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.