The government bought $350 billion worth of bank equity pretty quickly, but its effort to convince others to shell out big bucks for so-called toxic assets might take a lot more time. In light of the ever-changing bailout proposals, and the lack of agreement on fair pricing for the troubled assets, some distressed-asset investors say they intend to remain on the sidelines, at least for the time being. "Banks are still at the same place as before: 'At what price do these get purchased?'" says Kjerstin Hatch, a portfolio manager at distressed-debt investor Madison Capital Management. "We're absolutely waiting to see how this is eventually structured, and whether it fits the risk-return profiles. They're difficult assets to value, difficult assets to manage, difficult assets to price." The dislocation in the distressed-debt markets is steep and its potential solutions can be summed up with the unanswerable riddle of, "What comes first, the chicken or the egg?" The market dislocation has spawned fantastically profitable opportunities in the debt markets for some. John Jacquemin, founder of the Mooring Intrepid Opportunity Fund, notes that "there is no dearth of distressed debt buyers," and "plenty of hedge fund and distressed debt fund money ready and willing to buy this debt." However, while banks are being weighed down by bad assets, they refuse to sell them at the fire-sale prices offered. Instead, they've been hoping that Uncle Sam will purchase the debt at higher prices or that the market will eventually rebound.
At the other end of the dial, alternative-investment managers have gotten burned badly in the mortgage space, forcing the sector to consolidate or steer capital into safer assets to pacify angry investors. The few remaining distressed investors with enough risk appetite to place bets are also hamstrung by a lack of financing. That's because risk-averse banks that are holding on to those precious dollars to cover writedowns on just the bad assets that distressed investors would like to buy, as the market continues to deteriorate -- hence, the chicken and the egg. This sets up a scenario in which a distressed investor might only offer 10 or 20 cents on the dollar for a loan portfolio that has an economic value of 70 cents on the dollar, because that's how much cash they have available to make the bet. Without competing offers, banks have two options: Hold onto the loans in hopes of a market recovery or sell them at the steep discount, prompting a writedown of all debt to subterranean levels. Lone Star's deal last year to buy $30 billion worth of Merrill Lynch's troubled assets for 22 cents on the dollar is one high-profile example of the conundrum. One can guess which option banks have opted for, especially with the government providing hundreds of billions of dollars to shore up balance sheets. The new bailout intends to set up a program that will provide $250 billion to $500 billion in leverage for purchases of those souring debt securities. It will also expand an existing Federal Reserve program to buy $500 billion to $1 trillion worth of consumer debt, like credit-card, auto and student loans, to boost liquidity in the market.
But while those initiatives may grease the wheels for a recovery, private-equity firms and hedge funds are unlikely to step in until a compromise on pricing is reached. "There are tens of billions of dollars in private-equity and hedge funds to buy distressed assets," says Peter Vinella, a managing director with consulting firm LECG, who recently managed a CDO shop. "But no one's buying anything because no one has any idea what the price is." The government attempted to address the pricing issue with its first bailout initiative, the infamous Troubled Asset Relief Program to buy troubled assets from the banks. But that political football was tossed off the field because if the government bought the assets at rock-bottom prices, a good deal of the banking sector would be made insolvent. If the government paid too much, taxpayers could lose hundreds of billions of dollars on bad debt that never reached its purchase price. Vinella points out that even successful deals have burned the most respected investors - whether Bank of America's ( BAC) purchase of Merrill or Warren Buffett's losses to date on investments in Goldman Sachs ( GS) or General Electric ( GE). Douglas J. Elliott, a fellow at the Brookings Institute and a former investment banker at JPMorgan Chase ( JPM), says the pricing issue must be addressed before banks are willing to sell or distressed investors are able to buy. Otherwise, he says, the "bad bank" notion as currently outlined (the Public-Private Investment Fund), will not be effective. "At best, it will be modestly inferior to the solution of providing a guaranteed floor value for toxic assets without requiring banks to sell them to gain the protection," Elliott says. "At worst, the plan may fizzle by failing to achieve a large volume of purchases or may prove considerably more expensive for taxpayers than anticipated."
It may be too unwieldy, ineffective and time-consuming for the government to determine asset prices on its own. Instead, experts say there are two paths for quick resolution to the pricing issue: Nationalize the banking system, or allow the free markets to operate fully, with weak banks going bust. Both paths are painful, but some say it may be necessary to choose one to fix the problem quickly and effectively. There is strong resistance to both ideas, made evident by the government's handling of the nation's biggest financial institutions, including AIG ( AIG), Freddie Mac ( FRE), Fannie Mae ( FNM), Citigroup ( C), Bank of America, Goldman Sachs, Morgan Stanley ( MS) and JPMorgan Chase, all of which remain publicly traded entities. While nationalization or massive bank failures seem unlikely at this juncture, one thing seems to be certain: Even if the latest fix helps the battered financial system, it will take a significant amount of time to recover. "There's a misunderstanding in Washington that you pass these bills and everything starts working again," says Vinella. "That's not going to happen."