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Media Mentions

Accepted Papers

"Common (Stock) Sense about Risk-Shifting and Bank Bailouts" accepted subject to minor revisions at the Financial Markets and Portfolio Analysis

"The Goldman Sachs Warrants forthcoming the Review of Business

"The Put Problem with Buying Toxic Assets" forthcoming Applied Financial Economics

"Should Goldman Sachs and Morgan Stanley Try to Get Half Price on the TARP Warrants?" The Journal of Finance and Accountancy Vol. 2, pp. 1-8.

Working Papers

"A Binomial Model of Geithner’s Toxic Asset Plan"

"Debt Overhang and Bank Bailouts"

"Estimating JP Morgan Chase’s Profits from the Madoff Deposits"

"Lessons for the TARP Warrants from 1983 Chrysler Auction"

"A Model for Estimating the Cancellation Probabilities of TARP Warrants"

"Slicing the Toxic Pizza: An Analysis of FDIC’s Legacy Loan Program for Receivership Assets"

Valuing the First Negotiated Repurchase of the TARP Warrants

"A Binomial Model of Geithner’s Toxic Asset Plan" (pdf file 127 KB)

Abstract

This paper formally models the Public Private Investment Partnership (PPIP), a plan for U.S. government sponsored purchases of distressed assets. This paper solves both the problem of the asset manager buying toxic assets and the banks selling toxic assets. It solves for the fair market value of toxic assets implied by subsidized toxic asset auctions, and it estimates the size of the government’s subsidy. Moreover, this paper finds under what circumstances banks and asset managers will meet at a mutually acceptable prices. In general, healthier banks will be more willing sellers of toxic assets than zombies.

Keywords: bailout, banking, CMBS, CDOs, EESA, Emergency Economic Stabilization Act, lending, mortgages, Public-Private Investment Partnership, PPIP, TARP, RMBS, too big to fail, toxic assets, zombies

JEL Classifications: G12, G13, G18, G21, G28, G38

"Common (Stock) Sense about Risk-Shifting and Bank Bailouts" (pdf file 161 KB) with Yan Wendy Wu; accepted subject to minor revisions at Financial Markets and Portfolio Managment

Abstract

If a bank faces potential insolvency, it will be tempted to reject good loans and accept bad loans to shift risk onto its creditors. We analyze effectiveness of buying up toxic mortgages in troubled banks, buying preferred stock, and buying common stock. If bailouts for banks that are deemed “too-big-too-fail” involve buying assets at above market values, then these banks are encouraged ex ante to gamble on bad assets. Buying up common (preferred) stock is always the most (least) ex ante- and ex post-efficient type of capital infusion whether or not the bank volunteers for the recapitalization.

Keywords: banks, bailout, lending, risk-shifting, TARP, too-big-to-fail

JEL Classifications: G21, G28, G38

"Debt Overhang and Bank Bailouts" (pdf file 117 KB)

Abstract

When a bank is deemed “too-big-to-fail” by regulators, it may be tempted to buy risky assets. This paper analyzes bank bailouts involving the purchases of toxic assets, preferred stock, and common stock when the government wants to encourage efficient lending. It finds that preferred stock recapitalizations are the least efficient in correcting debt overhang problems from both an ex post and ex ante perspective. In contrast, efficient lending and voluntary participation can be best achieved without subsidy by purchasing either toxic assets or common stock. Nevertheless, troubled banks must be subsidized if they will voluntarily participate in any recapitalization.

Keywords: bailout, banking, debt overhang, common stock, Capital Purchase Program, lending, preferred stock, TARP, too-big-to-fail, toxic assets

JEL Classifications: G21, G28, G38

"Estimating JP Morgan Chase’s Profits from the Madoff Deposits" (pdf file 68 KB); revisions requested by the Risk Management and Insurance Review

Abstract

JP Morgan Chase allegedly had deposits from Bernard L. Madoff totaling $5.5 billion at one point in 2008. The Chase account was supposedly where most of the funds in his Ponzi scheme were deposited. Any large deposit can be a considerable source of profit to a bank. Assuming that the deposits returned the bank’s net interest margin and grew at a random geometric rate, this paper estimates that JP Morgan Chase generated $483 million in after-tax profits from this very large account over the course of sixteen years. With JP Morgan Chase the target of pending lawsuits relating to the Madoff fraud, this paper’s methodology and results may be of interest to litigants, prosecutors, journalists, and academics.

Keywords: deposits, fraud, JP Morgan Chase, litigation, Madoff, Monte Carlo simulation, net interest margin

JEL Classifications: G01, G21, G24, K13, K14, K23, K41, K42

"The Goldman Sachs Warrants" (pdf file 130 KB) forthcoming the Review of Business

Abstract

This paper values the Capital Purchase Program (CPP) and Berkshire Hathaway warrants issued by Goldman Sachs in 2008. The paper’s methodology could be of interest to policy makers, non-profits, journalists, and advisors for the government and the over 500 banks with CPP warrants outstanding.

