By James Kwak
Andrew Ross Sorkin’s Too Big to Fail sure is a page-turner; even for events that I already knew about in general, it’s full of new details and juicy quotations.
For example, on page 508 it lays out the details of Warren Buffett’s October 2008 proposal for a “Public-Private Partnership Fund,” which would eventually become the PPIP announced by Tim Geithner in March 2009. I knew that Buffett, Bill Gross, and Lloyd Blankfein had supported the idea, but I didn’t know the details. Buffett’s idea was slightly different from the eventual PPIP.
PPIP ended up having two flavors. In the toxic loan version, the equity would be split 50-50 between private investors and Treasury, and then the FDIC would provide leverage via a non-recourse loan (technically, I think it was some kind of loan guarantee); in the examples, it would be six to one. Buffett, by contrast, proposed leverage of four to one. Like PPIP, money would go first to pay off the government loan. However, then private investors would get all the money, until they had gotten their money back plus the same interest rate that the government got. After that point, investors would get 75% of the upside, and the government would get 25%.
I was curious about how the payoffs differed under these two proposals, so I graphed them. Note that this is for the legacy loans version of PPIP; leverage ratios do matter.
Thin lines are the Buffett proposal, thick lines are PPIP; blue is private investors, red is the government. I assume a single period and a 5% interest rate, but the interest rate doesn’t affect the shape of the curves. Private investors get a lot more upside under PPIP, but that’s basically because they have a lot more leverage (and hence get wiped out faster on the downside). In PPIP, they contribute 1/14th of the money and get half of the upside; under Buffett’s proposal, they contribute 1/5th of the money and get 3/4 of the upside. Curiously enough, the government also does better on the upside with PPIP. That doesn’t seem possible, except that the government is putting up a larger proportion of the money in PPIP than in Buffett. So moving from Buffett to PPIP, the returns for private investors and the government both go up, but that’s because the weighting is shifting from private investors (the higher returns in either case) to the government (the lower returns).
In the toxic securities version of PPIP, the leverage ratio was lower, bringing the thick blue line down closer to the thin blue line.
There’s nothing too scandalous here that I can see. But I thought someone else who made it to page 508 of Too Big to Fail might have had the same question, so here’s the answer.