The New York Times reports that Hank Paulson's desperate plan to use $700 billion of your tax money to buy toxic waste from banks could wipe out their capital. Either that or it could saddle taxpayers with losses that could hit unprecedented levels. To avoid this unpleasant choice, I have an idea -- I call it Tax Shield Preferred (TSP) -- that could provide capital to banks that sold their toxic waste at below market prices.
And make no mistake -- that is what Paulson's plan proposes to encourage. He wants financial institutions (FIs) that hold mortgage-backed securities (MBSs) to participate in so-called reverse auctions which will reward the FI willing to accept the lowest price with a part of that $700 billion. If an FI had booked its MBSs at 60 cents on the dollar and it sold them for that price to Paulson, then if their market value was 20 cents on the dollar, the taxpayers would take that a bath on the 40 cent difference. On the other hand, if the FI sells its MBS for 20 cents on the dollar to Paulson, then the FI takes that 40 cent loss as a reduction to its capital.
To explain the significance of this, I will have to do something a bit painful -- use some numbers. For example, if an FI holding, say, $10 billion worth of MBSs on its books and $8 billion worth of capital sells those MBSs for 20 cents on the dollar, it would need to take an $8 billion loss on the sale. Technically, this would leave the FI with no capital. And it's hard to see how that would help solve the problem. This is where TSPs come in.
TSPs are a security I thought up which would allow a profitable company to save on taxes in the short term while providing capital to the FI that issued the TSP. Let's say Company A, which pays a 34% corporate tax rate, has $10 billion in pre-tax profits. Company A would normally be required to pay $3.4 billion in taxes. Meanwhile, the FI we mentioned before with the $8 billion loss does not need to pay taxes since it's losing money.
However, the $8 billion loss could be an asset to the FI if it ever made a profit in the future. That asset is a tax loss carryforward that could shield it from paying future taxes if it becomes profitable some time, in say, the next decade. A TSP would allow the FI to sell a portion of the value of that asset to Company A. The TSP's value would be equal to the amount of tax that Company A would not have to pay if it bought the TSP. In the case I mentioned before, the TSP would be worth $2.72 billion (the $8 billion loss on the MBS sale times the 34% tax rate).
The FI could add the $2.72 billion to its capital base and Company A could use the FI's loss on the sale of its MBS to save on taxes. Furthermore, Company A would get an option to purchase the common shares of the FI at its market price at the time of its purchase of the TSPs. This idea would create value for the FI -- by helping it to raise capital and it would let Company A save on its current taxes.
However, if Company A exercised its option to buy the FI's common and the stock rose in value, Company A would have a capital gain on which it would pay tax. So eventually, the government could recover that lost revenue. TSPs are not a perfect solution to the problem with Paulson's plan. But they might help overcome a big roadblock.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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Reader Comments (Page 1 of 1)
9-22-2008 @ 12:09AM
Kent said...
The article is not a quick read but I got the concept after reading it (not skimming as I usually do). Contents are speculative but make sense that saves tax payers money while building equity and tax credits for distressed financial institutions if all works well. We don't know what Paulson's proposal to Congress is yet, but assume some of these ideas could be incorporated.
9-22-2008 @ 1:22AM
Kevin said...
I agree the concept works in theory, but it was being practiced by Fannie Mae & Freddie Mac prior to their bailout.
The biggest problem with this logic is the assumption these companies will make money on a forward basis to utilize those carryforward losses as tax write offs in the future. ONLY if profits are made can these assets be realized.
But if the FI does not make money in the near or mid-term future (since the fees associated with mortgage servicing, packaging, securitization, etc. were a huge part of the profit), then essentially these writeoffs cannot be considered an asset.
In addition, I do not think it is a good idea to treat these assets as a capital as it would make the Capitalization ratio utterly worthless. If people are asking for their money, you cannot give them a piece of paper saying these are our losses that can be used to offset ur income and pay less taxes.