Privitizing Gains, Socializing Losses

Nobel Laureate Joseph Stiglitz has a great deconstruction of the Geithner toxic asset plan in the NY Times.  If you want to see how the new corporate state works, where the government works with a small group of powerful insiders to the benefit of those insiders and the detriment of everyone else, this is a great example.

Stiglitz walks through how the Geithner plan will operate, and I want to do so as well.  I have added a few tables to help illustrate his example a bit better.

Let's begin with a financial asset that was originally worth $200.    To make things simpler, we'll assume that with the current economy there are now two outcomes for this asset -- a 50% chance it recovers and eventually pays off its full value of $200, and a 50% chance it becomes effectively worthless  (more realistically, there is a range of outcomes, but this does not really effect the following analysis).

The average "value" of the asset is $100. Ignoring interest, this is what the asset would sell for in a competitive market. It is what the asset is "worth."

This is a classic expected value analysis.  At business school, you spend a lot of your time doing these (trust me).  Expected value is just the percentage chance of each outcome times the value of the outcome, on in this case 50% x $0 + 50% x $200 = $100.

So Stiglitz hypothesizes a situation under the new Geithner plan where a private entity might be willing to pay $150 for this $100 asset.  That's certainly a windfall for the financial institution that owns the asset currently, since the asset is only worth $100 on the open market.  But why would someone pay $150?  Well, it starts with this:

Under the plan by Treasury Secretary Timothy Geithner, the government would provide about 92 percent of the money to buy the asset but would stand to receive only 50 percent of any gains, and would absorb almost all of the losses

The actual percentages are 8% from the private purchasers, 8% "equity" from the government, and 84% in a government-guaranteed loan  (Equity is in scare quotes because most investors learned long ago that if you provide 80%+ of the capital in a risky venture, you can call the investment "debt" all day long but what you have really done is made an equity investment).

So let's look at how the purchase cost is divvied up based based on a $150 purchase cost:

Taxpayer $138
Investor $12
Total $150

But we have already posited how this will come out:  a 50/50 chance of $0 and $200 for the final asset value.  So we can compute the outcomes.

50% Chance Investment = $0 50% Chance Investment = $200 Expected Value
Taxpayer -138 +25 -56.5
Investor -12 +25 +6.5
Bank +150 -50 +50

So there is a huge built-in subsidy here.   Now, I don't personally think the government needs to be injecting equity in banks.  But  I understand there are a lot of people who support it.  So perhaps the $50 subsidy of the banks in the above example is warranted.  But why the $6.5 subsidy of Geithner's old pals in the investment world?  This is a pure windfall for them, like finding money laying on the street.   Even Vegas does not tip the odds so far in favor of the house.

I agree with Stiglitz's analysis:

What the Obama administration is doing is far worse than nationalization: it is ersatz capitalism, the privatizing of gains and the socializing of losses. It is a "partnership" in which one partner robs the other. And such partnerships "” with the private sector in control "” have perverse incentives, worse even than the ones that got us into the mess.

So what is the appeal of a proposal like this? Perhaps it's the kind of Rube Goldberg device that Wall Street loves "” clever, complex and nontransparent, allowing huge transfers of wealth to the financial markets. It has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.

Update: I posted an update on the plan and these numbers here.


  1. Sean:

    The payments to the funds are to get the trades and price-discovery mechanism working again. People aren't going to buy or sell these things without some expectation of profit. Unless they are traded and prices discovered, banks are going to continue hiding them and remain zombies.

    That the requirements for funds are looking more and more tailored to the 'in-crowd' has actually been annoying some fund managers who have been tentatively dipping their toes in this area for months already.

    I dislike it, but I think it's better than just giving the money directly to the banks to do as they see fit. There are at least incentives to move with this, as opposed to sitting on cash.

  2. ElamBend:

    This is all looking like it is tailored to save the bond holders. The banks take a small loss on the sale of the assets, but save their butts by preserving the bonds. It's just another way of giving the banks money.

    See here:

    or here:

  3. More outcomes:

    How does the expected value change if you run the numbers like this:

    25% Chance Investment = $0, 25% Chance Investment = $75, 25% Chance Investment = $125, 25% Chance Investment = $200