By: Frank Armstrong, CFP, AIFA
Mark to Making a Market
Would you buy a “toxic” asset? Certainly not. How about a “legacy real estate-related” asset? Well that sounds much better.
As the credit crunch induced a complete economic meltdown during the final “lame-duck” months of George W. Bush’s presidency, his administration chose to take a mostly laissez-faire approach to the unfolding crisis. However, as Americans watched jobs and pensions disappear it became quite clear that the government would have to play a significant role. For government to do nothing would be for the US to copy the playbook that the Japanese followed in the early 1990s when confronting their own banking crisis – economists refer to the result, or lack thereof, as Japan’s “lost decade.”
At first the idea of the honest US taxpayer wading into the mess and buying up the “toxic” creations of greedy Wall St. bankers, unethical mortgage lenders, and a few criminally naive borrowers and speculators was a non-starter. The government instead found itself in the entirely un-American position of using taxpayer money to partially nationalizing blue chip banks-turned-penny stocks such as Citigoup – a fitting sequel to the government’s orchestration (however inconsistent re: Lehman Brothers) of the sale of former, sterling-silver nameplate investment banks to the handful of commercial banks still independently afloat in the Fall. Through the first two months of 2009 it quickly became apparent that the $350 billion of the $700 billion total TARP funds used to repeatedly buy equity in Citi and Bank of America had – while staving off financial catastrophe – failed to pull the US economy out of the tailspin.
The Flow of Credit requires True Bank Solvency
Following billion dollar write-downs through every quarter of 2007 and 2008, many of America’s largest banks were either consolidated with the assistance of the government or placed under de facto government stewardship. Witnessing this trend many regional banks, such as those with a strong presence in Florida like SunTrust and Regions, have postponed the “marking-to-market” of their pools of mortgage loans lest they are easily acquired or forced into bankruptcy. Many are aware that bankruptcy would no double result from marking-to-market since this would decimate their balance sheets to the point their tier-1 capital threshold – which legally entitles them to operate – would be violated many times over. However, this mark-to-market scenario is based on the 30¢-on-the-dollar the bad assets are currently valuated at. Many maintain that their true value is far close to 60¢ on-the-dollar. Of course, this is the crux of what is really a circular problem: since the market in which these bad assets historically trade has largely ceased functioning, a disconcertingly high level of uncertainty surrounds their price, trading is thus impeded.
Interestingly, one should recognize that far many more banks maintained a degree of prudency than did not, and this majority consequently does not fear bankruptcy today. To watch the news one would never guess that in all, only 3% – that is 252 of America’s 8305 different bank companies – were viewed by the FDIC as being in trouble. However, regardless of whether a bank finds it imperative to repair, or merely expedient to improve, its capital structure, this must occur before they can seriously attend to resumed lending. And for this to occur so must a market exist that will allow them to discharge their real-estate related assets at something approximating fair value.
Economic Equilibrium requires True Market Equilibrium
The loan securitization market developed from a non-existent industry in the early 1970’s into a vital near-trillion dollar mechanism through which banks and other institutions could replenish their capital and fortify their balance sheets. Only after 2003 did MBS originators begin throwing caution (i.e. their underwriting standards) to the wind and – in concert with negligent risk-rating agencies – allow the industry to become tainted by the same type of reckless behaviors exhibited by many of those then propelling the housing mania (the very source of the massive upswing in mortgages available for securitization in the first place!) Through late 2008 and 2009 this near-trillion dollar industry that had been integral to the credit market for decades virtually disappeared.
Courtesy New York Times
A few commentators rightly pointed out the fact that so-called “toxic” assets had been so vilified and their prices so overly-battered that many assets consequently possessed massive upside potential. However, their voices were drowned out by the “doom and gloom” scenario every pundit seemed to be propagating right up until a couple of weeks ago. Only now has this insight achieved a level of regard. Consequently, the plan only applies to those (likely) undervalued loans and securities created before 2009.
