A Solution for the Bad Asset Pricing Problem

The Original TARP plan and the Aggregator Bad Bank ideas both have one major flaw: lack of a mechanism to determine appropriate prices for bad assets. Here is an approach to tackle this pricing issue. This approach also gets more bang for the buck for the Treasury by involving private capital in buying of these assets. More clarity in pricing and involvement of private investors are desperately needed for markets to return to normalcy.

There are already a lot of private investors who have raised significant amounts of money to invest in distressed assets. However, a lot of this cash has not been invested yet. Part of the reason is that they desire lower prices to get their returns to higher target levels than what they can get at present. Sellers, on the other hand, are often not ready to sell at even lower than current prices, especially when they believe that prices are already too cheap based on fundamentals. This has led to a stand-off which is leaving these assets on bank balance-sheets. So long as these assets stay on their balance-sheets and uncertainty about their prices continues, banks facing mark-to-market losses can not focus on restarting lending in these markets again.

Lower asset prices is one way private investors can get higher returns. The other method is if they can get financing for buying these distressed assets. If for example, they can get 50% financing on purchase price of assets, they can buy twice the amount of assets they could buy without the financing, thus roughly doubling their returns (minus the cost of financing). This will allow them to pay higher prices for assets and still earn their target returns.

In the current environment, financing is generally not available to investors in these assets. Given that financing can increase returns significantly, it is especially valued by investors at present. And that is what provides the solution to the pricing problem, and can ensure that the banks get the highest prices possible for these assets today, without the risk of any future Mark-To-Market (or actual) losses.

To attract private investors to buy distressed assets, the Treasury can offer to provide financing to private buyers. Prospects of higher returns, especially in an environment where returns on other assets are low, will attract a lot of investors to the sector. However, financing will be provided to the buyer who has the highest bid on a given set of assets. That is important. The bidding process creates a mechanism for determining a fair market value for these assets. This plan will allow participation by numerous large and not-so-large investors, not just a few large investors selected by the Treasury. If the bid is too low and the bidder can make an exceptionally high return, another investor is likely to step in with a higher bid, if the bidding process is transparent and open to everyone. Different investors have expertise in different products. Those with the best expertise in the assets being offered will be able to value these assets and bid more aggressively. Since there will be multiple buyers competing to buy assets, with their own capital at risk, the plan would help in determination of fair market prices for distressed assets (instead of a situation in which TARP/Aggregator Bank manager is the only buyer). This bidding process also ensures the banks get the highest price possible for their assets in the current environment. If none of the bids are high enough, the bank is not required to sell, and can retain their assets. This ensures that banks are not forced by the program to sell assets at too low a price. If they choose to sell, their balance-sheet is cleared of these assets, and there is no future claw-back or liability related to these assets for them – the assets will be owned by a third party. They can go on to focus on other things.

Any cash flow received from the assets will be used first to pay interest to the Treasury and the private investors. Then, it will be used to pay principal back to the Treasury. Private investors will not get any of their principal back till Treasury has been paid back completely. The interest paid to private investors will be small (perhaps 4 to 5% range on their invested funds, not the face amount of securities) and will be meant to cover their expenses. The majority of their return will come at the back-end, their higher risk reflecting their higher returns. This priority for paying back Treasury funds first will protect public funds by decreasing the probability and amount of any potential losses on these assets.

Also, for home mortgage backed assets, the Treasury can help homeowner mortgage-holders facing difficulty by requiring recipients of financing to agree to certain pre-specified steps to help homeowners in loan workouts.

Providing financing, instead of buying assets for itself, provides more bang for the buck for the Treasury. As an example, if the Treasury offered 50% financing on AAA assets, and it has $100 Bn allocated to the program, the program will clear $200 Bn of assets from bank balance sheets. If the treasury used the funds to buy the assets itself, it will be able to remove only $100 Bn of assets from the banks’ balance sheets. Also, it reduces the risk of loss on these assets for public funds, since Treasury will be paid first and private investors will be bear the loss before the Treasury takes any hit.

