1. Banks take bundles of their bad assets, mortgages or securities, and then place them in a Government auction. It is a highest bid auction. It is not clear if there is a reservation price and it is not clear just how mush transparency there will be. The devil is in the details here. This was the stumbling point for the Paulson plan. Here is where we see the first risk. No one shows. The reservation price is too low or non-existent or there is a total lack of transparency and no one can purchase without some due diligence. This really needs clarification.
2. The auction proceeds and the buyer pays 7.5% and the Government puts in 7,5%. Equal equity but the buyer controls.
3. The buyer then somehow gets debt from the market and the debt is totally guaranteed by the FDIC, and somehow the FDIC can underwrite the debt. This is really another credit default swap. This CDS II is the real devil in the detail. Somehow no one has seemed to identify this issue.
4. The buyer holds the security for a while until it can be sold. This is a risk factot three. It assumes that there is a greater fool to purchase this at a higher price. Somehow there is a cash flow behind the security or perhaps a secondary market. Again there is the risk of another set of CDS behind this. Hopefully they are regulated.
5. Then the Government gets paid back, hopefully, and the Government makes a profit, hopefully.
The risk factors are shown below. Note that there is a hedge created by the Government FDIC debt guarantee. This means that there is a maximum loss of 15%. One can imagine the many derivatives which can be generated on this hedge. The figure below also a probability distribution, lacking any black swans and long tails, that lets one look at the spread of the returns.
We believe that this proposal is most likely the best that can be done at the present. The risk is placed upon the Government and there is no underwriting of the risk. This is the same as the naked risk taken by AIG which got us in the mess. This is a movement of chairs on the deck of some ship, hopefully not the Titanic. One can perform a set of detailed analyses on this scheme but I believe it will all rest upon the auction. This was the same problem Paulson never seemed to solve. Geithner seems to "solve" this via the FDIC underwriting. Hopefully this gets some traction. If it does, and if the toxic wast can be moved and monetized, then hopefully the system is put back in motion.
All of this is set in motion awaiting next weeks meeting of the G20 in London. That will, as we have been saying, is critical.
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