Auctioning your headaches: Part 2, the how
[Continued from yesterday's Part 1.]
Yesterday’s post laid out, using as our texts a Wall Street Journal article (plain text) and my Recap essay State of the Market 16: Auctioning Your Headaches (quoted in this font), why the capital markets were clamoring for an auction-sale approach to complex pre-restructuring assets that has now been dubbed the Public-Private Investment Program (PPIP).
Tell us the program!
Let’s see precisely how it works.
The new program has two parts. It will address both the legacy loans banks are holding on their balance sheets and the legacy securities backed by mortgage-related debt clogging the balance sheets of financial firms.
[1] Under the legacy securities program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include [x] certain non-agency residential mortgage-backed securities that were originally rated triple-A and [y] outstanding commercial mortgage-backed securities and asset-backed securities that are rated triple-A.
Decoding the jargon:
AHI blogs: translating finance to English for over four years!
‘Non-agency’ means other than the GSEs, Fannie Mae and Freddie Mac, which are fully liquid.
‘Residential mortgage-backed securities’ (RMBSs) are securitized assets whose collateral is mortgages on homes and apartments.
‘Originally rated triple-A’ means the securities were highest grade.
So the government will lend banks money, non-recourse – secured only by the assets, therefore relieving capital-ratio problems rather than making them worse – to provide liquidity for what was once very-good-quality paper. Reading between the lines, this makes sense only if the securities really are AAA credit quality, but for some reason cannot be perceived as such (probably because of all the dust clouds now in the marketplace). In other words, Banking on Value, Mark II.
“Over time, 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,” Mr. Geithner wrote. “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.”
Treasury will probably be very careful in choosing assets for this non-recourse lending.
“What we have heah … is a failuh … to resyndicate”
Assuming it is – and this task can be readily contracted to bond analysts (like Pimco?) – this action will be immediate liquidity, and very helpful.
I’ll have much more mobility once I get rid of these unrestructured assets
The more interesting program, however, is the second part:
[2] Under the legacy loan program, investment funds will be created to purchase pools of assets.
Treasury will provide 50% of the equity capital for each fund while private managers retain control of asset management subject to FDIC oversight.
Treasury said it will approve up to five asset managers “with a demonstrated track record of purchasing legacy assets,” but it might consider adding more managers depending on the quality of applications received.
To be pre-qualifed as a fund manager, the manager must submit an application to Treasury by April 10.
The asset managers won’t be subject to executive compensation requirements that have come into focus in recent weeks after American International Group Inc. sparked a public outcry by paying out $165 million in retention bonuses to top executives.
Already Congress’s buffoonish scapegoating of AIG is having its fallout in the inescapable logical fallacies. If the AIG retention bonuses were so unconscionable, why are we giving pre-approval to whatever incentive compensation the new buyers get?
“Because we need you now!”
As one of the President’s advisors is quoted, in another Wall Street Journal article:
Austan Goolsbee, a member of the Council of Economic Advisers, said companies will participate if the government lays out clear rules. “Responsible people want to participate if there’s a business reason to participate,” he said on CBS’s “Face the Nation.” He called the situation “totally different” from AIG or Fannie Mae, the government-owned mortgage giant which also got taxpayer bailout money.
Totally different! You haven’t given us your money!
That’s completely different!
Back to the main Journal story:
Banks will identify the assets they wish to sell. The FDIC will conduct an analysis to determine the amount of funding it is willing to guarantee. Leverage will not exceed a 6-to-1 debt-to-equity ratio, the Treasury Department said.
Meanwhile, the highest bidder will have access to the Public-Private Investment Program to fund 50% of the equity requirement of their purchase.
The capital stack thus offers a total of about 93% leverage, as follows:
In the PPIP program, let’s suppose the investor pool has $10 billion to commit. Match that with $10 billion of equity from Treasury, and lever the result by 6x; the result is a $140 billion pool, of which 85% ($120/$140) is debt, with the remaining equity split equally between private and government parties.
This approach – seller provides takeback financing, then splits the equity with the buyer – is a fairly common structure in private-equity and distressed-asset buying. Here, from State of the Market 16, is why Treasury pursued a leveraged-finance approach:
As it capitalizes the aggregator bank, Treasury therefore faces a series of major challenges:
1. Huge volumes of assets need to clear – be liquefied and refinanced – but right now there’s inadequate ready money to clear them.
2. Nobody knows precisely what the assets are worth.
3. Even assuming the assets are clustered into similar types – multifamily residential, say – they are individually complicated and require expertise.
4. Recovering value takes an army of experts. If bottom-up, one-by-one is the only execution that actually adds value – as a third of a century’s experience has convinced me it is – then these are individual encounters, not sweeping generalized repackagings. In fact, it was the phantom of mass packaging – what I think of as the blender-puree approach to restructuring – that led us into the securitization debacle.
