From Crony Capitalism to Crony Community Organizing: "Profit" Loophole in Bailout Bill Doesn't Require Net Profits.

Much of the blogosphere is up in arms because of the provision in Senator Dodd's financial bailout bill that might funnel profits from the bailout plan to ACORN Housing (related to the disreputable activist group ACORN), and other more reputable service organizations.

I have read Dodd's proposed statute and in some respects, it is far worse than has been reported. Senator Dodd has placed a loophole in the bill that is explicitly designed to siphon off tens or hundreds of billions of dollars to the Housing Trust Fund and the Capital Magnet Fund even if there are no net profits in the $700 billion venture.

Here is the provision that has already been widely noted:


(1) DEPOSITS.-Not less than 20 percent of any profit realized on the sale of each troubled asset purchased under this Act shall be deposited as provided in paragraph (2).

(2) USE OF DEPOSITS.-Of the amount referred to in paragraph (1)-

(A) 65 percent shall be deposited into the Housing Trust Fund established under section 1338 of the Federal Housing Enterprises Regulatory Reform Act of 1992 (12 U.S.C. 4568); and

(B) 35 percent shall be deposited into the Capital Magnet Fund established under section 1339 of that Act (12 U.S.C. 4569).

(3) REMAINDER DEPOSITED IN THE TREASURY.-All amounts remaining after payments under paragraph (1) shall be paid into the General Fund of the Treasury for reduction of the public debt.

The biggest problem here is that the 20% is not taken from net profits, but rather from any profit in the sale of each and every individual troubled asset.

For example, assume that the new Agency buys three troubled assets for $1 million each. One is sold for $2 million, while the other two are sold for $300,000. Thus, $3 million in investments are sold for $2.6 million, representing a $400,000 loss.

But Senator Dodd's bill does not provide for losses to offset gains: "Not less than 20 percent of any profit realized on the sale of each troubled asset" must be given to the two housing funds, so $200,000 of the $1 million profit on the one asset that made a profit must be siphoned off to the housing funds, despite the $400,000 net loss on the three deals taken together.

As an analogy, imagine a regular trader of stocks who takes lots of hedged positions and had net losses of 25% this year, but couldn't offset his gains with his losses, instead having to pay 15% income taxes only on his gains.

How much might be siphoned off under the Dodd bill? It all depends on how long the new credit Agency is in force, how often it turns over its portfolio, and how variable its returns are.

If the agency is in force for 4 years and turns over its portfolio every two months, then it would generate about $15 trillion in sales overall (650 billion x 6 x 4 = 15.6 trillion).

Let's assume that $7 trillion of sales generate a profit of $2 trillion and $8 trillion of sales generate a loss of $2.1 trillion, leaving a net loss of about $100 billion.

With a net loss, one might think that nothing would be funneled to the housing funds for service organizations, but that is not what the statute says or means. One looks only at the sales generating gains to determine the size of the payments to the housing funds. With $2 trillion in profits and $2.1 trillion in losses, the housing funds nonetheless get $400 billion dollars in "profits." (This is over 40% of a typical year's US total federal income tax receipts.) And that is the result if only 20% of "profits" are skimmed; the statute puts no upper limit on the skimming, so long as they come from profits (not net profits). Theoretically, the new Agency could potentially siphon off $2 trillion to the two housing funds, more than its $700 billion portfolio limit.

400 billion dollars may be a high estimate for the housing fund payments, but if they turn out to be only a tenth as large ($40 billion), they would still be huge. To reduce this massive skimming required by the Dodd statute, the new government Agency would have the incentive to engage in fewer transactions and do less to create a public market for troubled assets, thus significantly undercutting the chance that the bailout will work.

I was mildly in favor of the bailout until I read Dodd's proposed statute. The way that the statute is drafted is so tricky and its definition of profit is so unsophisticated and nonsensical that the statute smells more of graft than of an honest attempt to solve the financial crisis. We are moving from failed "crony capitalism" to failed "crony community organizing."

Other posts will deal with other provisions in the Dodd bill and whether ACORN Housing will actually apply for any funding.

Related Posts (on one page):

  1. From Crony Capitalism to Crony Community Organizing: "Profit" Loophole in Bailout Bill Doesn't Require Net Profits.
  2. Incentive Problems in the Dodd Bailout Bill.