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Incentive Problems in the Dodd Bailout Bill.

Senator Dodd's bailout plan has some serious drafting and incentive problems.

If the drafters of the Dodd scheme were to create a game based on the scheme (assuming a liquid market and rational behavior) and play a few dozen rounds one evening, they would know that the Dodd scheme won't work unless people do things that are directly contrary to their interest in making a profit.

Section 2(c)(2)(A)(i) provides:

"The Secretary may not purchase, or make any commitment to purchase, any troubled asset unless the Secretary receives contingent shares in the financial institution from which such assets are to be purchased equal in value to the purchase price of the assets to be purchased."

A LITERAL READING

If the contingent shares must be equal in value to the purchase price of the assets, then why would most companies sell troubled assets to the government at their current estimated value?

For example, if the government pays a million dollars for some troubled assets, then the company must give the government the troubled assets plus contingent shares worth a second million dollars. If the contingency had a 50% chance of occurring, then that would mean that the company would have to turn over a contingent right to $2 million in company stock ($2 million x 50% = contingent shares valued at $1 million).

But the most that would be payable if the government lost all $1 million on a $1 million purchase would be $1,250,000 in stock (1.25 x the loss). So a 50% chance of that would be worth $625,000, not the $1 million required by the literal language of the statute. In this view, the government could buy only troubled assets that where the chance of their becoming worthless was at least 80%. This makes no sense. And what company would want to receive just a million dollars in return for a million dollars in assets plus contingent shares worth a million dollars?

A FIRST GAME

The literal reading of the statute I went through above is probably not what was intended by the drafters. What the drafters probably intended is that, in return for paying a million dollars, the government would receive the troubled assets plus a contingent right to shares of stock that would be worth a million dollars IF they were NOT subject to a contingency. Since the shares ARE subject to a contingency, these contingent shares are worth something, but not a million dollars.

Nonetheless, this approach still doesn't make much sense for reasons that are best shown by imagining a game.

The government is paying a company million dollars for 2 things: (a) a troubled asset and (b) a contingent right to $1 million in stock.

Assume a heuristic game.

In the first round of the game, let's arbitrarily assign a value to the contingent right of $300,000 (eg, a substantial chance of up to $1 million in stock). Accordingly, in return for a nominal purchase price of $1 million, the company would trade the government an asset worth $700,000 and a contingent right (to up to $1 million in stock) worth $300,000.

Assume that an hour later, the government sells the $700,000 troubled asset for the market price of $680,000. According to the way I read the statute, the government has just sustained a loss of $320,000 ($1 million - $680,000). This triggers a penalty clause that gives the government 125% of its loss in company stock, measured by the stock price in the 2 weeks before the original deal. Thus, the government now obtains $400,000 of the company's stock.

From what we've learned in the first round of the game, a contingent share right (to up to $1 million in stock) should probably be valued at significantly more than $400,000 in the second round of the game; let's say it's worth $600,000. In the second round, the government agrees with another company to pay $1 million for a contingent right worth $600,000 and troubled assets worth $400,000.

Assume that an hour later, the government sells the $400,000 troubled asset for the market price of $380,000. According to the way I read the statute, the government has just sustained a loss of $620,000 ($1 million nominal price - $380,000). Again, the government is entitled to 125% of its loss in company stock, measured by the stock price in the 2 weeks before the original deal. Thus, after the second round the government now obtains $775,000 of the company's stock.

So our valuation of $600,000 for the contingent right in the second round was too low. In the third round, let's assign a value of $800,000 to the contingent right and $200,000 to the troubled assets. Again the government pays $1 million. An hour later, the government sells the $200,000 in troubled assets for $190,000. It now is allowed to take all $1 million of company stock to make up for 125% of its $810,000 in nominal losses.

Anyone who understands how such a game progresses would never play even one round.

A SECOND HYPOTHETICAL (or GAME)

The prior example assumed that the government was selling the troubled assets in its portfolio for as high a price as it could and that it flipped the assets quickly.

In a second example, assume that the government holds the property for a few months and tries to maximize its own profits, not to maximize the resale price. Assume that the government bought a million dollars in troubled assets from each of two companies, ACME and ZED. In the two months since the purchase, ACME's stock had dropped in half; ZED's stock had doubled in price. A rational government would sell the ZED asset for LESS than it was worth on the open market, because for every $1 the government lost on the sale of the asset it had originally received from ZED, it would gain $2.50 in ZED stock (125% of the loss measured by the original price of the stock, which has now doubled).

