The Feds will always lose! Do you hear me? The Feds will always lose!

Guy comes into the office today.  He's got a structure.  Boy, has he got a structure.  A can't miss proposition you might say.  50% going in returns. Principal protected three ways from Sunday, AAA rated, risk free.  Blah blah blah.  I'm just gonna go look for a cash machine. 

This sounds like a scam, but it's a more sophisticated one than it seems at first blush.  First of all, it's all completely legal and above board.  Well known financial institutions are involved (comforting ¿no?).  In fact, the whole thing is made possible by team Obama and the hard working boys at the Federal Reserve.  I like to think of these investments (which are, by the way, getting downright common) as a sort of 'Armageddon Put' because the logic of them always ends with, "so the only thing that can go wrong is if the US government were to default, and in that case who cares about your portfolio, 'cause the only things that's going to matter is bullets and bottled water."

You would think that this drastic form of risk management would cause people to question the very system that produces such an outcome, but, alas, once you've lived through mutually assured destruction as a kid, apparently nothing much worries you, excepting DOS attacks on Twitter of course.

Anyhow, the mechanics of said structure are complex, and, of course, highly confidential.  Which is why I propose to insert several blank lines in the blog before disclosing them ...

That ought to do it.  The idea is to start a bank.  Yep.  Well, first you fund a special purpose vehicle (SPV) which holds convertible debt that will convert into bank equity (when? why? stop nitpicking! who's sittin' on a million fucking dollars?).  And then this vehicle invests in a special carved out portion of a bank holding company (BHC).  But the upshot is that you put up equity for a bank.

This bank is like any other bank, except it has a fresh clean balance sheet, so it can get regulators to bless it leveraging up 10:1 by taking deposits because it has no hidden write-off lurking in the wings.  So, great.  You put up $1 of initial capital, you take $9 of deposits, and you have $10 to invest in something.

What something, you ask?  Well, it turns out that the TALF is still alive.  One might have thought that the slow uptake and the rapid narrowing of spreads on the instruments it was meant to support had made it obsolete, but apparently the delay was merely caused by legal wranglings over who could invest whose money in what, and now, just as the program is arguably useless, it is poised for massive growth.  Taxpayers delight.  So this bank will invest in the equity of a fund that participates in the TALF program.  Wait, you say, can a bank invest in equities rather than making loans?  Am I the only one around here that gives a shit about the rules?  But don't worry, we'll structure it as debt with a variable interest rate calculated on the basis of the profits, just like the special purpose vehicle that invests in the bank holding company. 

So the bank makes a "loan" that forms the equity piece of a fund that invests in the TALF program.  A refresher on the TALF.  The idea was that private investors put up some equity, Treasury matched this equity, and then the Federal Reserve guaranteed debt (ie, very cheap debt) issued by the equity up to a maximum level determined by the face value of the assets that were to be purchased minus a certain haircut dependent on the credit rating of the asset.  The debt is 'non-recourse' which means that it only applies to each individual asset that  is purchased, and not to the overall fund -- essentially, if you make a mistake and buy some crap that turns out to be worth less than the debt you used to buy it, you don't have to pay for the difference out of what you (hopefully) make buying the other assets.  This is basically meant to make you think a little about the price of the crap you're buying, but not too hard.

Anyhow, the Treasury eventually selected some firms that could use this structure to buy TALF eligible securities like AAA CMBS and such, which at the time of inception were trading at big discounts.  Now, they are trading at small discounts, but whatever.  These guys can still put up $1, have the Treasury put up $1 and go out and buy $12 of TALF barf.  The effective leverage is 6:1 for the equity.  It differs by type of asset, but let's just use 6:1 because I think that's actually the minimum leverage available in the program.

Great, now we have an SPV that owns a BHC, which owns the equity of a TALF fund, which owns ... some AAA rated auto loans or other drek of that sort.  The leverage on the initial investment is 10:1 times 6:1 on the TALF money, or 60:1 in total.  This is really all there is to the idea -- leverage on leverage.  So, the investor puts up $16.7 million, and controls $1 billion in securities, $983.3 million of which is guaranteed by the Federal Government either via the FDIC (remember the bank holding company takes deposits) or via the Fed's TALF program.

To top it all off, the guy had another bank come in, look at the structure, and guarantee the principal (ie the amount you would see the initial SPV with) so that you don't have to risk anything at all to get the ball rolling, you just have to sign off that you are liable for that amount, and then go to your bank and borrow against that principal protection.

AND SO HERE'S THE POINT -- holy shit, man, this is crazy!

This is like government guaranteed three-card Monty on a huge scale.  I'm not cynical enough to think that this is exactly what the Fed had in mind when they set these structures up.  I am cynical enough to think that these guys don't really know what the fuck they're doing though, because frankly this shit is so complicated and has so many unexpected consequences that no one could possibly know what the systemic effects of these programs might be once a bunch of clever people are offered lots of money to hack into them.  There is no way a few guys at the Fed are going to keep up with this.  All of which means that every program and subsidy set up now will be visited tenfold upon our heads at some point down the road.  Hang on St. Christopher on the passenger side.