Sunday, March 22, 2009

Toxic assets relief plan (FSP) details

The NYT and WSJ have details of the much-delayed, revised version of TARP (or the Financial Stability Plan, FSP), the Geithner Toxic Assets Plan, which is to be announced early next week. Essentially, the plan is to create funds in which private investors put in a small amounts of their own money, and in return get large, non-recourse loans from the taxpayer, with which to buy bad assets. They are, as expected, in line with the Obama administration's reluctance to seize "zombie banks" and embrace nationalization of insolvent banks.

It was originally proposed under the FSP to provide government capital and government financing to help leverage private capital on a massive scale, of more than $500 bn and even a $1 trillion, to help get private markets working again. This fund, targeted at distresssed assets, was to facilitate private capital regenerate the frozen market for the real estate related assets, thereby creating a market-based valuation mechanism for them. All the proposals now being considered are based on the assumption that it is possible to revive the markets and restore the prices of the now distressed assets.

James Kwak sums up the three components being suggested as being part of the proposal,

1. The FDIC will create a new entity (an "aggregator bank") to buy troubled loans, with the government contributing up to 80% of the capital and the remainder coming from the private sector. The Fed or the FDIC would then provide low interest (1.5-3%) non-recourse loans for up to 85% of the total funding (NYT), or guarantees against falling asset values (WSJ), which more or less amount to the same thing.
2. Treasury will create multiple new public-private investment funds to buy troubled securities, with Treasury contributing 50% of the capital and the rest coming from the private sector. It’s not clear from the news stories, but I think it’s highly likely that these funds will also benefit from either non-recourse loans or asset guarantees.
3. The Term Asset-Backed Securities Loan Facility (TALF) is a program under which the Fed was already planning to buy up to $1 trillion of newly-issued, asset-backed securities (backed by car loans, credit card receivables, mortgages, etc.). The idea was to stimulate new lending in these categories. This program will be expanded to allow the Fed to buy "legacy" assets - those issued prior to the crisis. This enables the Fed to buy toxic assets off of bank balance sheets.

Kwak's assessment : "In the best-case scenario: (a) the government’s willingness to bear most of the risk encourages private investors to bid enough to get the banks to sell; (b) the economy recovers and the assets increase in price from the prices paid; (c) the investment funds pay back the Fed (which makes a small spread between the interest rate and the Fed’s low cost of money); and (d) the government gets some of the upside through its capital investments. (I think the main purpose of that government capital is to deflect the criticism that all of the upside belongs to the private sector.) In the worst-case scenario, the market stays stuck because the banks have unrealistic reserve prices. Perhaps the idea is that, in that case, the TALF will allow the government to (over)pay whatever it takes to bail out the banks."

Most of the criticism is directed at the first and second components of the Plan. Paul Krugman (and here and here) describes these plans as victory for the "zombie banks". He writes, "Treasury has decided that what we have is nothing but a confidence problem, which it proposes to cure by creating massive moral hazard. This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized." More from Krugman here, as he describes thie Geithner proposal as equivalent to "cash for trash".

Since private investors would be contributing as little as 3% of the total share (one-sixth share of the 15% equity) and the government as much as 97%, and therefore having almost no skin in the game, it is being hoped that these investors can pay a higher than market price for the toxic assets (since there is little downside risk). Calculated Risk therefore says that "this amounts to a direct subsidy from the taxpayers to the banks".

Mark Thoma criticises these as give-aways to failed private banks, "The main objection is that the government will (in essence) overpay for these assets, and that will cost the taxpayers money. In the meantime, the banks - which get a windfall from the overpayment for the assets - could recover and do just fine. If the administration insists on moving in this direction rather than adopting a version of the Swedish plan, why not require some insurance against future taxpayer losses, e.g. require firms participating in the bailout to sacrifice future equity shares equal to the value of any losses that fall on taxpayers? There are probably better ways to structure this, but having such insurance in place could help with the politics of the bailout which the administration does not seem to get."

Naked Capitalism too is critical of the Geithner Plan, and other views are summarized here. Brad De Long has an FAQ of the proposals here.

In an earlier post, I had written about the Bebchuk Plan and its variants, which sought to establish many competing privately managed funds, financed with both private and public capital, to buy up the distressed assets. Then the bailout money can be allocated to these competing funds using an appropriately designed market mechanism, so as to ensure that the tax-payers get the best deal possible.

However, the fundamental issue of how to place a value on mortgage-related assets that have not been traded for months, that is at the ehart of any acceptable bailout plan, remains unresolved. The Geithner Plan does not address the central question of how to bridge the divide between what the banks want to sell the assets for and what investors are willing to pay for them. The government hopes that the subsidies it provides to investors are so rich that they will be willing to risk overpaying somewhat for the assets.

Update 1
Tim Geithner himself described the Public-Private Investment Program (PPIP), which will purchase real-estate related loans from banks and securities from the broader markets initially for $500 billion with the potential to expand up to $1 trillion over time, as having three design features,

"First, they will use government resources in the form of capital from the Treasury, and debt financing from the FDIC and Federal Reserve, to mobilize capital from private investors. Second, the PPIP will ensure that private-sector participants share the risks alongside the taxpayer, and that the taxpayer shares in the profits from these investments. These funds will be open to investors of all types, such as pension funds, so that a broad range of Americans can participate. Third, private-sector purchasers will establish the value of the loans and securities purchased under the program, which will protect the government from overpaying for these assets."

About its objective, he writes that "by providing a market for these assets that does not now exist, this program will help improve asset values, increase lending capacity by banks, and reduce uncertainty about the scale of losses on bank balance sheets. The ability to sell assets to this fund will make it easier for banks to raise private capital, which will accelerate their ability to replace the capital investments provided by the Treasury."

The attraction for private investors will be the low interest loans (effective loan subsidy) with its non-recourse nature and with limited share in the downside. The possibility of the government lending nearly 95% of the money for any investment is another major attraction.

The only investors, other than pension funds and insurance companies, with the sort of funds to participate in this program are hedge funds, private equity firms and sovereign wealth funds. These investors may be put off by the compensation caps and strict disclosure and governance rules that are likely to come with these proposals.

Update 2
More details of the Plan.

1. The FDIC would oversee a program in which banks offer bundles of whole mortgages for sale to investors, by means of an auction for each bank portfolio. The crucial incentive for investors — traditional fund managers, hedge funds, private equity funds, pension funds and possibly even banks — is that the government would lend as much as 85% of the purchase price for each portfolio of mortgages. On top of that, the Treasury would invest one dollar of taxpayer money for every dollar of private equity capital to cover the remaining 15% of the portfolio’s purchase price. The arrangement is similar to some of the distressed-asset sales arranged by the Resolution Trust Corporation for cleaning up the savings-and-loan debacle of the early 1990s.

2. The Treasury would help finance a series of public-private investment funds to buy up unwanted mortgage-backed securities, or pools of mortgages that have been packaged into bonds with a credit rating.

These two programs alone could buy $500 billion to $1 trillion worth of troubled assets. The Treasury would kick in $75 billion to $100 billion from TARP as equity.

3. The Treasury could pump almost $1 trillion more into the toxic-asset effort through a program called the Term Asset-Backed Securities Loan Facility, or TALF, a joint venture with the Federal Reserve. This program, which became operational last week, was originally created to help finance mostly new consumer loans and also some new business lending.

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