The Public demands True Accountability
Earlier this year the reception of taxpayer-subsidized bonuses by Merrill Lynch executives – these flowing through Merrill’s partially-nationalized new parent company, Bank of America – came to light and a great deal of public outrage ensued. In a twisted kind of sequel, Wall St. again demonstrated its inability to align compensation with performance as AIG recently attempted to proceed with the distribution of bonuses to the very employees largely responsible for the company’s misfortunes (!) While most Americans have by now accepted an unprecedented level of government stimulus spending as a necessary evil, accountability for the money is ever-more the watchword. The PPIP aims to ensure that government funds are used to buy up bad loans and securities only when the creation of long-term value is the likely outcome. However, in every historical instance the dispersal of funds by fiat automatically precludes this fundamental consideration. Only by handing over investment control to those whose very livelihoods – as opposed to that of politicians – require an eye for ROI can accountability be insured, which is why Geithner proposes to hitch the public money “railway cars” to institutional money manager “locomotives.”
And how many railway cars there will be! While many commentators have balked at further draining TARP funds while creating a massive public obligation under the plan – $100 billion in “real” Treasury money is to be leveraged to create $500 billion and possibly more, up to a $1 trillion lending ceiling – the bullish past two weeks nevertheless indicate that investors appreciate the serious commitment.
The Public-Private Investment Plan
Geithner’s battle-plan calls for a two-pronged attack by public-private funds to take out both the bad loans and the bad securities currently entrenched on banks’ (and other institutions’) balance sheets, and thereby rescue bank lending. The Treasury department will provide the foot-soldiers (the money) that will make up the overwhelming bulk of the funds; however, who exactly will play the role of commanding general is unclear. Fund stewardship is to be shared by private sector fund managers, who will have “full managerial control” and the FDIC, which “will provide oversight for the formation, funding, operation of these new funds” as well as oversee fund accounting.
i) Legacy Loans Program
To begin the process, since the FDIC is guaranteeing all the leverage involved in every loan purchase, it will have “contractors” assess the amount of debt that could prudently be assumed by a public-private fund with respect to the specifics surrounding the given loan pool asset up for sale. The FDIC is willing to guarantee all the leverage involved in a given purchase to a maximum 6:1 debt to equity ratio. Central to the plan is an auction process which ensures that only the highest bidder – that is, the manager who offers the highest amount of private equity – gets to partner with the government in purchasing bad loans from banks. This private equity capital portion will then be matched 1:1 by the Treasury.
To use the example illustrated in the plan, a private manager would only have to find $6 to buy a bad asset valued at $84 (which itself was valued by the bank at $100 back in the intoxicating days of the housing run-up). The remaining $78 would fronted by the government – $6 in actual taxpayer money to match the manager’s equity and the remaining $72 levered up 6:1 against the total $12 equity portion…that entire leveraged amount underneath an FDIC guarantee umbrella; that is, for all intensive purposes completely backed by the taxpayer.
In short, the private manager only has to find 7.14% in real money to buy 100% of the asset.
ii) Legacy Securities Program
In contrast to the Loans program where investors of all stripes are eligible, only five US-based institutional money managers will be chosen to partner with the government in the creation of five large private-public investment funds. An applicant must be able to raise at least $500 billion in capital – in addition to the minimum $10 billion he or she currently manages – and, of course, also boast an outstanding track record. Every dollar a manager raises will be matched by the Treasury. The Treasury will then provide an additional dollar – and in some undefined cases two dollars – as a loan against every private sector dollar the manager can scrounge.
In short, the private manager has to find at worst 33.3%, and at best only 25%, in real money to buy 100% of the security.
Making the Market
The centerpiece of the Public-Private Investment Program put forth on March 23rd is the fundamental reaffirmation of the fact there is no such thing as an asset that is “toxic.”
“Toxic” – Capable of causing injury or death, especially by chemical means; poisonous.
“Legacy” – A gift of property, esp. personal property, as money, by will; a bequest.
