Imagine a car lot that has 100 cars on it. However, some of these cars have
problems. Half of them will have engine troubles that total the cars - the
engines blow up and the cars are then worthless - and this will happen just
after purchase. The other half are perfectly fine. Unfortunately, there is no
way to tell prior to purchase which type of car you will get no matter how hard you try. Thus, half of the
assets on the car dealer's "balance sheet" - the cars on its lot - are toxic, and lack of transparency makes it impossible to tell which ones are bad prior to purchase.
If all the cars were in perfect shape, they would sell for $20,000 each.
Thus, there are (50)*($20,000) = $1,000,000 in assets on the books according to
one way of doing the accounting, but that doesn't necessarily represent the true
value of the cars on the lot.
The town where this dealership is located relies upon this business for jobs,
it is essential, but, unfortunately, business has fallen off to nothing. Nobody
is willing to risk losing $20,000 by purchasing a car that might die just after
purchase, so the price has fallen. The expected value of a car is $10,000, but
it's an all or nothing proposition, the car runs or it dies, and since people
are risk averse nobody is wiling to pay the $10,000 expected value. In fact, the
highest price they are willing to pay, $6,000, is lower than the minimum price the dealer is
willing to accept (I've assumed a reservation price of $7,500 for illustration, and a horizontal supply curve to make the illustration easier):
So how could the government fix the problem?
1. Government purchases of toxic cars
The government could buy the cars itself, say at $7,500 per car, or $750,000
total for the lot, drive them around a bit (stress test them), wait for the bad
ones to blow up, then sell the 50 good cars back to the public (who will no
longer be fearful since the bad cars are out of the mix). If they can get
anything more than $15,000 for each good car, they will make money on the deal
(well, there would be overhead and other costs to cover, but let's abstract from
minor details). But if cars end up selling for less than $15,000, they will take
(In the graph, the government intervention shifts the demand curve
outward until it intersects at the kink in the supply curve at Q=100).
The problem with this option is knowing what price to offer for the cars.
There is no market, and the firm's reservation price may be too high, i.e.
paying the reservation price will eventually lead to a loss. And it's worse. In
this example the percentage of bad cars is known, but the percentage of bad cars would also be
unknown in a more realistic example, so there's no way to know how many good
cars there are for sure, and what price they will sell for after the defective
cars have been culled out of the herd. If the government pays $7,500 per car,
and more than 62.5% of them go bad (not that much more than the 50% estimate),
then taxpayers will lose money even if they sell for $20,000. With the
percentage unknown, there's no way to know for sure what the breakeven price
This is, in essence, the original Paulson plan. The only twist is that the
price - the $7,500 in the example above, would be determined by an auction among
many dealers with the government accepting the lowest bid (which could be $7,500
in this example since that is the price the firm is willing to accept). As you
can see by thinking this through, there are questions about what price such an
auction would reveal.
One danger in this plan is that if you overpay for the cars, e.g. give $7,500 when the
breakeven price was, say, actually $5,000, then you have given the owner of the
car lot $250,000 more than the cars were actually worth (this will be the loss
to taxpayers). The dealer may need this money to stay solvent and stay in
business, but, nevertheless, it is a windfall.
There are a lot of uncertainties here, and lots of ways to lose money. But
it's possible to make money too.
2. Subsidies and Public-Private partnerships
Here, the government offers a subsidy to private sector buyers. Suppose that
the demand curve intersects the vertical line in the graph (at Q=100) at a price
of $4,000. Then in order to sell 100 cars, the government must subsidize buyers
by $3,500 so that the $4,000 offer is raised to the $7,500 the firm is willing
to accept (notice that the buyer willing to pay $6,000 gets a $2,000 windfall, so, except at the margin,
this plan gives surplus to people purchasing the assets - as with the first plan, this shifts the demand curve out until it intersects at the kink in the supply curve).
However, once again, the government will not know if it is getting this right
or not. Suppose it offers a $1,000 subsidy thinking that is generous enough. In
this example, that won't bridge the gap between the highest offer of
$6,000, and the reservation price of $7,500. Thus, the subsidy would be too
small to restart the market and the plan would fail. So the answer is to make
the subsidy large enough to encourage buyers, but the problem is that if it is
too large, the government will be giving money away unnecessarily.
And there's another problem. If there's a large gap between what people are willing to pay and what
dealers are willing to accept(the gap between $6,000 and $7,500 in the example), this would be problematic politically since it
would require subsidies that are unacceptably large.
And I should note that it doesn't have to be a subsidy. That's one way to do
this - as a giveaway - but another way is through a no recourse loan (what is
being called a partnership). Suppose that the government gives (up to) a $3,500 loan to
a private sector buyer to purchase the car for $7,500. If it's a good car and
the value rises above $7,500, say to $15,000, then government will get paid back
(with interest) since the asset can be sold profitably (another option is for
the government to demand a share of this profit through warrants or other
means). But if it's a bad car, the price falls to zero and the loan is forgiven
- it does not need to be repaid. So the private sector agents only have to put up a fraction of the price to control the asset, and their losses are
limited to the amount they put up while the gains are potentially large.
This is, in essence, the Geithner Plan. If many of the loans are not repaid, or
if the subsidy is too large, it could lose a lot of money, but it could also
make money too.
Now for the Saab story. Another option is for the government to simply take
over the car dealership. The dealership is essential to the economy of the town,
without it people will struggle, and the government - for that reason - might
consider temporarily taking over the dealership to prevent failure. In doing so, it would make an evaluation of
the company's assets, pay off the people who loaned the business money up to
this amount, which may require having them take a haircut, i.e. accept some
percentage of what they are owed on the bad loans they made, and the owner would
simply be wiped out (which is a benefit since the business is insolvent and this
allows the owner to escape the loans that cannot be paid through liquidation).
After taking over, the government would stress test the cars it now owns, put
the bad ones in the junk pile, and sell the rest back to the public. So long as
it didn't pay the creditors too much when it took over, i.e. the haircut is
sufficiently large, it ought to make money on the deal. But it could lose money
But, and I want to stress this, the point of these plans is not to make money, the point is
to keep the economy of the town going, to keep people employed. If people place
a large value on security, then even if the government takes a
loss on paper, it may not be an economic loss. That is, we must put a value on
the jobs that are saved and the security it brings (simply imagine that the
utility function has risk as one of its arguments - by lowering the risk of job
loss and the associated household disruption, you have made the agent better
off, and this must be counted against any loss from any of the programs above).
There is value in economic stability and security over and above whatever the government
makes (or loses) on the actual financial transactions, and this must be factored into the
evaluation of the policy.