5. Because each asset is a unique combination of attributes, each asset restructuring is an irreproducible experiment. Speed wins, judgment is all. Because of this, government cannot second-guess its restructurers, it has to motivate them … and nothing motivates like having your own money at risk. Yet (see Point 1) the government cannot sell 100% of the assets now.
Trouble ahead, trouble behind
In the original TARP program, the Treasury was going to buy assets directly, and restructure them. Secretary Paulson changed course, in my view, because:
In TARP, these challenges are greater because government as restructurer faces several deficits:
· Information deficit. Government knows that it doesn’t know anywhere near enough about these assets.
· Speed deficit. By its nature, government moves more slowly than the market.
· Expert-judgment deficit. Government does not maintain large stables of subject-matter experts.
· Liquidity deficit. The market is cash-constrained and what cash emerges doesn’t want to be used on these assets.
All of these deficits cannot be solved rapidly, so the government has to make it worth while for people to invest who have the armies of underwriters needed to do this restructuring. It’s made worthwhile by using leverage (pay no attention to the nonsense stories calling the structure subsidies), and it follows the tried-and-true hard-equity principle, the originator takes first loss.
You mean I’m in first-loss position?
Places the sponsor in first loss position. Following the control principle, in almost every well-designed program — this includes loan-origination models as well as ownership models — the lead operator takes 100% of the first loss. Since you can lose only what you have contributed, hard equity makes that first-loss exposure meaningful.
Hard equity is the miner’s canary.
“This – is an ex-equity position.”
Recall, too, that in this case Treasury is facilitating the sales, and in fact aligning with the buyers, not the sellers. The sellers have to look out for themselves:
Eligible assets will be determined by banks, regulators, the FDIC and the Treasury Department.
Be careful how you offload those assets
To make money on these assets, there’s only one route. Eventually, some restructuring agent will have to restructure each loan or asset individually:
Recapitalization for the five-legged man
Recovering on financial assets secured by real property requires action on the property itself, a bottom-up approach that takes each situation ‘bottom-up,’ one by one at the asset level, as follows:
1. Physical condition. Financially troubled assets almost always are physically obsolescent, either through capital backlog or simple deferred maintenance, and their recovery requires an injection of new cash to make those physical improvements. The right capital needs assessment and capital improvements plan is essential.
2. Operational optimization. Assuming capital can be found to renovate or refurbish the property, its NOI ought to improve subject to market constraints. Knowing what NOI to project is the basis for deriving an expected post-repositioning value and hence for demonstrating that the proposed improvements will more than pay for themselves, a critical element in raising the necessary repositioning financing.
3. Repositioning. The best plans come to naught if badly executed; repositioning requires the most expert property management in coordination with similarly capable asset management.
4. Financial restructuring. When the property’s sustainable NOI becomes clear, the value of each level of capital becomes clear too. By now the markets realize that swapping a higher-face non-performing and illiquid asset for a lower-face performing, and hence liquefiable asset is a trade worth making.
5. Liquefaction and recovery. Once it’s stable, once it has a trailing NOI, the asset can be sold, or financed against.
In thirty-three years in this business, I’ve found no other formula than applying these five steps, one-by-one, asset-by-asset.
The program will work only if willing sellers meet willing buyers in the money store – and to make sure that happens, treasury’s co-investing and providing financing.
In the money store’s basement, they can print more money!
“A broad array of investors are expected to participate in the Legacy Loans Program,” Treasury said in a fact sheet it provided Monday. “The participation of individual investors, pension plans, insurance companies and other long-term investors is particularly encouraged.”
As laid out in State of the Market 16, a decade ago my for-profit company acted as buyer-restructuring agent for HUD in the mark-to-market (M2M) demonstration program. The structure was extremely similar, the restructuring requirements much the same, and the results were happy.
The M2M demonstration shows that government can auction its headaches if it uses a shrewd partnership-interest auction structure. Via such an approach, government can solve its information deficit, speed deficit, and expert-judgment deficit, while routing around the liquidity deficit.
Private entities who dive in, with proper assistance, are likely to do very, very well for themselves.
Secretary Geithner’s approach has another handy wrinkle: the debt doesn’t count toward the TARP limits.
We’re keeping the vehicle available
With the commitment of between $75 billion and $100 billion to deal with toxic assets announced on Monday, it means Treasury has roughly $80 billion to $110 billion left in TARP funds. Much of that money could likely end up funding the Treasury’s program to recapitalize the largest
“We will make sure there is sufficient capital in the system for these institutions to manage through … a deeper recession,” Mr. Geithner said on Monday.
Somehow, these stress tests are never free …
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