Thursday, April 2, 2009

Geithner’s Non-Recourse Gift That Keeps on Giving to Bill Gross

On Bloomberg News by Jody Shenn:

Treasury Secretary Timothy Geithner’s plan to rid banks and markets of devalued assets may be a boon for Pacific Investment Management Co.’s Bill Gross.

The plan may reward investors with 20 percent annual returns on “really toxic” mortgages bought at 45 cents on the dollar by allowing them to borrow six times their money with “non-recourse” government-backed debt, New York-based Credit Suisse Group AG analysts Carl Lantz and Dominic Konstam wrote in a March 27 report. That loan would be worth 15 cents to an investor seeking the same return who can’t use borrowed money.

Geithner’s Public-Private Investment Program, or PPIP, promises to boost prices enough to encourage banks, insurers and hedge funds to sell their mortgage holdings, freeing them to make loans while creating a potential windfall for investors. Federal Reserve Chairman Ben S. Bernanke said March 20 that “credit market dysfunction” is countering efforts to fix the economy.

“One of the challenges has been that leverage has really been pulled away from the system and as a result the kinds of returns investors are looking for haven’t really been available,” said Ken Hackel, head of fixed-income strategy at RBS Securities in Greenwich, Connecticut. RBS is one of the 16 primary dealers that are obligated to bid at the Treasury’s auctions of government debt and which trade with the Fed.

Growing Interest

Since Geithner unveiled the plan on March 23, Pacific Investment, or Pimco, which manages the world’s biggest bond fund, and New York-based BlackRock Inc., the largest publicly traded U.S. asset manager, said they may be interested in participating in PPIP. Others include New York-based Apollo Global Management LLC, the private-equity firm run by Leon Black, and Los Angeles-based Colony Capital LLC, which has invested more than $39 billion since it was founded in 1991.

“This is perhaps the first win/win/win policy to be put on the table,” Gross, co-chief investment officer of Newport Beach, California-based Pimco, said in an e-mailed statement last week.

Pimco spokesman Mark Porterfield, Konstam and Lantz didn’t return calls seeking comment.

Geithner’s plan may already be working. Top-rated commercial-mortgage bonds rose 5.6 percent since March 20 to about 79 cents on the dollar on average, according to Merrill Lynch & Co. indexes. The most-senior class of benchmark 2005 securities backed by fixed-rate Alt-A home loans, or those ranked between prime and subprime, increased about 12 percent to 54 cents as of March 31, according to Deutsche Bank AG.

Government Loans

Geithner’s plan encourages investors to buy as much as $1 trillion of real-estate assets by using $75 billion to $100 billion provided by the Treasury and government loans. The goal of the Fed and the Treasury since September has been to cleanse banks of troubled assets.

The Treasury would match the money asset managers raise to join them in public-private funds. The Federal Deposit Insurance Corp. would guarantee borrowing offered to funds buying loans, while the Treasury and Fed would offer financing to mortgage- securities buyers. The Fed loans may be made available to investors that are not part of the public-private funds.

“Institutional investors, especially the largest, want to be able to put more leverage into trades so they can get higher returns for their efforts,” said David Castillo, a senior trader of structured-finance bonds at Further Lane Securities in San Francisco. “On paper the concept is wonderful, though I’m of the opinion most banks still won’t be able to sell.”

$12.8 Trillion

Analysts at JPMorgan Chase & Co., Barclays Plc and Deutsche Bank AG also say they don’t expect banks to sell many loans into the program because accounting rules mean they generally carry the debt at face value. That suggests they would record a loss when selling the assets, eroding their capital.

The credit markets began to seize up in 2007 as losses on subprime mortgages mounted. Since then, the world’s largest financial institutions have taken $1.3 trillion in losses and writedowns, according to Bloomberg data. Gross domestic product shrank 6.3 percent in the fourth quarter, the most since 1982, as banks reined in lending.

The government and Fed have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s, Bloomberg data show..

“Widening credit spreads, more-restrictive lending standards and credit market dysfunction are working against the monetary easing and leading to tighter financial conditions,” Bernanke said March 20, addressing the Independent Community Bankers of America’s national convention in Phoenix.

