Bad Asset Math, Bonus Edition

On Monday, writing about the Geithner asset purchase plan, I wrote that you should put your money on the pessimists and bet that the asset purchase plan will cost the government a bundle. I think I could have done a better job of explaining why. In general, you'll find a lot of people who will assume that "if Wall Street and private equity likes it, it's a bad idea." The thinking is that the sharpies on Wall Street will always get a good deal. I'm suspicious of that knee jerk response. The experience of the last year has shown that's not true: investment banks have shown themselves very capable of making horrendous bets in markets they designed themselves . The fact that private equity is willing to play with Geithner doesn't in itself mean we're getting ripped off.

But there's still reason to be skeptical that the government will get off pain-free. Supporters of the Geithner plan think we're using the power of the communal mind to come up with the right price. The private equity folks want to make money on this deal, and the temptation is to think that if they make money, the government does well, too. The only thing the government gives up is the notional value of its loan guarantees, and it even gets to share in the profits.

However, it doesn't work quite like that. The problem is that how the private equity players do in aggregate isn't what matters. It's how they do on each deal. Let's say they buy three batches of CDOs; we'll call these CDO Larry, CDO Moe, and CDO Curly. If CDO Larry turns out to be a good deal, while CDO Moe and CDO Curly are worthless, the investors can do quite well. The private equity investors can make a profit on Larry, but still call in the government's loan guarantees on Moe and Curly. You might say, hey, that's not fair. Shouldn't they have to cover the loss on Moe and Curly if they made a lot of money on Larry? Well, no. Not as the plan stands now if I understand it correctly. Maybe over the next weeks the plan will develop further. If Geithner & Co. can find a way around this problem, then this could turn out to be a much better deal for the government. But so far, I don't see what that way would be.