Paulson Plan Compared with Kotlikoff-Mehrling Plan

Three possible pricing structures can be contemplated: distress prices (current), support prices, and normal prices (pre and post crisis). The table below shows the relationship between the price paid for the bond under the Paulson Plan and the price paid for the insurance under KM. In each case, the two prices add to 100. The price of insurance is high when the price of the bond is low, and vice versa.

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The Paulson Plan involves outright purchase of $50bn worth of bonds in each tranche. Maximum loss in each tranche is thus capped at $50bn. The table below shows how the KM plan could be devised to achieve exactly the same maximum loss, in each of the three pricing scenarios. The key is to insure the face value of the bonds that the Paulson Plan would purchase outright.

Case 1: Distress Prices

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Case 2: Support Prices

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Case 3: Normal Prices

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Observations:

  1. In each scenario, the downside exposure of the taxpayer is exactly the same. If the bonds go to zero, then under the Paulson plan you lose what you paid. Under the KM plan you lose the face value of the bond minus the premiums paid.
  2. In each scenario, the upside exposure of the taxpayer is exactly the same. If the bonds go to par, then under the Paulson plan you gain the difference between par and what you paid. Under the KM plan you get to keep all the premiums and don’t pay out any claims.

Further Observations:

  1. The Distress Prices do nothing to recapitalize sellers of the distressed assets. If these prices are chosen, then recapitalization could be included in the plan by accepting preferred stock as payment for the insurance.
  2. The Support Prices help to recapitalize the sellers and support markets during distress times. As the economy returns to normal however no one will want to be paying these prices, and private insurers will step in charging lower prices.
  3. Support Prices near Distress levels will attract very little demand, but they may provide backstop for recovery of private market insurance at a more attractive price. Support Prices near Normal levels will attract a lot of demand, and crowd out any potential private insurance.
  4. Insurance of the AAA tranche is largely insurance against systemic risk, which should be the government job, so for the AAA tranche we want support prices nearer normal.

5 Responses to "Paulson Plan Compared with Kotlikoff-Mehrling Plan"

  1. DJC   September 27, 2008 at 10:01 am

    It’s not surprising the the CNBC pimps for Goldman Sachs would be pushing for Paulson’s bankster bailout. It has gotten to the absurd point that the US Treasury will be sending multi-billion dollar Corporate Welfare checks to Goldman Sachs monthly. General Electric owns CNBC, but CNBC is operated as the Ministry of Propaganda for Goldman Sachs. With only the exception of Rick Santelli from Chicago, the rest of the motley crew of CNBC financial analysts are on the Goldman Sachs payroll.Beware on any stock market tips by CNBC financial analysts. Goldman Sachs alumni Jim Cramer was pushing Bear Sterns stock two days before the bankruptcy. The unsuspecting US general public is duped repeatedly by massive disinformation.Paulson’s Taxpayer Bailout for Wall Steet to be approved with political payoffs to Congresshttp://www.washingtonpost.com/wp-dyn/content/article/2008/09/26/AR2008092601240_2.html?sid=ST2008092700401&s_pos=

  2. Guest   September 27, 2008 at 2:28 pm

    I’m just wondering why you think this is true: “The Paulson Plan involves outright purchase of $50bn worth of bonds in each tranche. Maximum loss in each tranche is thus capped at $50bn.”If Paulson is proposing to buy Supersenior CDO tranches, the maximum loss can be far higher than the price paid for the tranche. Why do you think AIG had so much trouble with them? Please indicate where the Paulson proposal limits losses to the price paid for the securities.

    • Perry   September 28, 2008 at 9:20 am

      AIG was not buying the Superseniors outright, it was insuring their face value. NYTimes this morning reports that AIG leaders thought there was zero probability that they would ever have to pay out. Hence they put aside no reserves, and proceeded to write enormous volumes of additional policies. Perhaps they thought they were being paid for regulatory arbitrage, not insurance. They thought wrong.

      • Guest   September 28, 2008 at 9:12 pm

        Supersenior CDOs are always unfunded: i.e. their purchase price is zero (only a few purchasers are eligible) and they are more accurately termed Supersenior CDS. I haven’t read the current proposal, but nothing in the original plan prevented Paulson from buying a supersenior CDO = selling supersenior CDS.

        • Perry   September 29, 2008 at 10:22 am

          Selling supersenior CDS is selling credit insurance, which is the explicit task of the second fund mentioned in the legislation (Section 102). Note also the mention of working to create a CDS exchange. Paulson maybe could have done this under his original plan, but I have seen no indication that he was prepared to do so. Quite the contrary.