Congressional Skepticism

The Treasury’s role in buying securities with private investors raises the risk the government would interfere with the businesses of its partners, said Jim Shallcross, who oversees about $14 billion in bonds as director of portfolio management at McLean, Virginia-based Declaration Management & Research LLC.

Representative Spencer Bachus of Alabama, the top Republican on the House Financial Services Committee, said in an April 1 interview that the distribution of half of the profits to the investor “does bother me.”

“But even beyond that, what bothers me even more is it’s taxpayer money,” Bachus said. “What you are doing is artificially inflating the price of those assets because at the present prices the financial institutions won’t sell them.”

Geithner signaled he’d oppose any attempt to claw back profits from investors participating in the program. Investors and banks “need to have confidence that the rules of the game are going to be clear, consistently applied in the future,” he said in an April 1 Bloomberg Television interview in London.

‘Taxpayer Loses’

Nobel prize-winning economists Paul Krugman, a professor at Princeton University in Princeton, New Jersey, and Joseph Stiglitz, a professor at the Business School of Columbia University in New York, blasted Geithner’s plan for putting the taxpayer on the hook for losses with what they say is little likelihood of success.

“The Geithner plan works only if and when the taxpayer loses big time,” Stiglitz wrote in the New York Times this week. “With the government absorbing the losses, the market doesn’t care if the banks are ‘cheating’ them by selling their lousiest assets, because the government bears the cost.”

Krugman wrote in the Times last month that “Obama is squandering his credibility” with the plan.

RTC Experience

While the government’s takeovers of failed savings and loans in the late 1980s and early 1990s cost taxpayers and let private investors gain, it succeeded in ending the crisis. The Resolution Trust Corp. recovered almost $400 billion from asset sales, short of their book value of $452 billion, the agency’s executives said on the day it was shut down on 1995. The government cost of the bailout totaled about $90 billion.

“There was a lot of concern that they were selling the assets too quickly and too cheaply,” said Raghuram Rajan, the former chief economist of the International Monetary Fund in Washington who’s now a professor at the University of Chicago. “There was a lot of second guessing, but it worked.”

The odds of Geithner’s programs succeeding would be low if the financing offered was “recourse,” Credit Suisse’s Lantz and Konstam said. That would require the funds to pay back the government funds with their own money if the value of the assets fell below the amount of the loans.

Declining Value

With recourse loans, the type of “toxic” mortgages identified by the Credit Suisse analysts, which have a hypothetical 40 percent annual default probability and only 10 percent expected recoveries, would be worth only 19.7 cents.

The type of loans that may be sold, New York-based Citigroup Inc. analyst Darrell Wheeler said in a March 27 report, include $93 billion of commercial mortgages that are probably carried on the books of banks at 65 cents to 75 cents on the dollar because they were meant to be packaged into bonds.

Unlike Geithner’s plan for loans, the public-private funds for securities will be limited initially to only five managers, such as Pimco and BlackRock, already overseeing $10 billion of the assets targeted. That program will buy securities from holders of toxic assets other than banks.

“There it’s probably going to work -- for five people,” said Dan Castro, chief risk officer at hedge fund Huxley Capital Management in New York. “You’re selecting a very small group of large guys and giving them all the advantages.”

Potential Profits

By providing loans, the government may allow investors to more than double their potential profits.

The most-senior class of a 2007 Goldman Sachs Group Inc. commercial-mortgage bond traded at 69.6 cents on the dollar on March 27, offering a yield of 12 percent, according to report that day from Bank of America Corp. analysts Roger Lehman and Julia Tcherkassova in New York.

If the Fed provides a five-year non-recourse loan and requires an investor to put up only 85 percent of the cost of the securities, then that investor could “walk away” when the loan expires and still have earned 25 percent returns, Lehman and Tcherkassova wrote. That assumes losses on the underlying loans don’t exceed 30 percent.

That type of bond has risen more than 10 cents on the dollar since the plan was announced, according to Wheeler.

The amount of leverage available under the Fed’s program hasn’t been announced. The FDIC program will offer as much as six times the money raised by the private-public funds from individuals and the Treasury.

‘We intend to participate and do our part to serve clients as well as promote economic recovery,’’ Pimco’s Gross said in the e-mail.

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