This, on the other hand, is a brilliant scam.

Economist’s View: “Despair over Financial Policy”

Citi holds $100mm of face-value securities, carried at $80mm.

The market bid on these securities is $30mm. Say with perfect foresight the value of all cash flows is $50mm.

I bid Citi $75mm. I put up $2.25mm or 3%, Treasury funds the rest.

I then buy $10mm in CDS directly from Citi [or another participant (BOA, GS, etc)] on the bonds for a premium of $1mm.

In the fullness of time, we get the final outcome, the bonds are worth $50mm

SAC loses $2.25mm of principal, but gets $9mm net in CDS proceeds, so recovers $6.75mm on a $2.25mm investment. Profit is $4.5mm

Citi writes down $5mm from the initial sale of the securities, and a $9mm CDS loss. Total loss, $14mm (against a potential $30mm loss without the program)

U.S. Treasury loses $22.75mm

Great program.

Too bad it’s funded with taxpayer dollars.

In practice things will probably be a bit different — the banks issuing the Credit Default Swaps will probably insist on a larger share of the loot, since they’re the ones who take a loss. But even if the swap is priced at $3.5M on a $10M investment the hedge fund makes money. (Oh, and of course the bank selling the CDS is committing a kind of fraud because they know that the price for the swap should be $10M/$10M, but since doing that deal mobilizes $20 mil of free money from the FDIC, they still come out ahead compared to not doing it.)

You’d think this could be prevented by forbidding the writing of CDSs on toxic, er, legacy paper, but since CDSs are unregulated private contracts, the best you could do would be to forbid the parties to the Geithner deal from doing it directly, and it would always be possible to find ways to make the money flow through intermediaries.

So essentially this is yet another pump-money-at-the-titans scheme, with hopes that the influx of dollars from the treasury will finally cause credit markets to unfreeze. But why the heck should banks be lending money in an evironment like this? Business is bad, and there are tricksy, devious borrowers out there. Just ask the Treasury.


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