**Interesting take on the PPIP:**

Heads or Tails?

March 29, 2009 David Kotok, Chairman & Chief Investment Officer

Dear Reader: Please give me 8 minutes to explain the $1.1 trillion federal government Public-Private Investment Program (PPIP).

Start here with this simple example. It’s a coin toss. Heads you win $100; tails you get nothing. How much would you pay to play? You can play as many times as you wish. Answer: not more that $50. For less than $50, you would play as often as you can. $50 is your breakeven; only a fool would pay more.

Now add Tim Geithner as your partner. He matches what you invest but you, and only you, get to set the price to play. Answer: you put up no more than $25 as the investor and that means he matches your number. At under $25 you play as much as you can. $25 is your breakeven as the investor; $50 is still the breakeven for the coin flip.

Now let’s add some of the leverage from the FDIC.

Suppose that the FDIC will loan you $40 as a non-recourse loan. You and Geithner each put up $5 for a total of $10 and, adding in the loan money, you pay $50 to play, just as before. If you get heads, you pay off the loan of $40, and you and Geithner split the rest. That means you get $30 for your $5 and so does he. Remember, you set the price to play. If you get tails you get nothing and lose $5, Geithner loses $5, and the FDIC loses $40.

Now suppose we have an auction to decide who will play.

The highest bidder wins the right to play as many times as he wishes. With this example the breakeven price rises from $50 to $70. At $70 you put up $15; Geithner puts up $15 and the FDIC still loans $40. Half the time you will win $100 and use $40 to pay off the FDIC, leaving $60 for you to split with Geithner. You will get $30 back for each $15 you play, when you win. The other half of the time you will get zero, since it’s still a coin flip risk.

Notice that the price to play went from a $50 breakeven to a $70 breakeven. This happened while the odds remained a 50-50 coin flip.

Also notice that the leverage ratio was low when you put up $15, Geithner put up $15, and the FDIC put up $40. Under the Treasury PPIP plan the leverage ratio can go as high as 6 to 1. Using the full 6:1 leverage ratio, a coin-flip breakeven point would be about $3.57 for the investor.

Here is how I get that number. You put up $3.57; Geithner puts up $3.57; the total investor’s equity is $7.14. The FDIC loans 6 times $7.14, or $42.84. Total price to play is $49.98. Let’s call it $50, which is the amount to play each time.

Notice that the breakeven auction price is now almost $93 each time. Remember you, as the private investor, are the one who sets the auction price, because you are the only one deciding the bidding. Geithner is matching you and the FDIC is loaning 6 times the equity.

The leverage and the risk transfer have raised the investor’s breakeven from a $50 auction price, if you did this all by yourself and without any leverage, to a $93 auction price when leverage is fully deployed. The risk of winning or losing is still a coin flip.

Let’s substitute a toxic asset on a bank’s balance sheet for the coin.

Instead of a 50-50 coin flip, with PPIP we have a toxic piece of a mortgage-backed debt instrument that has an uncertain value. If we use PPIP, aren’t we really inflating the price artificially? It seems to me the answer is yes.

How can we adjust for this risk transfer that allows the auction breakeven price to rise? That answer lies in how much the FDIC will charge to make the non-recourse loan. If the FDIC charges enough, it will bring the auction price back to $50 and restore the deal to neutrality. If the FDIC charges more, it will bring the price below what it would be without the leverage.

But if the FDIC underpriced the loan cost, it would then have subsidized the deal and allowed the auction price to rise. That means the seller of the toxic debt instrument got more than it was worth and the investor made a profit because of the FDIC.

Some of the risk of payment on that instrument transferred to the FDIC. That means it transferred to the FDIC insurance fund, which means it transferred to every insured deposit in every bank that pays an insurance premium into the fund. That means the depositor may be getting a lower interest rate on that deposit than he otherwise would get.

That is PPIP.

Some Questions. Will this process set a true “market price” for these toxic assets or are we using a gambler’s pricing mechanism? Has Geithner been transparent about this risk transfer to the FDIC? What will the FDIC charge investors when it assumes the 6:1 leverage risk? Will it price risk fairly or will it grant massive subsidy to banks?

Dear reader: you decide if this is a good thing or a bad thing. You decide if this is how it was presented to you. You decide if this is a sound policy solution for the US banking system or if you believe that our government has taken “moral hazard” to a new level with pee-pip?

For more details on PPIP see this weekend’s issue (March 30) of Barron’s and the columns on PPIP by Jonathan Laing and Andrew Bary. They start on page 25 and offer an investor’s view. As a money manager for our clients, the Cumberland firm will look at PPIP and may use it on behalf of clients after we have reviewed an official form of an offering document. As a private citizen concerned about my country and its policy direction, I think this reeks and stinks.

David Kotok, Chairman & Chief Investment Officer