning bid amongst all of the bids put in by various investors will go to the bank selling the toxic asset, thereby benefiting the banks' equity holders.  Since the government is losing money in any failure scenario, this is not essentially different than an ordinary bailout.  Money is flowing from the government to the banks.

        Investors also benefit handsomely provided they properly assess all the failure scenarios and their probabilities of occurrence.  This would require a lot of analysis - there will be far more than just the two scenarios in our simple example.  Only sophisticated investors will be able to take advantage of this offering.  We hope your particular pension fund or mutual fund does so.  Even if it does, it will skim a significant chunk of the profits and give you the remainder.

        Who pays?  Oh well, that doesn't take much explanation.  We, the tax payers, of course.  Will this plan succeed?  It depends on several factors.  Firstly, investors should be willing to put up a sufficient quantity of money for these assets.  Otherwise, the government will have to finance most of their purchases.  Secondly, the total amount obtained from the investors and the government for these assets should be enough to recapitalize the banks.  It's not clear that the currently appropriated monies are enough to recapitalize the banks.  That leaves the taxpayers open to being raided once again.