Monday, March 23, 2009

The Geithner plan - Is it enough? (Part 1)

At the heart of this complex plan is liquidity, which Geithner has identified as both the problem and the answer. Increase liquidity and assets price will rise towards fair value, banks’ capital ratios will improve and they will start lending again. Simple.

Secondary markets have become highly illiquid, and are trading at prices below where they would be in normally functioning markets. These securities are held by banks as well as insurance companies, pension funds, mutual funds, and funds held in individual retirement accounts.

Indeed, everything announced on Monday, from equity co-investment to leverage, is designed to make it cheaper and easier for private investors to buy these “legacy” loans and securities.

But is this enough? As banks team at Nomura points out, there is still no incentive for these private investors to pay a wrong high price for these assets, which after all might be trading at depressed prices because of poor underwriting and negligent risk assessment.

Although it is true that investors are given a non-recourse loan by the government to gain leverage (of up to 6:1 to buy loans or 2:1 to buy securities) and that the government co-invests in the equity, as the plan states, the investors stand “to lose their entire investment in a downside scenario”. As a result, while a lower cost of funds may allow investors to pay a higher price than without government funding, the incentive for pay a high price for legacy assets is small.

And this is important. Because if they don’t pay up, the banks have no incentive to sell - particularly if doing so triggers another wave of write-downs and forced recapitalisations.

As Nomura notes, emphasis ours:

Similarly the benefits to the taxpayer do not necessarily translate into benefits for the banks which hold the legacy assets. Private sector price discovery is said to “reduce the likelihood that the government will overpay for these assets” i.e. the assumption is that the clearing price for legacy assets under these arrangements will be low with private sector involvement (consistent with the fact that investors may lose their entire investment in a downside scenario).

In practice this means that banks which carry their legacy assets at above the clearing price will not be incentivised to sell, or for those which do (perhaps because they have already marked aggressively), a transparent clearing price could lead to a wave of write-downs and forced recapitalisations across the rest of the sector from those banks which are sitting on overvalued legacy assets.

In a European context, Nomura says this means Barclays, Deutsche Bank and, to a lesser degree, UBS.

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