By affixing the moniker of “legacy” to the battered mortgage-related loans and securities the new plan involves, the government is showing that, after months of mixed messages, it now has a dedicated plan with which to remind institutional money managers what they have always known, but in the past year or so of market chaos seem to have forgotten: in an environment of irrational fear the tendency of markets is to overshoot so, any asset selling for 30 cents on the dollar is not “toxic,” quite the opposite in fact; it is very likely a bargain!
The plan’s official release document illustrates how Geithner hopes to restart the market for mortgages and the associated securitization industry by impelling “price discovery” and restoring “investor clarity” with respect to the “excessive liquidity discounts” currently embedded in these legacy assets.
While by no means a silver bullet, after weeks of inconsistent signals by Geithner and others in the government, the sheer level of comprehensiveness in the PPIP alone has restored investor confidence appreciably. However, while the market has responded favorably to the plan so far, a variety of concerns exist.
- Government as Crutch
Much like that oft-heard maxim about the difference between giving a man a fish and teaching a man to fish, it is difficult to foresee which example the PPIP will turn out to be; that is, once the massive volumes of public money available through the PPIP are withdrawn will the private sector continue to invest on its own? Or will loan trading freeze up and the fledgling securitization market revival stall, leaving banks – and their concomitant levels of lending – right where they started?
- Who’s really in charge?
On one page of the plan: “Fund managers will control and manage the assets until final liquidation, subject to strict FDIC oversight.” Buried elsewhere in the plan: “The fund manager has full discretion in investment decisions, although it [the fund] will predominantly follow a long-term buy-and-hold strategy.” Obviously, Geithner wants to prevent a sell-off from occurring (once upward price movement begins), which could entirely unravel the plan; however, exactly how tightly handcuffed these fund managers will be in their freedom to trade these bad assets once purchased is troublingly unclear, and could significantly impede private sector participation from the get-go.
- The Wisdom of Resurrection
Can reviving structured finance, an industry that had become a “Frankenstein,” really be expected to yield positive results? One would hope that the past few months have so shaken the few investment bankers left standing that they have banished any thought of resurrecting the unsound underwriting standards which, combined with a heady dose of greed, evolved into downright reckless origination. However, market participants often have incredibly short memories.
Finally, the million-dollar question: what are these mortgage pools and mortgage-backed securities truly worth?
Some economists are outraged that the government is proposing up to 14x leverage in the latter case (albeit, only 3-4x in the former) when it was just such high levels of leverage that got Wall St. into trouble in the first place, and contend that any level of price support using public money is untenable and a waste. With regard to the private-public investments for mortgage loans, one economist commented that since the (maximum) 85% debt portion that the FDIC is willing to guarantees is non-recourse, and given the sliver of actual cost the fund manager must cover, the “investment” is actually much better characterized as a “put option” on the asset. Investors are basically offered a chance to participate in any upside if a 40¢ asset appreciates to 50¢, while the taxpayer foots the bill if that asset turns out to have been worth 30¢ all along.
Certainly a bidding process concerning an asset of uncertain true value in which the government promises to cover anywhere between 66% and 92% of the cost with few, if any, strings attached cannot result in true price discovery. The worst-case scenario features banks and other institutions unburdening themselves of only their very-worst assets (for why would they part with their performing investments?) by shifting them onto the back of the taxpayer at artificially inflated prices.
On the other hand, the FDIC is to receive an unspecified “fee” for its huge possible coverage commitments. Much more importantly, discounted cash flow analyses of the AAA tranches of the various mortgage pools that make up the bad loans (and that are behind the bad securities) show that true expected losses are nowhere near what corresponding asset prices currently reflect, especially in the case of CMBS. In short, there is considerable validity to the liquidity discount argument that underpins the plan. Whether it succeeds brilliantly – triggering resumed bank lending as well as returns for the public purse – or fail spectacularly and squander even more taxpayer money, the mere announcement of the PPIP has, to date, triggered a prolonged rally and restored investor confidence on a massive scale. With many billions in public funds expended since September 2008 and little to show for it, certainly this must be viewed as a significant improvement.