Banks, Investors to Hear Toxic Asset Plan

Banks looking to shed bad assets and investors interested in buying them will gain additional details on the Public-Private Investment Program.
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Banks looking to shed bad assets and investors interested in buying them will gain additional details on Thursday regarding the Obama administration's plan to kickstart the market for toxic debt.

Two industry groups, the Securities Industry and Financial Markets Association (SIFMA) and the Pension Real Estate Association (PREA) are hosting a summit to discuss the structure and potential impact of the government's Public-Private Investment Program (PPIP), which is set to begin operating this month. Officials from the

Federal Reserve

, Treasury Department and Federal Deposit Insurance Corp. will be on hand as featured speakers, and will likely address two key issues that have so far hamstrung the endeavor: Pricing and public scrutiny.

The

PPIP has gained little traction since it was announced with great fanfare over two months ago, calling into question how much success it will ultimately have. One pitfall pertains to a lack of confidence that the government won't spontaneously change the rules of the game to mollify populist rage.

Potential investors have witnessed punishment levied against firms receiving government support in the form of compensation limits, strict oversight and fiery questioning at congressional hearings, with

American International Group

(AIG) - Get Report

being the most prominent example. Banks have also faced a slew of restrictions that were added after accepting funds from the Troubled Asset Relief Program, money that some firms claim they didn't need in the first place.

The retroactive provisions and public scrutiny has made banks eager to repay those dollars as soon as possible.

JPMorgan Chase

(JPM) - Get Report

,

Goldman Sachs

(GS) - Get Report

,

American Express

(AXP) - Get Report

,

BB&T

(BBT) - Get Report

and

Northern Trust

(NTRS) - Get Report

have already applied to do so, and

Morgan Stanley

(MS) - Get Report

,

Wells Fargo

(WFC) - Get Report

,

Bank of America

(BAC) - Get Report

, and others have expressed interest in doing so as well.

"One of the things that has been the most challenging aspects of the federal government's efforts to put in place programs is the populist backlash against lots of different issues -- executive compensation being the classic example," says Kevin Petrasic, former special counsel at the Office of Thrift Supervision.

Potential

PPIP investors were mostly hedge funds and private-equity firms that tend to recoil from regulatory oversight in ordinary times. As a result, few have been eager to participate in the PPIP without explicit guarantees that the same restrictions and public flogging won't befall them.

There's also the initial issue that PPIP hoped to address, but which it may not be able to solve: The wide gap that exists between bid prices and ask prices on distressed assets weighing down bank balance sheets. Banks aren't selling these "toxic" holdings because managers believe prices offered are far below the intrinsic value. Investors aren't offering higher prices because they don't know where the bottom lies, or simply because they don't have to yet.

The government has an unenviable position in this financial crisis. Regulators must use taxpayer dollars to strengthen the banking system by fostering healthier, more profitable lenders. But they must also market their programs as ones that will not allow banks or investors to profit excessively on the taxpayer dime. What "excessively" means is anyone's guess.

As a result of those contradictory goals, says Petrasic, "you sort of have a half-implemented program that's not particularly effective because of hesitancy or distrust from private investors who don't know what could possibly happen. Will the government come in late in the game and change the rules, adversely affecting those investors?"

There are two components to the program, the major one to tackle asset-backed securities that the Treasury Department will oversee, and a smaller one regarding whole loans that the Federal Deposit Insurance Corp. will oversee. While the Treasury portion is still set to launch this month, the FDIC on Wednesday said it would postpone a pilot sale of assets through its Legacy Loan Program until the summer.

"Banks have been able to raise capital without having to sell bad assets through the

Legacy Loan Program, which reflects renewed investor confidence in our banking system," FDIC Chairwoman Sheila Bair said Wednesday. "As a consequence, banks and their supervisors will take additional time to assess the magnitude and timing of troubled assets sales as part of our larger efforts to strengthen the banking sector."

Hundreds of billions of dollars' worth of troubled assets are weighing down the balance sheets of the country's biggest banks, from behemoths like BofA and

Citigroup

(C) - Get Report

, to major regional players like

Fifth Third

(FITB) - Get Report

,

KeyCorp

(KEY) - Get Report

,

PNC Financial Services

(PNC) - Get Report

,

US Bancorp

(USB) - Get Report

and

Capital One

(COF) - Get Report

.

Conditions stand to worsen if a resolution isn't reached soon, especially for firms that haven't written down assets to rock-bottom levels. Those heavily exposed to assets whose performance is still deteriorating, like commercial real estate and credit card debt, or areas of the country whose economies haven't yet stabilized, stand to get hit the worst.

On the other hand, a return to profitability for the banking industry last quarter, and signs of life in the housing market and broader economy has given investors faith that a rebound is at hand. The

surge in investor confidence has been evidenced by the tens of billions of dollars banks have raised in the market to fill in capital shortfalls identified by the government's stress tests.

Petrasic, who now counsels financial firms on participating in the PPIP at the law firm Paul Hastings, says that by installing adequate oversight, being transparent and emphasizing that the PPIP seeks to benefit all participants -- including taxpayers -- the Treasury Department could successfully launch its pilot program this month with minimal pushback from public advocates.

"You want a program that works," says Petrasic. "There's got to be a certain give and take...but I think the key thing is to separate what happened in the past from what happens going forward."

Chip MacDonald, a Jones Day lawyer who advises banks, asset managers and other financial firms on the PPIP, says a solution can come in the form of a collaborative "bad bank" in which buyers, sellers and taxpayers all share in upside or losses that stem from deals.

Under such a plan, a portion of financing would come from the FDIC and all three parties would retain an interest in the assets while working to restructure loans for troubled borrowers. It would bring banks closer to offered prices, since they'd retain a stake in the potential upside they predict; and bring sellers closer to banks' demanded prices, since part of the financing comes from the government, limiting downside risk.

Regulators could also install terms that provide significant upside potential in exchange for government funds. In working out troubled loans, regulators can oversee the program to ensure that struggling borrowers become more profitable for the banks without being exploited.

MacDonald still has faith that a public-private program can be successful, citing

Grant Street National Bank

, a subsidiary of toxic loans that was spun off of

Bank of New York Mellon's

(BK) - Get Report

predecessor in the late 1980s, as well as

Kearny Street Real Estate Co.

, which held a troubled swath of

Bank of America

(BAC) - Get Report

assets in the 1990s.

"I think it can be done," he says.

One way or another, the outcome of the toxic-asset debacle is likely to designate winners and losers in the banking sector based on a traditional notion of prudent lending or aggressive moves to write down or get rid of bad debt early on. Fred Fraenkel, vice chairman of the Beacon Trust investment firm, and former head of global research at Lehman Brothers, says such risky holdings are best left to vulture investors who can "steal these assets at low prices with government sweeteners."

"The current environment should reward banks who kept their balance sheets pristine and their lending capacity intact," he adds.