Toxic Waste Dumps
The government is banking on its new partnership with private investors to properly value toxic assets weighing down bank balance sheets, but the program could fail if the bids come in too low. The Public-Private Investment Program unveiled Monday by Treasury Secretary Timothy Geithner intends to spend up to $1 trillion in government funds to finance private investors' purchase of illiquid mortgage debt. Financial companies have been forced to write down the value of these assets due to accounting rules, hitting their bottom line and forcing them to cut back on lending. By creating a marketplace for these securities, the government hopes to allow banks to unload them on investors that can hold on to them in the hopes that they rise in value. In return, banks would have cleaner balance sheets and be free to resume normal lending. Under the program, the Federal Deposit Insurance Corp. would auction off assets banks are seeking to divest to funds in which the government and private investors are partners. The thinking is the private investors will reduce the likelihood of the government overpaying for this junk. But the free leverage and downside risk protection the government is offering investors prevents the market from operating independently. The Treasury is doing everything it can to entice buyers.
In its explanation of how the program will work, Treasury used an example in which a private investor could bid $84 for loans carrying a par value of $100. The Treasury would guarantee $72 of financing, leaving $12 in equity. The Treasury then provides 50% funding and which in this case is $6, resulting in the private investor only having to put up $6.
The huge risk for the banks in this auction is that the bids will come in too low. For example if Bank of America ( BAC)values its undesirable Alt-A mortgages at 50 cents on its books and the buy side low balls the bid at 20 cents, then the market has determined that the true value is 20 cents. That will send the accountants at the bank scurrying to place that new lower price on the entire portfolio. So, in our example, BofA may rid itself of some bad product, but at the cost of trashing it entire portfolio. And in reality, analysts think the toxic assets will come in much lower than the 84 cents the government uses in its example. Ken Spears of Savills, a firm known for placing valuations on products, believes bids won't top 50 cents to 60 cents on the dollar for the majority of the assets. Chris Whalen of Institutional Risk Analytics suggests the number is closer to 30 cents on the dollar. Ultimately, the banks know there is little value on these assets, whether they admit publicly or not. There's a reason why there is no market for this junk -- because no one wants it. But with the government's help, buyers may take a shot. The buy side bears no downside risk to this deal. Only the taxpayer is exposed to the downside risk. Marquee money managers like Blackrock ( BLK) and PIMCO indicated an interest in investing. One source at a money manager firm in New York said that their private equity clients started generating capital last week in anticipation of the Federal Reserve's announcement of the new program on Monday.
But the guys in the trenches didn't seem as enthusiastic. One distressed bond trader said his clients weren't interested in the program. They are concerned about facing a backlash similar to the one being faced by AIG ( AIG) executives paid bonuses after the company accepted government aid. Congress responded to the public uproar over AIG's situation by passing legislation that would punitively tax employees' bonuses, legislation that could now affect other companies who had accepted aid. Only time will tell if investors embrace the PPIP, but a related federal program that sought to aid investors in buying toxic assets through providing cheap financing has gotten off to a slow start. The Term Asset-Backed Lending Facility, or TALF, has only used $7 billion of the $200 billion originally allotted when it kicked off earlier this month. Banks better hope there's more interest when it comes to unloading its junk.