Monday, March 23, 2009

Understanding the Mechanics of the New Plan

On the Wall Street Journal's MarketBeat by David Gaffen:

The newest iteration of the plan to buy up the unwanted assets from financial institutions has received kudos from Wall Street Monday, as major averages have advanced by 6%. But there are still a number of nagging holes that have not been clarified in the plan – even though a bit of additional clarity seems to have been achieved through the release of a fact sheet from the Treasury Department.

“Insofar as the direction of the market and the economy is predicated on the help of the banking sector, this is a message that we’re moving in the right direction,” says Dan Ripp, president at investment bank Bradley Woods & Co. “The problem you’re still presented with is – and it’s the same as what happened in the fall – what price do you have to pay to get ahold of these?”

The new plan has a number of wrinkles to it, but the question of price remains central to whether it will work. Private-equity firms and other fund managers are likely to be interested in buying this debt at bargain-basement prices, but if the banks are not enticed to sell because they believe it undervalues these assets – and thus forcing them to take losses on loans that they’d rather hold onto in hopes of recovery – the process will still be jammed. Michael Feroli, economist at J.P. Morgan Chase & Co., says that the government’s stress tests may “force banks to sell into the Legacy Loans Program.”

But the hope, according to Chris Seyfarth, a partner with Ernst & Young’s transaction advisory services group who specializes in real estate, is the attractive leverage terms, along with the limited downside for investors, “will allow investors to pay more than they would if they didn’t have access to the attractive debt provided by the FDIC and with the government investing alongside of them.”

A CLO to Buy a CLO
The Treasury provides an example in its fact sheet, suggesting that if a bank wants to sell a portfolio of loans they value at par, they’ll go to the FDIC, which will provide up to six-to-one leverage for the private investor that bids successfully for the assets. In this example, if the assets are then sold at 84 cents on the dollar, the “buyer would receive financing by issuing debt guaranteed by the FDIC,” according to the Treasury.

That seems to suggest that the fund – call it Bob’s Toxic Debt Partners Private-Public Investment Fund Version I – will sell debt that is securitized by the payments from the various loans in the pool. In a sense, this doesn’t make it much different than the original collateralized debt that the banks stupidly bought and watched become worthless. (There is a guarantee from the FDIC, though.)

With this example, the 84-cent price is divided between 72 cents financed through FDIC-backed debt, and an additional 12 cents of equity, split between the private fund and the Treasury Department. Both share in the upside if the prices of these securities rebound, and spreads on Markit Group’s index of credit default swaps on investment-grade debt did decrease in cost, suggesting some positive reaction, according to Phoenix Partners Group.

Will this structure entice a private fund to pay 84 cents on the dollar instead of the 20 cents where an asset may be trading, knowing now they’re only paying six cents of their own money (with interest to be paid later)? Or do they balk, thinking that at best, these securities are still not worth anywhere close to 84 cents? On the other side, if a fund offers, say, 60 cents on the dollar, will the banks in question agree to take that marked-down price in order to resolve this issue? This would accomplish the task of narrowing the bid-ask spread on these assets and would also reduce the government’s obligation (as they’re taking the big middle zone). Or will banks walk away from such a bid, thus condemning this program to another idea cast aside that didn’t work?

In addition, if the funds themselves have to sell debt (backed by the FDIC), who are the buyers of this debt? Other private equity funds as well or asset managers? Or the banks? The FDIC is guaranteeing these debt sales — that doesn’t sound like the FDIC is actually borrowing the money themselves, and the Treasury fact sheet does not say that the Treasury will sell debt to finance the private buyer’s borrowed portion.

It’s not crazy to think that valuing the assets will continue to be difficult as the Obama Administration attempts to backstop the housing market through programs to allow reductions in interest or principle. Securitized assets are sold based on expectations of steady, predictable payments – but this would impair that. “On the one hand you have these programs that make these assets worth less and less every day,” says Tom Fant, portfolio manager at Atlantic Advisors. “On the one hand it helps the homeowner out and destroys value in the securities, and then they’re trying to pump up the value of the assets when offering leverage [to investors].”

A Trillion Here, A Trillion There
A larger, more crushing problem emerges when one considers the sheer level of guarantees undertaken by the government in the last several months, one that many believe will lead to an unavoidable increase in the cost of funding for the Treasury, one that then causes all interest rates to go up, obviating the improvement in rates that the Fed and Treasury are trying to accomplish. “Overall including the new Treasury program, the federal government has made commitments and promises which are not financeable,” says Martin Weiss, president of Weiss Research.

Stephen Stanley, chief economist at RBS Greenwich Capital, says it is unfortunate that “the government has managed to fritter away so much of what seemed to be a massive amount of gunpowder, and now that it is finally ready to engage in the big battle, it has to ration its bullets.”

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