If you are a regular reader of Seeking Alpha, chances are you are a sophisticated investor and will already understand the concept of this entry well. Yet as I talked to some of my investors around town (and listened to members of Congress!), I realized there were so many misconceptions about the mechanics of Paulson's proposed rescue package, I wrote the following to my clients:
The Hedge Fund of America, LP
After listening to Congressional testimony and speaking with investors, it is clear people are confused about Treasury Secretary Hank Paulson's $700 billion dollar plan to rescue the financial system. There are many details and nuances to be worked out, and success is in no way guaranteed. Below is a simplified discussion of how the plan is structured, and what the plan is trying to accomplish.
Many are mistakenly under the impression the government is planning on raising $700 billion and making some type of expenditure that gets vaporized into an ailing institution, leaving the tax payer with a "bill" of $700 billion. This is a categorically false understanding of the plan, both in mechanics and financial reality.
The US Treasury is planning on raising $700 billion so it can invest in high yielding mortgage backed securities [MBS] currently owned by our nation's financial institutions. This does not constitute an expense; it is an exchange of cash for an asset. Mortgage related losses on securities have eroded capital so as to make it more difficult for many banks to make new loans, which is why this crisis is potentially devastating to the growth and health of the economy.
If executed properly, the plan could: allow financial institutions to get mortgages off their balance sheet, (while taking appropriate write downs), free up capital so institutions can once again lend, and actually make money for tax payers. Make money you ask? Yes. Here is how.
The Treasury is in the highly desirable position of being able to borrow billions of dollars for ten years at a measly 3.75% (the rate on treasury bonds). Under the plan, the $700 billion would be used to purchase mortgage backed securities with potential yields of 10-15% or even higher, depending on quality. Even if the government bought the most toxic debt and collected a couple of interest payments, they'd be in the money. Taxpayers would participate in gains as well as the losses. Every hedge fund in the world would love to have the government's low borrowing advantage and the benefit of time. What's more, there are plenty of distressed, high yielding opportunities out there.
One should not conceptualize this as moral hazard, socializing losses or rescuing the "bad apples" that created the problem. This is more akin to the US taxpayer committing capital to participate in a hedge fund with a large structural advantage. There are many risks involved in a government venture such as this, but conceptually it is simple: borrow at 3.75%, invest at 15%, and pocket the difference on $700 billion. Simultaneously this plan provides much needed liquidity to reignite frozen markets.