Since private investors, who will have their own capital at risk before Treasury’s capital, will be buying and managing the assets, the Treasury will not need to build as big an infrastructure as it will need if it were to buy the assets itself. Nor will it need to pay management fees to third-party managers. Also, by using the private sector, this program can be ramped up much more quickly.

I had originally included this suggestion among a few I had made to the Federal Reserve and Treasury officials in October after the original TARP plan was announced. I was happy to see the announcement of TALF, which will provide financing for new origination. However, financing for existing distressed assets will help clear the bank balance sheets of these assets, which is needed before banks are likely to increase originating new loans. Also, current Treasury plans do not include the Commercial Real Estate sector. It should be included before the issues in the sector escalate and become much bigger, as it will have significant impact on smaller regional banks, that hold a lot of commercial real estate debt.

No single step will solve all the problems. Neither will this one, and it should be one of many approaches. But this approach can be effective since it will start the process for establishing prices for distressed assets, involving private capital in solving the problem, and cleaning up bank balance sheets, which are all prerequisites for eventual return to normalcy in the credit markets.

Comments

[citetez:]

I have a proposal for resolution of the current housing/foreclosure/su... mess: Fannie Mae and Freddie Mac guaranteed long amortization loans to permit refinancing of unconventional loans into viable fixed rate loans given without reference to current loan to value ratios. This would lead to a rehablilitation of “toxic” mortgage paper and reflation of bank capital ratios. Best of all, it can be accomplished with minimal cost and risk to the taxpayer.
The current problem initially arose from borrowers in unconventional mortgages who were being squeezed by an increase in their rates and without an ability to refinance either because they cannot find a loan they can afford or because their homes are depreciated in value. They went into foreclosure creating a downward pressure on home prices. As home prices were pushed down, others found that their equity no longer supported the loan they wanted. This was accentuated by layers of securitization. The mortgages were branded as “toxic” and the cancer spread into the perception of conventional mortgages causing a freeze in the mortgage securities market and in lending. Banks simply cannot lend because their mortgages are considered “toxic assets” that have to be devalued by mark-to-market rules that do not function in a dysfunctional market causing a hit to the bank’s capital requirements.
The answer is to break the cycle and recreate a vibrant mortgage market by creating reasonable loans to qualified individuals that the market can in fact “bank”on.
Most people do not want to walk away from their homes and want to avoid foreclosure at all costs. Answers involving forcing banks to take a capital loss on the loans and refinance with a lower equity value seem motivated by a desire to punish the bankers and can result in a windfall to homeowners. It seems tough to justify forcing the lenders to absorb the losses caused primarily by a market collapse, particularly when market collapses are often followed by a return of value. This is particularly true of the real estate market which tends to run in 10 to 15 year pricing cycles. It is almost inevitable that in 10 years most if not all homes will reach or exceed the values attributed at the peak of the last real estate rice boom. Accordingly, the most efficient answer is not the forced recognition of losses now, but a system which allows people to stay in their homes with mortgages they can pay and allow tie to address the value issue.
To accomplish this, the treasury should create a mortgage reparation plan utilizing the GSEs they now control. The Treasury should dedicate about 300 Billion of the remaining bail out funds to capitalize Fannie and Freddie Mac. These funds will be the entities capital base to address liquidity/confidence issues. The GSEs would then offer special mortgages to persons who: 1) currently have a mortgage other than a 15 year or 30 year fixed mortgage; 2) are not more than 2 payments behind on their current mortgage; 3) are living in the home in question as their primary residence; and 4) can establish an ability to afford the payments on the new mortgage. The terms of the special mortgages would designed to assist affordability: They would be 45 year mortgages offered with a rate fixed for 15 years at a fixed rate based on current market rates, and after 15 years the rate would reset at the then current rate. Qualification would be based on ability to pay under those terms. The loan amount could not exceed current mortgage debt (i.e., no “cash-out” loans) and the loan would be available without reference to the home’s current value.
The 45 year term would lower monthly payments substantially to make the mortgage affordable. The fixed rate would alleviate the problems of adjustable rate resets. The loan is fair to the homeowner because they are able to stay in their home with an affordable monthly payment. They are not forced to take the loss in home value occasioned by market conditions, nor is the bank. Banks would get capital infusions as mortgages are paid off. The number of foreclosures should then move toward more normal levels. With time, the market would reflate, and the homeowner could refinance or sell at their leisure. Under this scenario, most of the special mortgages would not reach the 15 year rate reset, and for those that did, the homeowner would probably have more and better options than are available today.
The GSEs, solvent and with a restored market confidence would be able to float bonds supported by the new mortages, and backed by the 300 Billion capital infusion which would be dedicated as a capital reserve for the mortage program. Once in place, the program should allow the bleeding to stop and permit time to heal the wounds our housing market and financial system has suffered.