Keywords: bailout, banks, banking, Capital Purchase Program, Emergency Economic Stabilization Act, Goldman Sachs, options, TARP, too big to fail, valuation, warrants

JEL Classifications: G01, G13, G21, G28, G32, G38

"Lessons for the TARP Warrants from 1983 Chrysler Auction" (pdf file 35 KB)

Abstract

This paper discusses the rationales for why auctions are a better way to sell the TARP warrants than negotiations. Despite the fact that 1983 Chrysler warrant auction resulted in an implied volatility of less than zero, it generated higher prices for taxpayers than the current TARP warrant negotiations. The author estimates that the 1983 Chrysler warrant auction generated 91 percent of the theoretical value of the warrants. This is much more than the 66 percent of fair market value that the Congressional Oversight Panel estimates for the first eleven negotiated repurchases of the TARP warrants.

Keywords: auctions, bailout, banks, banking, Capital Purchase Program, Chrysler, EESA, Emergency Economic Stabilization Act, JP Morgan, options, TARP, Troubled Asset Relief Program, valuation, warrants

JEL Classifications: A44, G01, G13, G21, G28, G32, G38

"A Model for Estimating the Cancellation Probabilities of TARP Warrants" (pdf file 70 KB)

Abstract

Under the Capital Purchase Program (CPP), U.S. taxpayers hold warrants issued by over 270 publicly traded banks. The provisions of the CPP allow for half of the warrants to be cancelled if the recipient bank issues enough preferred or common stock by the end of 2009. This paper develops a model to estimate the probability of a qualified equity issuance that is consistent with standard option pricing techniques. The model is based on the transaction costs of issuing new equity and can be solved numerically.

Keywords: bailout, banks, banking, Capital Purchase Program, Emergency Economic Stabilization Act, options, TARP, valuation, warrants

JEL Classifications: G01, G13, G21, G28, G32, G38

"The Put Problem with Buying Toxic Assets" (pdf file 50 KB) forthcoming Applied Financial Economics

Abstract

This paper uses the option pricing arguments of Merton (1974) to demonstrate that even solvent banks will be reluctant to sell volatile, toxic assets at market prices. Banks’ shareholders have insolvency puts that give them limited liability in the event of default. The insolvency puts are more valuable when the banks’ assets are more volatile. Shareholders in banks will require any buyer to pay for the lost volatility as well as the market price of the toxic assets. Thus, taxpayers must be ready to richly overpay if they want banks to voluntarily part with their toxic assets.

Keywords: TARP, too-big-to-fail, toxic assets, mortgage securities, FDICIA

JEL Classifications: G01, G13, G21, G28, G32

"Slicing the Toxic Pizza: An Analysis of FDIC’s Legacy Loan Program for Receivership Assets" (pdf file 73 KB)

Abstract

The Legacy Loans Program is an elaborate way of slicing the FDIC’s receivership assets. At best, the financial structure is irrelevant to the FDIC’s expected long-run recovery rates. Yet, it may boost short-term prices by creating bond insurance liabilities that will come due several years down the road. If the private investor can increase the value of the toxic loans through non-contractible investments, then the public equity stake and subsidized leverage may hinder the FDIC from obtaining the best recovery rates from these troubled loan portfolios.

Keywords: Banks, FDIC, LLP, Legacy Loans Program, loans, mortgage securities, PPIP, Public Private Investment Partnership, real estate, receivership, TARP, toxic assets

JEL Classifications: G01, G13, G21, G28, G32

"Should Goldman Sachs and Morgan Stanley Try to Get Half Price on the TARP Warrants?" The Journal of Finance and Accountancy Vol. 2, pp. 1-8.

Abstract

The cancellation provisions in the Troubled Asset Relief Program (TARP) warrant agreements loom large for the investment banks Goldman Sachs and Morgan Stanley. These banks could gain hundreds of millions of dollars by issuing equity to satisfy the cancellation provisions of the TARP warrant agreements. Nevertheless, they could maximize the value of these provisions by postponing an equity issuance if they could afford to wait to unwind the TARP investments.

Keywords: bailout, banks, banking, Capital Purchase Program, EESA, Emergency Economic Stabilization Act, options, TARP, Troubled Asset Relief Program, valuation, warrants

JEL Classifications: G01, G13, G21, G28, G32, G38

"Valuing the First Negotiated Repurchaseof the TARP Warrants" (pdf file 50 KB) revisions submitted to the Journal of Applied Finance

Abstract

Old National Bancorp was the first publicly traded bank to buy back its Capital Purchase Program (CPP) warrants. It paid $1.2 million, which is below the low-end of this paper’s estimates of the fair market value of the warrants. This paper estimates the warrants are worth between $1.9 and $6.9 million. This low negotiated price from the perspective of taxpayers indicates that the U.S. Treasury would have probably gotten a better price marketing those warrants to third party investors.

Keywords: bailout, banks, banking, Capital Purchase Program, Emergency Economic Stabilization Act, financial crisis, options, TARP, Troubled Asset Relief Program, valuation, warrants

JEL Classifications: G01, G13, G21, G28, G32, G38