How Taxpayers Can Get Hosed Even When Private Investors Get Rich

Original Link: http://www.businessinsider.com/how-taxpayers-can-lose-money-even-when-private-investors-get-rich-2009-3

By John Carney

Tim Geithner keeps saying that investors would share in the downside of any losses in assets purchased through the Public-Private Investment Partnerships. But that’s just not true. It’s entirely possible for the private investors to make money while taxpayers lose money.

The reason is that the asset purchases are financed with non-recourse loans, which effectively means that the private investors can just walk away from any money losing deals while keeping the upside from the winners. Basically, the government is enabling the equivalent of jingle mail. The private equity investors in the plan can treat money losing deals like homeowners underwater mortgages: default on the debt and hand the crappy loans back to the government.

A blogger named Nemo described the problem very nicely. Paul Krugman linked to his blog, and it seems to have crashed now due to the traffic. We'll describe the argument of Nemo here.

Say a bank has 100 mortgage pools with a face value of $100 each. No one knows what these mortgage pools will actually be worth because we don’t know what the default rates will be and all the models we developed earlier have turned out to produce misinformation. For simplicity’s sake, let’s assume that half are worth $100 and half are worth $0. On average, the pools are worth $50, and the true value of all 100 pools is $5000.

The FDIC provides 6:1 leverage to purchase each pool, and some investor takes them up on it, bidding $84 apiece. Between the FDIC leverage and the Treasury matching funds, the private equity firm thus offers $8400 for all 100 pools. That’s $600 from Treasury, $600 from the investor and $7,200 from the FDIC.

Half of the pools wind up worthless. So the investor and the Treasury each lose half the money they invested, $300. The FDIC lent $3,600 but because the loan is non-recourse, the investor doesn’t have to pay it back. Instead, it just hands the FDIC the worthless paper.

The other half wind up worth $100, for a $16 profit each. The FDIC gets paid back its $3,600 loan. After paying back the loan, the total profit on the pool is $800. That profit gets split evenly with the Treasury. The investor makes $400.

A $400 gain less the $300 loss leaves the investor with a $100 net gain. So the investor risked $600 to make $100, a tidy 16.7% return. The Treasury is in the same position as the investor, making $100. It almost looks like the tax-payer has made money on this deal.
And the bank did well, too. It unloaded assets worth $5000 for $8400. So the bank made $3400.
So in the end, the investor made $400, the Treasury made $400, the bank made $3,400 and the FDIC lost $3,600. The FDIC funds its own loans by borrowing from the Treasury, which means the Treasury—that is, the US taxpayer—is out a net $3,200.

Of course, the FDIC will still owe the money to the Treasury. How will it pay back the loan? It has proved impossible for the FDIC to raise fees on banks because their balance sheets are so shaky. It seems likely that the Treasury will simply have to cancel the loan and eat the loss, or taxpayers will have to inject funds to bailout the FDIC. Either way, taxpayers eat the loss.