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.
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
Case 2: Support Prices
Case 3: Normal Prices
- 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.
- 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.
- 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.
- 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.
- 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.
- 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.