Monday, March 23, 2009

The Geithner plan - Is it enough? (Part 2)

Posted on Financial Times Alphaville by Tracy Alloway:

Anyone worried that Geithner’s toxic asset plan would encourage investors to overpay for toxic bank assets should be relieved. It doesn’t.

What they should be worried about, however, is whether it will actually do anything for the banks.

Here’s the example contained in the Treasury press release of the way the public-private partnership Legacy Loan Program will work.

US Treasury - Sampe investment under Legacy Loans Program

Under that example, the private investor is putting up 7.14 per cent of the value paid for the asset ($6/$84= 0.071428) in equity.

Say this private investor wants to pay a little more for the added certainty of beating other bidders. He decides to pay $90, a 7.14 per cent increase on $84.

This leads to equity of $12.86 ($90*[1/7] = $12.857142). Of that equity, the private investor pays half, or about $6.43. The rest, $77.14, is FDIC-guaranteed.

So, under the higher price, the private investor is also putting up 7.14 per cent of the value paid for the asset in equity.

The same goes if the private investor chooses to pay $100 or $50 or whatever. The government will consistently be paying for roughly 7 per cent of the asset up front. The remainder, always 86 per cent of the total paid, will be guaranteed by FDIC.

The government subsidy to the investor remains the same no matter what price is paid - so the investor is naturally incentivised to seek the lowest value possible. In fact, Alea picked up on the theme this morning before the full plan was published:

… private investors won’t overpay because they are in a first-loss position, furthermore this crisis being of a systemic nature, correlation is high, this means equity is risky because yields are lower than normal relative to more senior tranches and would sell off sharply if conditions were to normalize, a rational investor will bid assuming low or 0 correlation.

So there is likely to be a gap between the mtm value of the toxic assets and what a rational investor would pay, reducing or eliminating the incentive for banks to participate.

This is a “pingouins sur la banquise” problem, only the truly starving for capital will jump.

It’s something that was mentioned by Yves Smith at Naked Capitalism too:

even if the investors understand and fully accept that the current market price is markedly below the “true” value of the toxic paper, the math to the investor still does not appear to work. That means the program will have to offer even richer subsidies or will elicit very few successful bids (and then only on the best of the dreck, where the “real” value of the paper appears to be not too horrifically below the level at which the bank is carrying it on its books). That’s a lot of cost and drama for perilous little benefit. …
Of course, one can always make the argument that what’s needed in the financial system is a bout of painful writedowns for banks and the acceptance of real prices for their assets. In that sense, Geithner’s plan may be a success by forcing banks to finally deal with their balance sheets in a realistic way. If the plan was, however, intended as a not-so-subtle way of recapitalising banks at the taxpayers’ expense via overpaying for assets, we question whether it will work.

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