Category — The Bailout

What are the current issues with the bailout plan?

1. Banks will not dilute their equity to the government.
2. The US Congress wants bank equity and further, does not trust Hank Paulson to buy the best CDSs, CMOs, CLOs, and other toxic assets to make the bailout profitable for the taxpayer.
3. We are running out of time. If we do not get a deal done soon, imagine, just imagine what the butterfly spreads on LIBOR at the end of 2009 will look like as banks try desperately to shore up their capital at the close of earnings season.

So let’s act quickly and rationally, using a mechanism we currently operate every day.

Every time the Treasury sells debt to finance the US Government, it runs what is known as a Dutch Auction.

1. It announces how many billions of bonds it intends to sell
2. Everyone intending to buy the bonds bids
   a) An amount
   b) A yield on that amount
3. The Treasury fills its order selecting the best yields and amounts. (for full disclosure, once the Treasury has reached its amount, the highest yield becomes the single yield for all auctioned securities.)

This mechanism is a perfect solution for our current bailout. In short, here is how it would work.

1. The government auctions off a $500 Billion of Equity ($700 may be too much).
2. Registered banks and insurance companies submit anonymous bids of
   a) An amount of capital
   b) A percentage stake of equity stake in each company
3. The Treasury would fill its auction by selecting the best bargains for its dollars.

Once the auctions are awarded, the selected companies would be allowed to do the following:

1. Choose if the awarded money will be preferred equity or common equity
2. If it is preferred, the rate should be floating against current 10 year treasury rate. This should reflect the new marginal cost the taxpayer now incurs to finance the government.
3. If corporations choose to redeem the preferred shares they can buy back the shares at cost plus the current 10 year treasury yield times the share value. The funding would be used to immediately retire treasury debt.
4. If the shares are common, the government can choose to sell these equities at any time or participate in any buy-back plan.

The benefits are as follows:

1. The Taxpayer now owns a share of all banking and economic activity and better, is protected against government borrowing costs.
2. Banks, now with more capital, can write down their subprime assets.
3. In addition, with the participating option, banks need their subprime assets to perform only as well as the treasury rate times the equity they receive. Once they receive their required capital, they can write down their assets to perform as well as a marginal treasury rate.
4. Finally, no one needs to buy anything but equity in banks and insurance companies. If physicists, mathematicians can’t value these assets, let’s not even try. We could administer this auction by election day, move on, and stave off a recession.

Let’s end with a story.

Once, as a broke college student, I attended a church supper with a good friend. After supper was cleared, the entertainment turned to a lottery game, which worked the following way:

1. Everyone who wanted to participate bought a raffle ticket
2. Every round would consist of the Minister drawing a ticket from the bowl
3. If your raffle ticket was selected, you were eliminated from the game
4. Before the beginning of the new round, the remaining entrants could choose to end the game, but only unanimously, and then split the money.

Now, in the early rounds when there were roughly 100 people playing, no way would there be consensus to end the game. But sure enough, as the numbers dwindled down to six or seven, a decision to collude was reached. As a champion of that decision, I too walked away with $300, enough to pay my bills for that month of school.

One by one as the Government works toward a solution, banks are failing and being sold off at miniscule values to the equity holders, eliminated from the game. First it was IndyMac, then Bear Stearns, then Lehman, then AIG, then WaMu and finally yesterday, Wachovia (who by the way, only a week ago had its chairman on CNBC saying how great Wachovia was going to be when it emerged from this crisis).

Maybe they’ll now be few enough to collude in this fashion and take the money as equity, letting us all move on.