Yesterday I created a little scenario that would allow banks to game the Geithner plan at government expense. I labeled it low probability because it required collusion. The problem was, like so many others, I was looking at a single trade (ok, two trades). It turns out that there is a way to game Geithner’s plan that doesn’t require collusion, and shifts huge amounts of money from the government to the already rich. It’s basically the pump and dump stock scam, except that the government has already signed up to be the mark.

First, this example (via the CalculatedRisk link above) demonstrates that it is possible, in principle, to have an investor make money and have the taxpayer lose money, simply by having more than one trade.

Today, Yves Smith linked to this interfluidity article by Steve Randy Waldman and called it “Today’s must read.” That’s quite an endorsement, and despite Yves saying it was “bloody obvious,” it took me a minute to connect the dots. Now I see what Yves and Steve saw. Read the interfluidity article. Here’s the scam:

Some banks are being priced right now by two competing forces. They’re either going to go under (in which case the bank has a stock value of zero), or they’re going to survive (in which case the bank has some bigger stock value). The current stock price is essentially the expectation value between the zero value and the bigger value. Remove the chance of bank failure by removing their troubled assets, and the expectation value converges on the bigger value. To start the game, bet on a bank that is currently troubled. You can either buy stock or buy call options. Then, overpay for the bank’s troubled assets. Since only 7% of the “investment” in the troubled assets is yours, you can afford to take the entire loss. Just make sure that your initial bet was large enough to profit greater than the amount lost on the troubled assets. Since the government puts up the other 93%, you’ve profited off of the stupid investment.

Because this profit is made entirely by ripping off the taxpayer, it can’t be arbitraged away. The due diligence is extremely simple to perform.

On the plus side, this lends credibility to the “success” of the plan.