Accrued Interest, after looking at the bank bailout plan, has come up with an interesting conclusion: the Legacy Securities Program will be a great success, but the Legacy Loan Program is stillborn, unless some big changes are made.
I’ve done some deep dives on bank residential loan portfolios. Getting detailed data is a challenge, but basically I tried to figure out what percentage of the bank’s current portfolio is “challenged.” High CLTV, bad geographics, low FICO, etc. You can make a relatively safe assumption that most of the loss reserve is pledged to those kinds of loans. Anyway, I can’t find any big banks that are holding, say home equity loans at less than 90% of face. Unless the Legacy Loan Program winds up buying assets at $90 or more, banks won’t sell.
Using some pretty reasonable assumptions, the PPIPs aren’t going to buy these loans until they drop to the low 80s — which means that there simply won’t be a market-clearing price for most of the loans.
But what happens if one or two desperate banks end up selling loans at say the 82.5 cents on the dollar which Accrued Interest reckons would be a reasonable price? Since the whole point of this program is to provide price discovery, wouldn’t that mean that the rest of the banking system would have to mark their loan books to the newly-discovered valuations?
I’m not sure what the answer to that question is. From a simple accountancy perspective I think the banks can continue to classify these loans as held-to-maturity assets, and thereby avoid having to mark them to market. But when it comes to the government’s stress tests, it’s going to be hard for the banks to persuade Treasury that the loans are worth significantly more than anybody is willing to pay under the PPIP. So if the loans don’t clear, that could be prima facie evidence that the banks are not actually as solvent as they say they are. Which could be a nasty unintended consequence of this whole plan.