Monday, March 23, 2009

The “Geithner Put” (Part 2)

Posted on Self-Evident:

In Part 1, I gave an example of how a private investor could buy some loans for $8400, ultimately realize $5000 on them, and still earn a 16.7% profit. Milo Minderbinder would be proud. The loser would be the FDIC, which is interesting because the FDIC is financed not by the taxpayer but by the banking industry — or at least, it has been so far. So even if the FDIC needs to tap their new $500 billion credit line to make good on tons of bad loans, in theory they will eventually repay the Treasury by exacting higher insurance premia from the banking industry.

Thus Part 1 could be read as a transfer of wealth from good banks to bad banks and private equity. Assuming Treasury actually demands repayment on the credit line and does not just write it off…

Part 2 of the Geithner Put is called the Legacy Securities Program. Here again, the Treasury provides an example:

Step 1: Treasury will launch the application process for managers interested in the Legacy Securities Program.

Step 2: A fund manager submits a proposal and is pre-qualified to raise private capital to participate in joint investment programs with Treasury.

Step 3: The Government agrees to provide a one-for-one match for every dollar of private capital that the fund manager raises and to provide fund-level leverage for the proposed Public-Private Investment Fund.

Step 4: The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.

Step 5: As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.

Step 6: The fund manager has full discretion in investment decisions, although it will predominately follow a long-term buy-and-hold strategy. The Public-Private Investment Fund, if the fund manager so determines, would also be eligible to take advantage of the expanded TALF program for legacy securities when it is launched.

This may sound similar to Part 1, with the Treasury providing the leverage instead of the FDIC… But it is actually completely different. The key concept is the non-recourse loan. If Treasury wants to hire a handful of money managers, ask them to raise private capital, match the capital raised, and then let them lever up 3:2 or 2:1, that is not a subsidy in the same way as Part 1. In this case, the loans are full recourse with respect to all of the assets run by that manager. So it is not trivial to construct an offensive example, and this structure by itself is not so bad.

No, the bad part is this bit which appears a few paragraphs earlier:

Expanding TALF to Legacy Securities to Bring Private Investors Back into the Market

… stuff elided …

  • Funding Purchase of Legacy Securities: Through this new program, non-recourse loans will be made available to investors to fund purchases of legacy securitization assets. Eligible assets are expected to include certain non-agency residential mortgage backed securities (RMBS) that were originally rated AAA and outstanding commercial mortgage-backed securities (CMBS) and asset-backed securities (ABS) that are rated AAA.

Whoops, there are those “non-recourse loans” again. The TALF is the Fed’s new $1 trillion program to provide non-recourse loans against new asset-backed securities. Part 2 of the Geithner Put extends this program to existing securities. (Note the phrasing “originally rated AAA”. We are definitely talking about toxic assets here.)

So the Treasury provides equity investment and loans in funds to purchase assets, and then the Fed provides the subsidy via a non-recourse loan. The degree of leverage here is determined by the “haircut” applied to the assets; a 10% haircut corresponds to 9:1 leverage, for instance. Search for “collateral haircuts” in the TALF FAQ to get an idea of the numbers. Although bear in mind those are for the current TALF, and we will have to wait to see the haircuts for the Geithner Put extension.

Apparently, we are left with private equity firms and bankers being able to fleece the FDIC and the Fed via abusing the non-recourse loans, with the Treasury/taxpayer participating in the upside of the fleecing. Which is fine, I guess, if you believe the FDIC and Fed are themselves good for the losses; i.e., that the losses will not ultimately be placed on the taxpayer. Color me skeptical, especially with regard to the Fed.

But I do give them points for creativity.

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