When stock prices have climbed since acquiring the troubled assets, the worse the government does in selling troubled assets -- ie, the lower the prices it accepts from buyers — the more money it makes. This perverse incentive renders the scheme unworkable if you want actors in the Dodd scheme to maximize returns.

ANOTHER DRAFTING ERROR

The bill also contains this bizarre definition:

As used in this subsection, the term "contingent share" means any equity security traded on a national securities exchange.

Again, this makes no sense. Contingent shares of bank stocks are not generally traded on exchanges such as the NYSE or AMEX and will not be traded on exchanges under the bill.

Sagar (mail):
may be the purpose is not to help the economy, but to give the public the impression that they are trying to do something about it.

btw, shouldn't Dodd and Frank sort of stay out of this since there may be a conflict (or appearence of impropriety)?

also, surprising that there are no comments to this post! may be there's too much math for partisan bickering:)
9.27.2008 3:26pm
Morat20 (mail):
Jim:

You seem to be missing something really fundamental here, and your mistake occurs when you say:

And what company would want to receive just a million dollars in return for a million dollars in assets plus contingent shares worth a million dollars?


And the answer? [i]Only a company desperate to avoid bankruptcy and utter ruination, which has exhausted all non-governmental options[/i].

It's not SUPPOSED to be a good deal for the private business. It's a bailout. The whole point is to make the terms so unpleasant for those qualifying for the bailout, that only the desperate will take it -- and sell as few troubled assets as they can.

Whenever a collapsing business is bought out, they often agree to terms that are truly disadvantages for them -- because they have no other choice.
9.27.2008 4:08pm
not sure I heard you correctly:
btw, shouldn't Dodd and Frank sort of stay out of this since there may be a conflict


Sagar,

You have a problem with the involvement of Senator Dodd and Representative Frank?

Article I, Section 9:
No money shall be drawn from the treasury, but in consequence of appropriations made by law; and a regular statement and account of receipts and expenditures of all public money shall be published from time to time.


You seem to be suggesting that Secretary Paulson should embezzle the money from the treasury of the United States. But surely, that's not what you really meant.
9.27.2008 4:37pm
Tom Maguire (mail):
FWIW, I can offer this ray of hope - that looks like the Dodd draft from last Monday (the DeLong website is dated Monday) so we can hope that that contingent equity provision is gone and restructured to make sense.

I had posted on it (and I'm kicking myself for missing your Acme/Zed share price wrinkle) but had offered the following points:

1. The Dodd plan does not actually provide new capital to the system. Instead, if Treasury pays $1 billion for an asset, all the seller ever gets is $1 billion. Depending on whether Treasury sells the asset, the seller later learns whether it was a straight sale at $1 billion or a sale at the Treasury re-sale price coupled with bizzaro warrants that dilute current shareholders.

Net effect - no price-risk reduction for the seller and reduced ability to attract new private capital, since investors can't guess the ultimate dilution caused by a Treasury re-sale.

As to whether this "protects" the taxpayer, well, assets prices can move due to broad market changes, not because the Treasury over-paid. Leaving sellers on the hook for assets they have "sold" is sort of counter to the logic of selling them.

Finally, what if the Treasury simply holds these assets to maturity and funds them? On a cash flow basis they will have a gain or loss, but, absent a re-sale, there is no "taxpayer protection" or contingent equity.

Much, much cleaner would be for the Treasury to buy (i.e., pay for) conventional warrants with a share price, maturity, and total proceeds at the time they buy troubled assets. Then if the seller does well for any reason the Treasury can profit, regardless of the price performance of a specifc asset. And as Treasury exercises warrants, new capital comes into the market.

I did see that Paulson was willing to accept some warrant provision on *negotiated* sales, but not auction sales - he wants everyone, healthy or weak, to join the auctions.
9.27.2008 5:35pm
Sagar (mail):
Not sure you heard me correctly,

I was not saying Paulson should get his hand in the cookie jar without congressional approval. In fact I don't like this $700B "bailout". My comment was that pols who have taken money from the banks should not be the key players in writing the law regulating (or deregulating) them.
9.27.2008 5:54pm