PPIP Alternative: Pay for Valuation, Hold Until Recovery

With the announcement of the Public-Private Investment Program (PPIP) we now have another BIG announcement from the Treasury and another plan that allows banks to deny the reality of poor lending decisions.

There are three key elements that will determine the success or failure of the PPIP.

1.Price: Will the bid match the ask and create a market clearing price.
2.Mark to Market: Creating a market gives the banks incentive to hold the assets.
3.Incentive: Is there an incentive for the private sector to bid up the price?

Price

To declare the program a success the bid/ask spread cannot exist, if the banks are not willing to part with assets at the bid, or market clearing price, then the program will fail. Once again the government has failed to solve the most fundamental problem with these assets: price. The high degree of leverage coupled with FDIC backing could boost the price the private sector is willing to pay, the question remains: Is that enough to entice the banks to sell?

Mark to Market

The second issue is that if the banks do not sell the assets they can no longer claim there is not a market for these securities. By Treasury’s reasoning, the cheap financing will produce bids above current market levels thus boosting bank capital. However, as we shall see the only incentive to pay above current market for the assets is simply a desire to hold that asset.Therefore if the bank is going to receive that mark on assets regardless of whether they sell or not, the incentive is to hold the asset and potentially realize a gain.

Incentive

The original math for this analysis was done by FT Alphaville.

From the Treasury’s press release: (Click to enlarge)

Using this example, the structure will look like this:

Price Paid: $84
FDIC Financing:$72 or 85.6%
Equity Amount:$12 (84-72)
Private Capital:$6
Public Capital:$6

% of the Asset Paid for by Private Capital: 7.14% $6/$84

If we change the sample a bit and assume that the private investor wants to pay $90 for the assets then here is the math.

Price Paid: $90
FDIC Financing:$77.14.or 85.6%
Equity Amount:$12.86 (90-77.14)
Private Capital:$6.43
Public Capital:$6.43

% of the Asset Paid for by Private Capital: 7.14% $6.43/$90

The same result occurs if the private bidder pays $70 or $100, in every case the private investor only pays for 7.14% of the assets. Therefore there is no incentive to pay a higher price. This raises serious doubts as to whether the program will work at all. A better solution would be to provide more leverage if the bid is above the current market value. In this way, private investors have an incentive to pay up for the asset.

This, of course, leads back to key element #1 - what price will “clear” the market? Price has been the holdup of every program so far, banks will not sell at market prices and investors will not pay up.

What’s more, the whole program begs the question – if this is such a good deal for investors then why not just give the loans to the banks and have them place the assets in a side-pocket account and wait for the returns to roll in?

If Pimco, BlackRock, et al, are so willing to purchase these assets then they surely see a profit opportunity. The profit opportunity exists irrespective of the purchaser of the asset, in other words, if its going to make money for Pimco then it will make money for Citibank (C). Once again this assumes the banks are willing to sell at the bid. If the banks are willing to sell at the bid, then a more efficient solution would be the pay Pimco and BlackRock a fee to value the assets. Once the value is established, simply mark the assets at this price and place them in a side-pocket account. The loans that would have been given to private investors should be given to the banks under the same terms. In this way, both the banks and the taxpayer benefit by realizing the same returns Pimco and BlackRock expect.

Disclosure: none

Comments

[ACG00008:]

I would imagine that having different assumptions about cash flow from assets and the eventual return of principal (discounted or whole) from the assets, as well as targeted return hurdles would effect how much a private investor would pay for an asset. I would imagine that knowing exactly how much capital you would have to put up to purchase the asset (7.14%) would make it easier to calculate the price you need to hit your return hurdles based on your assumptions. I would think that allowing greater leverage and less equity just to compensate for a higher bid would put us in the same place we are now.

Mar 26 12:42 PM