Affordable Housing Institute : US

Last week, to the delight of Wall Street and as reported in the Wall Street Journal, Treasury Secretary Geithner finally unveiled the long-awaited financial-recapitalization plan for up to $1,000,000,000,000 worth of complex non-performing securities, in what the administration inelegantly named the Public-Private Investment Program (PPIP).  

 

“A PPIP structure will bring fast fast fast relief!”

 

WASHINGTON — The Treasury Department unveiled its plan to deal with the toxic assets weighing on banks’ balance sheets Monday, acknowledging that the financial system continues to face “acute pressure” and is working against economic recovery.

 

The coordinated effort of the Treasury, Federal Reserve and Federal Deposit Insurance Corp. will attempt to address the issue of “legacy” real-estate-related assets that Treasury Secretary Timothy Geithner said is reducing banks’ willingness to take risks and to lend money to consumers.

 

A month ago, I predicted the structure – as we’ll show below, it wasn’t hard to do so –

 

I won’t be chicken in predicting the future!

 

– in State of the Market 16: Auctioning Your Headaches (.pdf), from which I’ll quote (in this font) alongside the Journal’s commentary

 

               

 

Core to this plan is the hypothesis, as I’ve written extensively before, that the assets aren’t without value, they are merely – ‘merely’ – highly complicated and require restructuring, simplification, and resolution.

 

“This will help banks clean up their balance sheets and make it easier for them to raise private capital,” Mr. Geithner said.

 

In terms of moving and making the market, this program has two goals: (1) create demand for these securities (’buy-side’ intervention) by providing leverage, which increases buyer upside potential, and (2) increase that demand by bringing into the market capital that until now had been sitting on the sidelines – the vast pools of private equity.  As I wrote in State of the Market 16:

 

Treasury Secretary Geithner’s announcement of a shift in TARP policy to an ‘aggregator bank’ is proposing the classic workout/ recapitalization strategy, good-bank/bad-bank, successfully used in similar asset-pricing collapses going back through the centuries [at least as far back as Genoa's 15th century Banco di San Giorgio – Ed.].

 

Such a move is now appropriate, but does not tackle the fundamental challenge – fixing the ‘broken’ assets.

 

Who’s going to fix my broken assets?

 

Actually, ‘broken’ is unhelpful shorthand – rather, the assets are non-performing and complex, meaning that their complexity is an obstacle to asset resolution. Doing that requires working at the level not of the securities or derivatives but directly with the assets – the properties – and restructuring their operations and financing, returning them to performing status in a new financial configuration.

 

The goal is to get private capital off the sidelines and into the game.

 

We wan t you newbies playing, not watching

 

“We have to complement this program with a range of approaches to help get these securities markets back to a point where they’re working again,” Mr. Geithner told reporters Monday morning.

 

Leverage is the lure that will bring in the first-mover high-yield experts, like this one:

 

Pacific Investment Management Co. said it intends to take part in the program as both a buyer and manager of troubled bank assets, Pimco founder Bill Gross said Monday.

 

Nothing like a confident corporate motto!

 

Bill Gross is widely regarded as a contrarian guru of fixed-income securities.  His 1997 book predicted a decade of low stock-market returns and high bond yields – oops – but he may yet be having the last laugh).

 

“Four or five managers are going to be selected — we hope to be able to do that on the securities side. On the bank-loan side, we hope to be able to participate as a buyer,” Mr. Gross told CNBC.

 

The distinction Mr. Gross draws is key to the whole process. 

 

We at Dunder Mifflin are the world’s best managers

 

Managers are entities that Treasury will hire to be their auctioneers. 

Buyers are the people from whom the assets will be bought – using the structured finance we’ll lay out later in this post.

 

I’m ready to buy

 

For Mr. Gross to be a manager is to be expected.  Expertise, bird’s-eye view, good fees – what’s not to like.  But if Mr. Gross moves into the arena with hard capital, that will be significant.  As I’ve written about hard equity:

 

Gets the borrower’s undivided attention.  “When you’ve got them by the wallets, their hearts and minds will follow.” — with apologies to John Wayne.

 

 “Who you apologizin’ to, pilgrim?”

