How The Equity Stake Thing Will Work

Krugman reads the equity stake part of the Dodd plan as the conduit via which Treasury might give Wall Street "a real infusion of capital, if that becomes necessary".  I don't read it that way.  Treasury's shares in the firms only vest  once the related asset is sold for a loss, and the number of shares is calculated by reference to the dollar value of that loss. That is, the equity stake is supposed to be a make-whole provision to cover the loss - which tells me that the intention is to sell the stakes at the same time as the sale of the related asset. I doubt that Treasury is going to get shares in various firms and then play them long as part of this program. We supposed to be unwinding a specific mess, not getting involved in board fights and proxy battles. If there is a public infusion of equity into Wall Street firms, they'll do it through a separate program.

Assuming I am right and the equity securities will be sold immediately, I think this covers the range of possibilities:

Let's say the Troubled Asset Program (TAP) purchases mortgage-backed securities with a market value of $500,000 from Company A, whose stock is trading at $50/share. Company A would have to give TAP warrants for 10,000 shares ($500,000/$50). A year goes by and TAP sells the mortgage-backeds:

1. Scenario 1: Proceeds of the sale are $750,000. The profit of $250,000 is split 20% to residential assistance programs and 80% to the Treasury. The warrants in Company A lapse.
2. Scenario 2: Proceeds of the sale are $500,000. No gain or loss. The warrants in Company A lapse.
3. Scenario 3: Proceeds of the sale are $250,000 and the stock price of Company A is $100 per share. TAP is vested in 5,000 shares of Company A ($250,000 loss/$50 price at time of purchase). Selling 5,000 shares @ $100 per share yields $500,000, so overall TAP profits $250,000. (Presumably, this is a "profit" sale situation that triggers the same treatment as Scenario 1.)
4. Scenario 4: Proceeds of the sale are $250,000 and the stock price of Company A is $50/share. TAP is vested in 5,000 shares of Company A ($250,000 loss/$50 price at time of purchase). Selling 5,000 shares @ $50/share yields $250,000. No gain or loss overall.
5. Scenario 5: Proceeds of the sale are $250,000 and the stock price of Company A is $0.10 per share. TAP is vested in 5,000 shares of Company A ($250,000 loss/$50 price at time of purchase). Selling 5,000 shares @ ten cents each yields $500. Net loss is $249,500.

I posted that comment here, where there is a copy of the bill up that everyone can comment on. Scenario 3 raises the question of what the bill means when it says "profit" - does that mean including the sale of the related equity, or just on the sale of the troubled asset? I think it has to be inclusive to make sense, but either way it should be spelled out.

Comments

[Tom Bozzo]

In the Dodd plan the trigger for vesting of the contingent shares is the difference between "the amount the Secretary receives in disposing of such assets" and "the amount that the Secretary paid for such assets," with "troubled assets" being the antecedent of "such assets." So in Scenario 3, the loss on the troubled assets would seem to trigger the vesting, and the Treasury would be allowed to keep the profit on the vested contingent shares as a penalty for being stuck with the toxic waste.

The question for the lawyers would be whether the statutory language would make the value of the vested shares part of the proceeds of "disposing of the troubled assets." It looks like no if the proceeds of the share sale are regarded as a separate transaction -- but I'm an economist, not a lawyer, so have no idea if that's how the terms would be read.

[Mithras]

Tom-
I'm not suggesting that the contingent equity shares somehow prevents the vesting of the equity under Sec. 2. I'm asking whether the vested equity shares are part of the calculation of profit under Sec. 5.

[Tom Bozzo]

Ah, thanks for clarifying. I'd agree that the draft section 5 is ambiguous as to how those proceeds would be split -- and at a glance the draft wording leans towards those proceeds go to reducing the public debt. No idea if that's how it's intended.

[Aquagirl]

"That is, the equity stake is supposed to be a make-whole provision to cover the loss - which tells me that the intention is to sell the stakes at the same time as the sale of the related asset. I doubt that Treasury is going to get shares in various firms and then play them long as part of this program."

What makes you think so? There are some government agencies that are regular participants in bankruptcies, they take on equity as part of their distribution under the plan of reorganization. While there are concerns about corporate control, those agencies have to carefully plan the sale of those equities because to dump them all at once would depress the price and lower the agency's recovery. If losses are large, the related equity stake is large and the treasury can't sell them all at once without reducing its own take, driving down the share prices, and possibly destabilizing the affected firms and the economy even more. I think they have to hold.