Warning: This post could be a bit technical. It may well end up with I-don’t-know-what-I’m-talking-about. Apologies.
I’ve been thinking about PPIP recently, in order to safeguard the tax payers. My previous posts can be found here and here.
The Deal
Let me restate the deal here: private investors will bid for a pool of loans or securities as equity investors, say the settling price is $100; private investors will put down $100/14=$7.1 in equity; the Treasury will match the amount in equity, in this case another $7.1; FDIC would leverage the $14.2 up to $100, by guaranteeing $85.8 debt, or 6X equity (or less on a case-by-case basis).
The Option
The FDIC guarantee could be seen as writing a European put option with the following parameters: S0=100, St=85.8, (assuming that) dividend=3%, I=3%, annual Std=10%~20%, t=8 years.
The put option is worth $3.8~11.2 (a note for those technical readers: Delta=-0.1935, Gamma=0.0088, Theta=-0.0009).
In other words, if the bidding price is a fair price (without overpaying), FDIC is giving a 1.9~5.6% subsidy to selling banks. If the total pool is $1 trillion, it is $19~56 bn.
On the other hand, FDIC is also receiving fees on this one. Suppose that the premium is 1%, cumulative default is 30%, they may have a break-even.
Gains and Losses
So weird, isn’t it? I thought it is a deal to subsidize the banks with tax payer money, now it turns out that the tax payers have more on the up side. Thoughts could be volatile sometimes.
But the gains must come from some guys. The possible candidates are: the banks (because of depressed market price) and the debtors-to-be (because of low interest rate), and the possibility skews towards the banks. If so, why are they selling?
I may well be wrong. Something is missing here..
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