Hoisted from comments:
Say I am SAC Capital. I get to be one of the bidders on bank assets covered by the programCiti holds $100mm of face-value securities, carried at $80mm.
The market bid on these securities is $30mm. Say with perfect foresight the value of all cash flows is $50mm.
I bid Citi $75mm. I put up $2.25mm or 3%, Treasury funds the rest.
I then buy $10mm in CDS directly from Citi [or another participant (BOA, GS, etc)] on the bonds for a premium of $1mm.
In the fullness of time, we get the final outcome, the bonds are worth $50mm
SAC loses $2.25mm of principal, but gets $9mm net in CDS proceeds, so recovers $6.75mm on a $2.25mm investment. Profit is $4.5mm
Citi writes down $5mm from the initial sale of the securities, and a $9mm CDS loss. Total loss, $14mm (against a potential $30mm loss without the program)
U.S. Treasury loses $22.75mm
Great program.
It’s just a scheme to transfer losses from the bank to the taxpayer with an egregious payout to a middleman (SAC) to effectively money launder the transaction.
You’ve also transmuted a $30mm economic loss into a $36.75mm economic loss because of the laundering. So its incredibly inefficient.
How did fraud and money laundering become the national economic policy of the US?
One would have to be a criminal to participate in this.
Update: One Kid Dynamite in comments suggested the CDS proceeds were overstated. If we adjust for his assumption, the Citi loss is reduced ($9.5 million versus $14 million in example). The investor would also show no profit on a $2.25 million investment (note the quick and dirty analysis did not allow for time value of money, which means he loses money). If the investor anticipated that, it means he would not bit at all. So you need either overly optimistic investors or an even richer subsidy from Uncle Sam. And that’s before you get to the other two issues, first, that even this example has Citi showing a loss on sale of dud assets (which we don’t see happening, the whole point is for banks NOT to show losses). So the bid would have to be even higher, the full $80 million.
Second, if we further accept Kid Dynamite’s observation that the CDS would be more pricey (any input here?) that basically means there deal would produce an expected loss. Again, no trade unless investors are too optimistic. Think we have an excess of optimism in this environment?
But this little example does serve to illustrate that even if the investors understand and fully accept that the current market price is markedly below the “true” value of the toxic paper, the math to the investor still does not appear to work. That means the program will have to offer even richer subsidies or will elicit very few successful bids (and then only on the best of the dreck, where the “real” value of the paper appears to be not too horrifically below the level at which the bank is carrying it on its books). That’s a lot of cost and drama for perilous little benefit. Back to the original post:
Folks, this IS even worse than I thought, and you know I have a constitutional predisposition to take a dim view of things (although it was clear from the get-go that the introduction of private parties to give air cover to the Treasury would make the exercise more costly without adding any value).
I suggest you write/e-mail your Congressmen, and more important, any of you who have MSM media contacts, call this to their attention. There will no doubt be useful further grist on this thread and on the post on which this comment first appeared. But the analysis above is damning on its face. I’d like to have someone have Geithner try to explain why it WON”T work like that, and how this abortion solution is in our collective best interest.
AIG bonuses are a sideshow (as offensive as they are, don’t get me wrong on that one, the symbolism is awful). It is diverting attention from the real crimes and serving to get nay-sayers branded as populists, which is code for “jealous of their betters”.
But this sort of thing in reality, as Paul Krugman points out today, is not a class issue but a recognition that the program is so heinous that it represents a fundamental danger to an already damaged economy:
… that these funds will have skewed incentives. In effect, Treasury will be creating — deliberately! — the functional equivalent of Texas S&Ls in the 1980s: financial operations with very little capital but lots of government-guaranteed liabilities. For the private investors, this is an open invitation to play heads I win, tails the taxpayers lose. So sure, these investors will be ready to pay high prices for toxic waste. After all, the stuff might be worth something; and if it isn’t, that’s someone else’s problem.
Krugman’s comparison to the S&L crisis is actually too favorable. The losses then were only $100-$120 billion in total. The damage (as in losses to the taxpayer) on this one program are almost certain to be greater if the Administration gets its hoped-for take-up.
Now that level of loss (ex the unnecessary subsidy) might well be warranted IF it were putting the markets on a sound footing, by providing a backstop while investors did price discovery on bad assets. Price discovery is a necessary part of this process. One could argue the reason the offer in the illustration above is $80 million and the bid is only $30 million is that no one is interested in bidding when the sellers aren’t serious. If the banks really were to start unloading assets, the initial buyers would get a steal, but more capital would come forward. You might not see bids rising to the “fullness of time” $50 million level, but you would see bidding rise above the current level. (Note, however, that the banks simply are not willing to show more losses, which means, as in the S&L crisis, the bad assets need to come into government hands via institutions that are in the worst shape being declared insolvent and taken over, and the assets sold out of receivership. There is simply no sensible mechanism by which the government can provide these massive subsidies. We’ve now had three attempts at it, two under Paulson, and now the Geithner monstrosity. A bad idea is a bad idea. We need to move on to Plan B).
With price discovery (or the equivalent via more realistic marking of their books), some banks would be toast and need to be put in a form of receivership. But pretending these banks are viable, keeping the incumbents in place (who have incentives to take risk with taxpayer money, if nothing else so they can try to show profits and slip the leash) is the worst of all worlds. Some of the big banks already have been nationalized from an economic perspective, yet we keep alive the dangerous and costly fiction that they are functioning, private concerns. The Japanese did a variant of this program via letting zombie banks hold dead loans at grossly overvalued prices and pretend to be solvent, and look how well it served them. Oh, and in the end, the banks had to take the losses.
There may also be a Constitutional issue, as another reader alleged:
Geithner/Summers are willfully evading Congressional oversight. After the Tequila/Mexico financial crisis, the banks wanted 20 billion and Congress wouldn’t give it, so Summers/Geithner under Clinton evaded that buy misusing the government’s ESF, argually illegally. Now, given that Congress doesn’t want to authorize more money, Summers/Geithner are trying to misuse Fed/ DIC authority to hand out cash. This is illegal because the FDIC and Fed are authorized to lend, but not to hand out gifts/grants. Lending non-recourse undercollateralized is a gift/grant.
I know we are all suffering from outrage fatigue, but this is a worthy target for your ire. I hope you find a productive outlet for it.
PS No vigilante stuff or threats to preps or suspected perps, please. First, it’s counterproductive. It elicits sympathy and will lead the companies to hire bodyguards, which if they are on Federal life support, comes out of our collective hide. Second, it’s bad karma.
Steve 
Posts
Yves, I agree this program is a scam, but i’m confused by some of the math in this post.
1) in the example given, SAC only books a net $4mm gain on the CDS right? they pay $1mm, and they receive $5mm (50% on $10mm protection). The post said they book a $9mm gain.
2) the CDS wouldn’t really cost $1mm per $10mm – it would cost more like $5mm per $10mm. simply, if the CDS is priced correctly, the CDS portion of the trade will be a wash – you’re operating under the assumption that we know the true value of the bonds.
i think you can redo this post to make it more realistic, and offer a better proof of how much of a scam the TALF is at the taxpayers expense.