Wednesday, March 25, 2009

How to game Geithner's plan
Ways to Play the Rescue Game

Timothy F. Geithner, the Treasury secretary, has offered generous financing to the private investors to help bail out banks. His promise of lots of cheap leverage could make investments in toxic assets attractive. But ingenious minds will probably find elaborate ways to play Mr. Geithner’s game. Here are two ideas.

The first game is for banks. A bank sells $7 million in so-called legacy loans. It then reinvests $1 million of the proceeds in a fund, receives another $1 million in equity from the government and borrows $12 million with a guarantee from the Federal Deposit Insurance Corporation.

The fund then buys $14 million in loans that are nearly identical to the ones the bank sold, paying the same price if it can. The bank can now reap half the gains on a $14 million portfolio, rather than retaining all of the upside from its original $7 million of loans. But it has capped its downside at $1 million, rather than $7 million.

The second game is for investors. Here the investor spreads his bets among funds with different approaches to buying legacy securities. Some focus on residential or commercial mortgages, others on credit card loans, in different vintages and geographies. The aim is to make sure that, even if some funds plummet in value, others do well.

Imagine playing Colony of Vultures with just two funds. Our investor, who has $2 million to play with, puts $1 million each into Vulture 1 and Vulture 2. The two Vultures now borrow $9 million apiece from the Federal Reserve, giving them each $10 million to invest. Vulture 1 makes 30 percent; Vulture 2 falls 30 percent.

This might seem like a dumb strategy that leaves the investor flat. But the availability of nonrecourse funds, meaning the loans are backed only by the assets they have purchased, changes the outcome. Vulture 1 is now worth $13 million. After paying back the $9 million loan, the investor has $4 million. He loses all the $1 million he has put into Vulture 2, but the remaining losses are absorbed by taxpayers. Our investor ends up doubling his original $2 million stake.

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