Raw Deal for Taxpayers — Revised to Take Into Account the Cost of Debt Financing

This morning, the Treasury Department unveiled its “Public-Private Investment Program.”  This program is designed to entice private investors to “partner” with the Government to buy the so-called toxic assets (most of the assets are mortgage-backed securities).  But this is not a “partnership” in any sense of the word.  While profits will be split 50-50, the Government, and in turn the taxpayers, bears more than 92% of the risk.

Here is How It Works: As detailed in the Treasury Department’s press release, for every dollar of equity a private investor puts up, the government will also put up a dollar of equity and borrow another $12 dollars.  However, the loans are non-recourse to the private investor.  What this means, in layman’s terms, is that the private investor can only lose up to the $1 of equity he or she puts up; the investor is not responsible to pay back any amount of the loan.  Only the Government is responsible to pay back the $12 borrowed.  Therefore, for every dollar a private investor puts at risk, the Government is risking $13.  While the first set of losses, up to the amount of equity, is split evenly between the government and the private investor, all of the other losses are borne by the Government.  Therefore, a vastly disproportionate amount of the risk is borne by the Government when viewed in light of the fact that 50% of the upside goes to the private investors.

Real Life Example: Private investor bids $1.4 billion (“bn”) for a set of RMBS and is the winning bidder.  The investor puts up $100 million (“mm”) in equity, the Government puts up $100 mm in equity, and the Government borrows the remaining $1.2 bn to finance the purchase.  In five years, the investment is sold for $1.68 bn.  That is  a ~$180 mm profit ($280 mm in increased value of the asset minus ~$101 mm in interest (5-year treasuries are yielding ~1.68%) or a 12.9% return on the purchase price.  Under the 50-50% profit sharing provision of the plan, the investor does not see a 12.9% return.  Rather, he or she sees a 90% return (or 18% average annual return) on the equity he or she invested ($90 mm in profit / $100 mm of invested equity).  However, the Government, because it is wholly responsible for the repayment of debt, sees only a ~6.9% total return (or ~1.4% annual rate of return) on every dollar that it stood to lose.  It is hard to see what private investor would turn down the opportunity the Government is giving; it is also hard to see any investor who would invest in the Government’s shoes.  To get a 18% annual return, all the investor has to do is buy an asset that increases in value a mere 4% / year.

Already such high profile investment firms as PIMCO have jumped at the chance to invest “with” the Government.

Even if we impose ordinary income tax rates (~50%, when taking into account state income taxes) instead of long-term capital gains rates, the returns to private  investors  still average an annual rate of 9% after taxes.

Possible Solution: Allow everyone to invest with the Government.  One way to do this is to force the private investment firms that “partner” with the Government to sell limited partnership interests in these equity investments to the public (not just to so-called “sophisticated investors”) in the form of ETFs.  The Government can subsidize the management fees and allow ordinary citizens to share in the upside of this program.

This will give the plan more public legitimacy.  Can you imagine the outrage in 5 years if firms such as Blackstone, Carlyle Group and Pimco end up making billions on this (while all the risk was shouldered by the taxpayers)?  The public will be convinced that Washington is a racket to only benefit Wall Street.

Update: Dan Gross, one of my favorite business reporters, also supports the idea of allowing ordinary investors to invest alongside the investment firms and the Government:

But it wouldn’t be hard to arrange for small-fry investors to participate in the bailout. The government could partner with investment-management firms—especially well-regarded investment-management firms such as Vanguard and TIAA-CREF—to create mutual-fundlike vehicles in which individuals could invest as little as a few hundred dollars in the effort to stabilize the banking system. The feds could even offer such an investment as a check-off on tax returns. Or we could present it as an allocation choice for federal employees’ retirement accounts. Legacy loans and legacy assets could be offered as an option for state-sponsored 529 college savings programs, in which investors typically commit to lengthy holding periods. Or they could be made part of the universal savings accounts that Obama supports.

And if the private-equity or hedge-fund industry had an ounce of PR savvy—a really big if—it would help individuals make similar investments while waiving the management and incentive fees.

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3 Responses to “Raw Deal for Taxpayers — Revised to Take Into Account the Cost of Debt Financing”

  1. Michael Says:

    Does the interest on the gov’t debt really come out of the Gov’t’s equity not the “entity” equity?

    • mschonholz Says:

      Michael,

      In the example I give above, the asset’s value increases to $1.68 bn from $1.4 bn paid. I net out the interest on the debt ~$100 mm, leaving the joint venture with $180 mm in profit to be split between the investor and the government.

  2. The Public-Private Partnership Does Not Solve the Root Problem: Pricing of the Assets « Political Junkie Goes Hollywood Says:

    […] Political Junkie Goes Hollywood Part of Bill O’s Vast Left Wing Conspiracy « Raw Deal for Taxpayers — Revised to Take Into Account the Cost of Debt Financing […]

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