Wednesday, March 25, 2009

Treasury resale may prove best option

From the Financial Times by Julie MacIntosh, Aline van Duyn and Deborah Brewster:

The US government’s efforts to jump-start its toxic asset resale programme by luring investors with debt financing has prompted criticism that private funds will not shoulder enough of the risk. But it may be the best way to bring markets back to health and making good on government investments.

A new US Treasury programme aims to find private-sector buyers for troubled loans and securities that continue to clog banks’ balance sheets. A few investors who buy into pools of assets using government financing may hold them to maturity, later splitting their returns with the government.

But most buyers may want to sell them – potentially with the debt still attached – on a shorter time frame to lock in returns if the market floats higher. The government would also realise gains on its equal equity investment in tandem. But if the assets lost value, it could bear most of the losses.

Guy Haselman, a principal at hedge fund group Gregoire Capital, says there is potential for playing the system if the assets are flipped between banks and investors. “When the taxpayers find out that the acquiring hedge fund will have the ability to sell the asset any time, especially right back to the selling bank ... and get a commission from the buying bank, then it could get more politically ugly,” he said.

But one person familiar with government thinking said it envisioned groups of investors would commit to holding their pools of assets for several years – not weeks or months – before selling, in the same way investors in private equity funds commit their capital.

The creation of a market for these assets is the government’s goal, and those who lauded the plan after it was announced on Tuesday said investors must be allowed to reap gains on their investments for it to work.

“The government shares in all upside, so to the extent that private investors make money, so does the government,” said Jason Goldberg, analyst at Barclays Capital. “I’m not sure how it could be called ‘gaming’ the system.”

Investors considering whether to participate in the programme raised more questions on Tuesday over their ability to exit investments and on how the assets will be packaged and priced.

Those who are betting the programme will succeed are basing those wagers partly on the belief that a lack of liquidity is the main reason for the assets’ fall in value.

But if depressed prices reflect the weak underpinnings of the housing market, consumer credit and the overall economy, gains could be scarce – or longer in coming. These assets are, after all, backed by home mortgages, car loans and other forms of credit that eventually need to be paid off. Their quality, rather than their liquidity, may be the problem.

“While most have focused on the dramatic upside possible and the leverage offered, the buyer still ends up losing 100 per cent of his albeit small equity interest should he only marginally overpay, and so even the buyers may be nervous,” said Tim Backshall, chief strategist for Credit Derivatives Research.

Some voiced concerns over whether loans held by banks would be cheap enough to draw investment. The leverage offered by the government may not bridge the gap between what buyers want to pay and what some banks are willing to accept, for fear of further markdowns.

“We believe the programme will be more successful in attracting security related assets, which are generally marked-to-market, relative to loans,” said Mr Goldberg.

The government may be hard-pressed to find buyers for assets that are backed by second-lien home mortgages even if it offers to finance the purchases with 99 cents of debt for each penny invested, one banker said, because those assets appear to be inherently worthless.


A sweet deal for investors?

The Geithner plan unveiled this week presents investors wanting to buy toxic loans from banks with three options:

1. Buy a loan (or security), hold it in the hope its value will appreciate and then sell it

2. Hold the loan to maturity

3. Buy loans, restructure them and sell them on

If they choose the first option, investors could get a sweet deal at little risk:

The chart below shows a hypothetical scenario in which a public-private partnership buys a loan initially worth $100 from a bank at the reduced cost of $84. The private investor would invest $6 in equity, the Treasury would take a further $6 in equity and the remaining $72 would be funded by FDIC-guaranteed loans.

The chart shows net profits for the taxpayer (the Treasury plus the FDIC) and private investors, at a range of selling prices when the loan is sold after one year.

It assumes that 2% interest is paid on the loan, while the FDIC is paid a ‘guarantee fee’ of 1% (the actual rates are not yet known).

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