Question in my mind that is unclear regarding the Treasury Plan. A basic assumption needs to be clarified: Are returns allocated on a Total Portfolio basis or a Per Asset / Security basis?
The proponents argue that the private investors are in a first loss position, and are therefore incented to not overpay.
Opponents imply that that there is an incentive to overpay, because the potential losses on a given security is limited to only the portion that the private
investor puts in, but the potential gains are unlimited - effectively giving the investors a free Put option.
My question is this: is the "first loss position" applicable to the entire portfolio of securities, or allocated on a per security basis? In other words, this really depends on where the parenthesis are in the equation. I understand that the FDIC loans would be the first in line to recieve the returns, but would those returns in allocated on the entire portolio? If it is allocated for the entire portfolio, than this plan isn't so bad. Otherwise, if it is allocated on a per security basis, than this plan is free tax payer welfare.
For Ex.
Take 2 securities: Investor pays 70$ for each. 5$ each come from the private hedge fund and TARP and the remaining 60$ from the FDIC loan. One security is "toxic" and is worth $40, other is "misunderstood" (in Krugman's term) and is worth $100. One would think that in such a scenario, both private and public investors would break even, as the entire portfolio would be breaking even, as shown in the equations below:
Investment: 70 + 70 = 140
Returns: 100 + 40 = 140
140=140 ; thus, breakeven should be the fair outcome
The overall portfolio should breakeven on this scenario. However, depending on the structure of the loan, the returns to the private investor and the public could be wildly different.
If the returns are allocated on a per security basis, than the private investor would lose the 5$ investment on the toxic asset, but would make a fantastic 15$ return on the misunderstood asset, thus returning 10$ net on a 5$ investment, or 200% (!). On the other hand, the public would lose $25 on the 1st security and only gain $15 back on the 2nd security, thus obtaining a net loss of $10. Not exactly an equal sharing of risks and returns between the public and private sectors!
However if the returns are allocated on a "total portfolio" basis, than the above scenario would be a break even for both parties, public and private, as indicated in the equations above. The returns on the 2nd security would go to pay off the losses on the 1st security, thus the FDIC would breakeven along with the TARP and private investors
The example that Dr Krugman has given on the NY Times blog , and others critics imply that the structure of the funds will be the former (per security basis), and not the later (total portfolio basis). If that is the case, this is a really bad plan. On the other hand, if it is the later (and Krugman's assumption is wrong), than this plan could be deemed reasonable, though there would still be issues around governance - as banks might be incented to overpay by setting up "intermediary investors", or investors themselves might overpay if they took long positions on the bank stocks, but some of that could theoretically be worked out.
Regardless, this is a critical question that needs to be answered, and there is dissagreement among many right now on this issue.