 

No matter how much economists wish people were rational calculating machines, we are more complex than that.  (It is a weighty economic conundrum why some people walk up escalators.)  Not all money is emotionally equal  – psychologists have demonstrated that people will work harder to recoup losses than they will to increase gains.  “Having skin in the game” is more than a metaphor, it’s an apt expression of the human subconscious expressing anxiety at having an integral organ hostage to fortune.  Developers will go to the ends of the earth to recover their invested simoleons.

 

“The realization that one is filing Chapter 11 in the morning concentrates the mind wonderfully.” — with apologies to Dr. Samuel Johnson.

 

“Can’t I sue for misuse of quotes?”

 

Up and down Wall Street, the capital markets greeted the news with something approaching relief:

 

Meanwhile, Morgan Stanley backed the government’s plan and said it believes it could help stimulate the credit markets. “The Public-Private Investment Program looks like an innovative plan from Treasury and we expect the plan could have a positive impact on the credit markets,” the investment bank said in a statement.

 

It will, because it goes back to principles that were sound a year ago, but impossible to implement because too much was happening too fast.

 

The new program marks a return by Treasury to dealing with the illiquid assets that have snagged credit markets.

 

Former Treasury Secretary Henry Paulson abandoned plans to deal with the toxic assets last year, in part because of the difficulty of determining a proper price for assets where no market currently exists.

 

Although price difficulty was an obstacle, that’s not the principal reason Secretary Paulson shelved his original plan.  Rather, he faced a macro-market problem – aggregate banking-sector capitalization – and it was necessary to shore up bank capital ratios by the TARP injections. 

 

Let’s solve that pesky capital-ratio dysfunctions, shall we?

 

As I wrote at the time:

 

Actually, the terms are incredibly clever in balancing between the government’s desire to see banks visibly strengthened and its equal desire not to get fleeced.  They did with a combination of very cheap equity and equity kickers calibrated to incentivize speed.

 

1.  Preferred stock: the sandwich between debt and equity

 

The preferred stock that each bank will have to issue will pay special dividends, at a 5% interest rate that will be increased to 9% after five years.

 

In today’s environment, five percent fixed is very cheap money.  It gets cheaper because it doesn’t have to be paid immediately. 

 

Preferred stock is a distinct type of capital:

 

§  It’s not debt – it doesn’t have to be paid.

§  It’s not common equity – it earns no share of ongoing profits.

 

Rather, it sits sandwiched behind the debt, ahead of the common equity. 

 

Preferred equity is the tasty filling sandwiched between debt and equity

 

With the bank capitalization now stabilized, Secretary Paulson’s heir, Secretary Geithner, can return to the original problem, moving these complex assets (which need repricing and restructuring) off the balance sheets of public and regulated banks and onto the balance sheets of private-equity institutions with the muscle and risk tolerance to recapitalize them.

 

Mr. Geithner said Treasury hopes the program will unfreeze the market for the assets. He said alternative proposals — letting the assets fester on bank balance sheets or having the government directly purchase them — would put too much risk on the backs of taxpayers. The government needs to balance the potential losses for taxpayers with the need to get credit markets functioning once again.

 

“I am very confident this scheme dominates all the alternatives for trying to find that balance,” Mr. Geithner said.

 

I’ve got a dominant grip

 

Gotta love that game-theory speak – it’s not just better than the alternatives, it dominates them, meaning it is superior in every particular.

 

I am superior in every particular

 

Highlighting the policy choices the U.S. is making, Mr. Geithner and Treasury referenced previous banking crises in Sweden and Japan as providing lessons in the current turmoil. Treasury documents released Monday said that letting illiquid assets sit on bank balance sheets “risks prolonging a financial crisis, as in the case of the Japanese experience.” Mr. Geithner, discussing the issue with reporters, warned against taking the opposite strategy from the Japanese and being too aggressive with government intervention.

 

We took a lesson from Sweden

 

“We’re not Sweden, we have a very complicated financial system,” Mr. Geithner said, referencing that country’s move in the early 1990s to effectively nationalize some banks.

 

So much for the why of the move.  Now, how does it work, and for whom?

 

What’s next?

 

[Continued tomorrow in Part 2.]

 

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