Tuesday, September 23, 2008

TARP (Troubled Asset Relief Program) Sounding Board (Update 3)

Size of program? The program is to be limited to $700 billion “outstanding at any one time” but it is not clear whether that is par, book or market value.

What assets? The program will buy mortgage-related assets from any financial institution having significant operations in the U.S., unless the Secretary of the Treasury determines that broader eligibility is necessary to effectively stabilize markets. Mortgage-related assets include residential and commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages that were originated or issued on or before Wednesday, September 17, 2008. (They probably exclude CDOs.) Bank of America has opined that buying whole loans could be problematic, because they “present the difficulty that the asset is not as easily fungible in that servicing of the asset needs to be considered. However, the GSEs securitization capacities could be employed to deal with these loans…”

Which financial institutions? Any institution including, but not limited to, banks, thrifts, credit unions, broker-dealers, and insurance companies, having significant operations in the United States; and, upon the Secretary's determination in consultation with the Chairman of the Board of Governors of the Federal Reserve, any other institution he determines necessary to promote financial market stability. Steven Pearlstein (in Saturday’s Washington Post) points out that “[if] foreign banks and investors are also benefiting significantly from the U.S. government initiatives... some of the costs and risks... [could] be shared with [those] other countries, through the IMF.”

“It’s not clear whether securitization trusts can participate. Given that the trustee is the nominal owner of the loans in the securitization, perhaps ABS trustees (since they are typically US banks) as sellers would be eligible. This point is not clear, however. Given that about 80% of subprime loans are owned by securitization trusts, it’s important that the TARP can buy loans from these trusts. On the other hand, the systemic risk of the banking system may dictate that the TARP should use its dry powder on banks. Further, there may be legal and other hurdles to servicers doing whole loan sales from securitizations.” (Credit Suisse)

What price? “Does [the Treasury] pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets.” (WSJ)

The Treasury was initially floating the idea of using a reverse auction to price the assets. “Here, the government would stipulate the category of assets to be purchased, potentially capping the amount, then solicit offers to sell from eligible banks. The auction process would create a market clearing price, one that generates the lowest price for the government, thereby “protecting” taxpayers. The drawbacks to this plan are that the price that banks would be able to submit would reflect only close to current marks. This would benefit investment banks with assets marked to market close to where a fair market value may become realized under this process as that would entail little further capital reduction. But for banks with assets (loans or securities) with marks far from where this process would settle fair market values, the cost in terms of capital could be prohibitive, and the program would yield them little benefit. Moreover, such a process may simply highlight the inaccurate marking and hasten a determination of capital insufficiency.” (Bank of America)

“[Another] approach would simply postpone the issue of valuation to a future date. By taking assets into the TARP at the last reported mark (in quarterly reports for example), the government could remove assets from bank balance sheets without creating a capital need and without needing to determine a “fair market price” for which financial markets cannot currently provide one. Under this scenario, to avoid a complete transfer of risk and effective bailout of shareholders, the bank would need to remain on the hook for losses, agreeing to reimburse the government for any eventual losses. That approach while avoiding the issue of market values, would require some stretching or suspension of “true sale” accounting rules. Alternatively, for GAAP reporting the assets could remain, but regulators could treat them more beneficially for capital purposes. Alternatively, the government could decide simply to buy the assets at some arbitrary inflated mark (relative to current market values) with no further claim. That would represent the most beneficial outcome to equity holders, though we doubt such an outcome would eventually be part of the plan given the history of interventions and a no bailout for equity holder principle employed to date.” (Bank of America)

In Tuesday’s Congressional testimony, Fed Chairman Bernanke floated the idea of using “hold to maturity” prices: “I believe that under the Treasury program, auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets.... There are ‘substantial benefits’ to buying assets at a cost close to the hold-to-maturity value.” [Although no one has yet figured out what is meant by “hold-to-maturity pricing”, Credit Suisse opines that it accounts for expected collateral losses.]

“Many assume that the TARP will lose money if the Treasury pays above the market price, but the funding advantage of this program (borrowing at Treasury rate) enables it to price assets at relatively higher level than the current market pricing without sacrificing net return. In addition, given that most distressed buyers require double-digit unlevered returns, the TARP can buy at half the yield (4%-8% v. 8%-15% for market returns) and still generate returns relative to its marginal cost of funding.” (Credit Suisse)

Overpricing protection? Christopher Dodd has put forward the idea of “contingent shares” (or “loss participation”). They vest when the government sells the institution’s mortgages or related securities at a loss. The vesting rate is 125% of the dollar value of the loss (the number of shares to be based on the average price during the 14 business days prior to the original purchase date). If the institution does not have any publicly traded shares outstanding, senior debt securities will be taken.

Who will run it? “The Treasury plans to hire asset managers to purchase and manage the assets. It also sounds like they are giving themselves the option to issue mortgage-related securities (“vehicles that are authorized… to purchase mortgage-related assets and issue obligations…”), although this would likely be via one of the GSEs.

Termination? Two years from the enactment date, but will require a report to Congress within three months of the first exercise of the program, and semiannually thereafter.

Accounting may pose a major stumbling block. “Back in the RTC days, most of the problem assets were loans that were generally held at book value (along with some loan loss reserves). The US government was then able to pay a price that was somewhat (but not significantly) below par to buy these loans. In many cases, the S&L in question was already bankrupt, so loss recognition was not a major deal stopper. Today, many mortgages are held in securities form in banks’ AFS portfolios. A sale at a price significantly below a bank’s book value for these assets has two potential consequences — a negative impact on income and regulatory capital and the potential to taint the bank’s entire AFS portfolio.” (Citigroup)

Democrats are seeking to add subprime relief, including mortgage “cramdowns”.“Barney Frank said the plan would have to include requirements that the government reduce the loan amounts or improve the terms for many distressed borrowers. “We should be more willing to write down the mortgages,” Mr. Frank said in a telephone interview on Friday. “We’ll become the lender. The government will wind up in a controlling position so that we can reduce the number of foreclosures.” (NY Times)

1 comment:

Anonymous said...

"TARP" is appropriate.... 'cuz that's all I am going to be able to keep over my family's heads.