Feb 09 07:14 AM

[Tom Armistead:]

This is a bad proposal.

For over a year, those who expect to profit from the destruction of the US economy have spread news of doom and gloom, shorted finaincial stocks into oblivion, spread rumors and manipulated CDS spreads. Meanwhile they have withheld their capital from constructive uses, in the expectation of gorging on the proceeds of fire sales.

I am at a loss to understand why the US Government should spend taxpayer money to line the pockets of these vultures by agreeing to fund their feast.

Better to deprive them of their prey by creating a fair price for these assets, many of which are worth far more than what the market will pay. I am a small time investor and I can't see why the hedge funds should be funded to buy AAA debt at distressed prices. It's not supposed to work that way.

Feb 09 07:21 AM

[glassbox:]

Hi Tom! I completely agree with you that those who have made money shorting stocks and deploying destructive practices have withheld capital. In fact, I'm of the opinion that all shareholders (and regulators will have to be the initial sponsor of this movement) should impose a much higher cost of borrowing scrips for shortsellers.

In my opinion, short selling in the current environment is highly lucrative - only because it cost so little to borrow and there is no need for one with a short position to disclose his position (with the excuse that it would make it unprofitable for hedge fund managers and the likes to do their research - what an excuse!). In times like these, capital should be deployed constructively, not destructively.

The US government should not allow the same hedge fund managers who made tonnes of money so called 'cleverly' shorting stocks and buying CDS that created this huge imbalance and putting jobs and stability at risk to be allowed to buy anything at the distressed prices they want.

I firmly believe money should only be made, and cleanly made by creating value, real value that comes in hard work, belief and faith and resilence...not by exploiting a market abberation or inefficiency that these 'intelligent' people know that by doing so, will result in a depression like scenario.



On Feb 09 07:21 AM Tom Armistead wrote:

> This is a bad proposal.
>
> For over a year, those who expect to profit from the destruction
> of the US economy have spread news of doom and gloom, shorted finaincial
> stocks into oblivion, spread rumors and manipulated CDS spreads.
> Meanwhile they have withheld their capital from constructive uses,
> in the expectation of gorging on the proceeds of fire sales.
>
> I am at a loss to understand why the US Government should spend taxpayer
> money to line the pockets of these vultures by agreeing to fund their
> feast.
>
> Better to deprive them of their prey by creating a fair price for
> these assets, many of which are worth far more than what the market
> will pay. I am a small time investor and I can't see why the hedge
> funds should be funded to buy AAA debt at distressed prices. It's
> not supposed to work that way.
>
>
>

Feb 09 09:29 AM

[Leftfield:]

I'm trying to figure out how the investors the Treasury would finance are qualified? And, offering low fixed rates to homeowners in trouble now presupposes qualifying them too.

The problem involved unqualified, unvetted buyers in the first place. Nice, the taxpayers have to do the job the finance capitalists avoided in the first place. Keep those bonuses coming!

Sounds too simple. I can agree it would be good to save homeowners who can manage with some relief. But, this is crony capitalism, welcome to the future. More crony capitalism to fix the failures of previous crony capitalism.

I don't hold my breath for good execution. We keep voting the same jerks in, how can the result improve? By definition, we'll get most of the relief to the most connected. The ones who can grease the politicians. The perpetrators.

Feb 09 02:53 PM