The Paulson Plan, "Give me $700 billion dollars, and don't ask questions", has been rightly debunked. Earlier this week, Chris Dodd (D-Conn), released a draft proposal that takes the same essential approach as Paulson (the gov't should buy troubled assets from financial firms), but in a non-insane way. (Note: No text is available, that I can find, of the bill as it's currently under negotiation. So I'm working from Dodd's initial draft as best I understand it. But news reports suggest that the working draft is much closer to Dodd's than Paulson's, including "an equity mechanism to protect taxpayers").
I'm not here to argue about whether a bailout is necessary at all, or whether some radically different alternative might be better. Rather, my purpose is to describe the warrant mechanism in Dodd's draft and its implications. Nor will I be addressing several other sections of the Dodd plan (an oversight committee, money market stabilization fund, etc).
Paulson's plan essentially gives the Treasury Secretary license to purchase whatever troubled assets at whatever prices he wants. If they're later sold at a profit, taxpayers win. If sold at a loss, taxpayers lose. It's quite possible that the current market price of many assets is too low (based on the income they would generate if held to maturity), because everyone is trying to deleverage simultaneously, and no one wants to take on more risk. Brad Setser has argued that the bailout can't work if the Treasury were paying current market rates, because bank balance sheets couldn't absorb the write-downs. So the plan almost certainly involves paying higher prices than the market currently would, but it includes the hope that market prices are artificially low.
Dodd's proposal of equity warrants offers a lot more than just hope. Essentially, if the Treasury overpays for an asset, and later could only resell it for a loss, the company we bought it from has to buy it back at the original price instead -- if they're reasonably economically healthy. There's still some taxpayer risk, but only if the asset can't be resold at a profit AND the company we bought it from has failed (or at least suffered a significant stock decline since we bought the asset).
Technically: Whenever the Treasury purchases an asset, it will receive a warrant entitling it to stock equal to 125% of any realized loss, based on the stock price at the time of the initial purchase.
An example: We buy a pile of assets from Company X for $1 billion. Company X's stock is currently $10/share. Two years from now, we sell the assets.
- For $1.2 billion. Great, $200 million profit to reduce the deficit.
- For $800 million. The warrant kicks in, and we receive ($200 million)/($10/share)*125% = 25 million shares of stock in Company X.
a) If X has gone bankrupt during these two years, we're out $200 million.
b) If X is not bankrupt, but their share price is below $8/share, our equity position won't fully make up for the loss on the asset, but it's better than nothing.
c) If X has done reasonably well, and their share price is above $8, then the stock is worth more than the $200 million loss on the assets. At this point, it is in X's interest to bid the original $1 billion when the assets are up for resale, rather than issue the stock. The taxpayers break even, and X has had the use of good capital in the meantime, allowing it to survive a liquidity crunch, extend credit to others, etc.
(2c), and to a lesser extent (2b), are what makes the Dodd plan vastly better than Paulson's proposal. It eliminates the scenario of "taxpayers are stuck holding bad assets while the company we bailed out goes back to making money".
In fact, it makes the program look more like a repurchase agreement or a collateralized loan. These are the tools that the Fed has been using over the last year to extend credit to the markets -- issuing Treasuries in exchange for questionable assets via repurchase agreements or some of the newer lending facilities (TAF, TSLF, PDCF). But the Fed's balance sheet is only $800 billion, and they've used most of it. The bailout, with warrants to force economically healthy companies to repurchase any assets that can't be sold for a profit, rather resembles an extension of these Fed lending programs to the Treasury.