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We'll Call Them, um, "Bail Bonds"?


| Image by Newtonian Finances Ltd

The New York Times

has a story about the

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to allow ordinary folks to invest in the bank bailout:

The story explains the deal--still sketchy and provisional--like this:

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The administration's leaker is pitching the idea as a political balm:

Most of the story, in fact, turns on the idea that "retail investors" should have a chance to share in the bailout's "upside," and that if they can do so, all will be well:

Whenever a billionaire in a suit pitches something as a "win-win deal," I reach for my gun. The problem here, of course, is that the people in control of the bailout funds--the Pimcos, Black Rocks, and Legg Masons--are the guys who are getting big federal money to lever up their bets. Will I, too, get $20 (or $30) of guaranteed federal money for every $1 I "invest?"

The answer is as yet unclear, but would seem to be "no."

Also, the big boys will be taking fees to "manage" the program--so they invest a few billion of their own, get it multiplied 20-30 times by taxpayers' money, and then skim their management fee off based on the leveraged 30x investment. If they're 2-and-20 types (and the

to afford the "private equity" people their usual 20 percent of all the profits) that means they're really putting in next to nothing, because that first few billion they "invest" goes right back to them in fees.

Let's look at a sample deal to illustrate what I mean: Pimpco (a completely made-up hedge fund name) invests $5 billion in the PIP-whatever. Ben Bernanke/Timothy Geithner puts in $100 billion more through FDIC-backed methods, so Pimpco has $105 billion with which to buy the newly named "legacy assets."

Pimpco takes 2 percent of assets under management as its fee: $105b x .02 = $2.1 billion

Pimpco's net investment is now $5.0 - $2.1 = $2.9 billion.

Let's assume the investments lose value, and after a year the $105b package is worth only $90 billion. Technically, Pimpco's investment is wiped out, right? Its $2.9 billion is now dust.

But wait! The full investment is still worth $90b, and it's a year later, time for Pimpco to take its 2 percent-of-assets fee. $90.0 x .02 = $1.8 billion back to the highly skilled people at Pimpco.

Pimpco now has invested $5.0 - $2.1 - $1.8 = $1.1 billion.

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Next year is a better year, and the fund recovers to $100 billion. Pimpco pinches off another $2 billion. It has now made $900 million on its original $5b investment--a 6 percent annual return, in gross (not "Bill Gross") terms.

Yet the main pile is still worth $5 billion less today than it was three years ago.

Now s consider the "Main Street" side of the equation. As a passive investor, Joe SixPack is probably going to be in that big pile with Pimpco's $5 billion in equity. In fact, it appears likely that J6P's $10,000 will be folded into Pimpco's $5b, reducing the need for Pimpco's principals (who are not in any way related to Bill Gross) to come up with any money of their own. But let's skip over that. Let's assume that J6P gets to be the part of the pool that can take 80 percent of any profits.

Now let's look down the road, say, five years. Let's figure on a best case scenario--one in which J6P did not lose his job or have to take care of a wife with cancer or send a child to college or chip-in for destitute parents. That is, J6P has let his money ride, rather than asking for it back--and discovering that he's wiped out--during the initial years.

So, five years down, the economy is in recovery, and somehow these bonds are worth more than they had been at the start. Let's assume the thing is up 43 percent, at $150 billion now.

Let's say for the sake of round numbers, it just went up this year, after lying flat for the past two. Here is Pimpco's rake:

Year 1: $5b in and $2.1b out

Year 2: $1.8b out

Year 3: $2.0b out

Year 4: $2.0b out

Year 5: 2 percent of $150 billion = $3 billion, plus 20 percent of $45b profit = $9 billion

Pimpco's total: $19.9 billion, or $14.9 billion in gross profit. Pimpco quadruples its money.

Here is J6P's rake:

year 1: $10,000 invested minus 2 percent fee = $200

Years 2-4 minus 2 percent fee, prorate = approximately $750, deferred

Year 5: investment increased in value 43 percent to $14,300; 2 percent fee is $286; equity investors get 80 percent of the gain, or $3,440 of the $4,300 increase in value.

Gain on investment ($3,440) minus investment management fees ($1,236) = ($2,204).

J6P receives $12,204 on redemption.

In five years, he's made a cool $2,204, or a little better than 4 percent interest, compounded monthly. And he only had to risk it all and lock it up for 5 years. The

Times

, in its droll and matter-of-fact style, alludes to this potential outcome in the story's last paragraph:

A "win-win-win" scenario, indeed.

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