To Splurge Or Not To Splurge

I went to bed with the news that McCain wasn’t sure if he would support the splurge. Not that anyone needs my vote on this thing, but I woke up trying to figure out if I am in favor of it. So I’ll read (links) and think outloud and hopefully get somewhere.

My friend Tom Evslin, a conservative in the best sense of the word, posted his thoughts titled Just Say No. He argues the splurge is a short term fix and we should invest the capital in long term solutions to our economic problems instead.

My friend Roger Ehrenberg, a wall street guy who made the leap to startups and VC a few years back, thinks we must do something:

Bottom line, I think the system would remain too jammed for too long
simply letting things play out on their own. Now I am a free markets
guy. I grew up in the markets. Love the markets. Believe in the
markets. But this market is badly broken, and it needs a bridge loan to
begin the healing process. And this can and must be structured in a
manner that achieves the objectives without unfair and inappropriate
bailouts. The devil is in the details. But to toss aside the call for
action is, in my opinion, playing a dangerous and unnecessary game.

Mohamed El-Eria, Co-CEO of the huge bond fund PIMCO, wrote this in the FT yesterday:

As is now widely recognised, left to their own devices, US financial
markets simply could not accommodate the large and simultaneous
shrinkage of multiple balance sheets without major damage to
institutions and, critically, the system. Last week, the damage had
migrated to the essential component of any financial system – the
smooth functioning of cash, collateral and counterparty risk management.

You
would think all this would be too arcane for the politicians to take
notice until it was too late. Yet they did because disruptions affected
money market funds and, as such, became a real and present danger to
the average American. In these circumstances, the authorities had no
option but to act urgently. They did so by coming up with a bold and
targeted multifaceted approach. In the process they made two
transitions that are key to successful crisis management: most
importantly, move away from piecemeal measures and towards a
comprehensive and self-reinforcing policy programme; and see internal
measures supported by some action by other countries.

I am persuaded by Roger and Mohamed’s arguments that there is just not enough liquidity in the system and it needs a "bridge" and the lender of last resort is all of us, the US taxpayer.

But when a venture backed company runs into trouble and needs a "bailout" from its investors, the investors who step up generally get all the upside (with a generous carveout for the management team that will take the company forward). And when they are done right, these "recaps" (or "cramdowns") can be very profitable for the investor of last resort.

Look at what Buffett did with Goldman Sachs. He got a $5bn investment at what looks like an attractive valuation, he got preferred stock so his money gets out before any other equity holder, he gets a 10% interest rate, and 100% warrant coverage in the money. That’s the kind of deal the investor of last resort gets.

I do believe that the "splurge", as I’ve been calling it, can be structured as an investment of the taxpayer’s money into the fragile banking and brokerage system. And I am thrilled to see that someone on capital hill is smart enough to tranche the money as we would do in the venture business. Why invest $700bn when you can start with a couple hundred billion and see how its going?

What I want to know is what our upside is on this deal? We’ve been talking about $700bn which is what we call "the total capital requirements" or the $250bn which is what we call "the first round". At $700bn, that is $2300 for every citizen of the US, a huge sum for most people.

What I have not seen is a probability adjusted set of outcomes and an expected value of the gains on this investment we are being asked to make. If this money is not coming back, then its an expenditure and we should not do it.

If the probability adjusted return on this investment is $1.5tn then we should do it in a nanosecond. We would not approve any investment without doing this work and neither should our government. If I were Bush, McCain, or Obama (all three of them ideally) I’d send Paulson and Bernake to their cubicile and tell them to do the numbers and come back with the return projections before voting on this.

That’s my two cents for what it’s worth.

UPDATE: The comment thread on this post is what all comment threads should be, an informed honest tough conversation about this issue. I highly recommend it and want to thank everyone who has weighed in so far.

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