The “Geithner” Plan; It’s a Good Start. (posted 3/25/09)

 

ppip_chart

Source for the above: U.S. Treasury Department

I like this so-called Geithner Plan to remove toxic assets from the banks. The plan refers to “legacy assets”, which means assets acquired during “the period of foolishness” for which no true market-determined price exists because of either quality impairment or lack of a liquid market, or both.

Both loans and asset backed  securities are problems.

The overhang of troubled loans has made it very difficult for banks to raise new capital from the private market and, therefore, placed a tight limit on lending.

The asset backed seciurities are held not only by banks but also by pension funds, insurance companies, mutual funds, and funds held in IRA’s and 401K’s. They are highly illiquid and are trading at prices that are almost certainly well below where they would sell in normal markets.

I may be a bit thick, but it took me a while to fully digest the Treasury’s new plan.  After reading all the press accounts and various comments, some conflicting, I was still unsure, so I went directly to the Treasury Department’s website and found these two summaries of how the plan will work: (the bold italicized inserts are by me for clarification)

Sample Investment Under the Legacy Loans Program

Goal: To cleanse bank balance sheets of legacy loans and reduce the uncertainty associated with these assets; involve private investors to set prices; use FDIC expertise to provide oversight for the formation, funding and operation of the new funds; Treasury puts up 50% of the equity, but private managers will be the asset managers, subject to FDIC oversight

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a (not to exceed) 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72
(about 86%) of financing (debt issued by the buyer, collateralized by the purchased assets, and guaranteed by the FDIC), leaving $12 (about 14% of total) of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

Source for the above: U.S. Treasury Department

Presently, the market value of these loans is unknown. Presumably, involving private investors, , who will share equally with Treasury the first 14% of any loss, and whose capital input is subject to 100% loss, to set the price in an auction process, will, as Sheila Bair of the FDIC, “tease out” that part of the value discount resulting from the assets” illiquidity.

It is only after the first 14% of losses that  the principal value of the FDIC guaranteed loan will be negatively affected.

Sample Investment Under the Legacy Securities Program

Goal: to restart the market for legacy securities (asset backed securities tied to residential real estate, commercial real estate, and consumer credit) to free up capital and stimulate the extension of new credit

Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.
Step 2: A fund manager submits a proposal
and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.
Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.
Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.
Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

Source for the above: U.S. Treasury Department

In this case, the first two thirds of the risk are shared equally between private investors and the Treasury (taxpayers). Beyond that, losses fall entirely on the Treasury.

The key questions seem obvious? Will it work? Is it big enough to do the job? Can private investors raise the money?

Big enough?  Truthfully, nobody knows.  The estimates are sheer guesses, and vary by trillions.   However, if the plan works in providing true market-determined prices that are significantly above the wild guesses, the size of the problem will be diminished, perhaps to a confidence-inspiring degree.  But that’s a hope, not a forecast.

As to private investors putting up money, I can’t believe that’s any problem at all.  Already there are plans afoot to start new funds and mutual funds, with good quality sponsorship.

A bigger problem might be getting banks to agree to sell these assets, and take a permanent hit to capital.  There seems to be a very large difference between what the banks think they are worth and what motivated buyers might pay.  I don’t think that will happen, but that may be only a poorly informed opinion.

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