Simplifying the Toxic Assets Plan 5 comments
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by Dirk van Dijk
OK, we finally have the details of the Treasury's toxic asset plan, and the market seems to like it. Let me try to simplify what is going on with it.
Right now, the crux of the problem with the legacy (toxic) assets is that they are complicated parts of home mortgages -- many of which have gone bad, and many more of which are likely to go bad in the near future. Suppose a bank has $100 million (face value) of these assets on its books. It has already marked these assets down to $80 million, and taken headline-grabbing losses as it has done so. It would like to get these assets off its books, but it claims that there is no market for them.
We think that is not quite a true statement, since there are people out there who might be willing to buy those assets for $10 million. That, however, would require the bank to write-off an additional $70 million. If it did so, it would be bankrupt, and the FDIC would have a big pizza party on Friday night, the way they regularly do with smaller banks (as in 3 of them last Friday). However, this bank is in the class that has been deemed "too big to fail."
What the new plan does is has the government pick out a bunch of money managers with some experience managing these sorts of assets. Money managers will be competing with other money managers.
Say a money manager is willing to buy these toxic assets for $70 million. It would put up $5 million in equity and the government will also put up $5 million in equity capital. Thus, we have $10 million in total equity capital supporting $100 million in face value assets, and $70 million of market value.
The government will then lend this partnership (itself being a 50% partner) $60 million on a non-recourse basis. The interest rate on this loan was not given, but we can assume it will be quite low (and for simplicity sake will ignore the interest cost in the calculations). The bank will have to take another $10 million write-down -- which will hurt, but it sure beats marking it down by $70 million.
Ok what happens now? Let's consider two different scenarios.
In the first case, the "suspend mark to market" crowd is right, and over time it turns out that these assets are really worth $90 million. Then when everything is unwound and the assets either mature or are sold off, the partnership ends up making a $20 million profit, and the $60 million loan is paid back. The profits are split between the investor and the government, each of which will have turned a $10 million profit on a $5 million investment. Hey, I wouldn't mind seeing my $5 million turn into $15 million.
The private investor gets a 200% return. The government also makes a 200% return on its $5 million equity stake, but in reality, it put up not $5 million, but $65 million -- the loan plus the equity stake. So the government's real return is a bit over 15%. Still, not all that bad.
If the partnership were able to buy the assets for $60 million rather than $70 million, the profits for both sides will be greater, but much more magnified for the private investor. In that case, the investor would have only put up $4.16 million (ditto of government equity), and if the assets eventually were with $90 it would be a $15 million profit to each side, or a 260% return to the private investor. Clearly, there is an incentive to try to get the lowest price they can for the assets.
OK, what about the other scenario? Let's say the assets over time only prove to be worth $50 million and the partnership paid $70. In that case, the private investor loses his $5 million investment, but that is all he loses. He is free to walk away from the deal and the government owns all the assets, and is out $15 million. Remember this is a pretty optimistic bid given that right now, without the loans and guarantees, the private market is only willing to pay $10 million for these assets. If the assets are only worth $30 million, the investor still loses just the $5 million, but the government eats a $35 million loss.
In many ways, this structure should sound a little familiar to you -- at least the non-recourse leverage part of it. You probably engage in it yourself. You do it when you take out a purchase mortgage (effectively, but not legally so when you refinance). You put down, say, 10% of the purchase price and borrow the other 90%. If the house goes up in value, your profit is determined not by the total purchase price vs. the total sale price, but is 10x that. For example, you buy a $200,000 house and put $20,000 down. A year later, the house rises to $250,000 and you sell. You pay back the $180,000 loan and have $70,000 left, or a 250% return on your $20,000 investment.
If the house goes down to $150,000 instead, you mail in the keys and walk away. Yes, you are out the $20,000, but the bank has to eat the other $30,000 loss. It probably even has, since that's what is causing all these mortgages to go bad in the first place (well, at least a big part of it -- there are a few other causes as well).
Given the size of this program, starting at a total potential market price for $500 billion of assets ($714 billion of face value in the 70% example) the holders of these toxic assets, most notably the big banks like Bank of America (BAC) and Wells Fargo (WFC) will not be able to claim that this is just a liquidity problem -- that the only reason that people are only willing to bid $10 million for the $100 million face value of assets is that they don't have the cash to bid more. That's plenty of cash to do so.
If with all this cash in the hands of several of these public private partnerships they start to bid up the price of these assets to $80 million, well then, problem solved. The bank that currently owns them will not have to take any more write-downs. If they bid them up to $85 million, the bank would actually write up the asset and report a profit (reversal of a previously booked loss).
There have to be both buyers and sellers for there to be a market. The assumption on the part of the government plan, and of the banks and most of the press is the reason that there is not much activity in this market is that there have been no buyers. But is that assumption true? There are buyers out there, but they are only bidding $10 million right now.
Citigroup (C) could sell vast amounts of its toxic sludge at $0.10 on the dollar tomorrow if it so chose to. The result of course, though, would be that Citigroup would be even more broke than it is now; it would have to take that additional $70 million hit, and you can see what the $20 million hit it has already taken has done to it.
This is sort of like someone who is sitting in an underwater home, and needs to sell. He could sell the house he has the $200,000 mortgage on for $20,000, but then would have to bring $180,000 to the closing. But since it is a non-recourse loan, he would be silly to do so when he can just walk away.
Citigroup is not in that position. It also has a highly leveraged balance sheet, but the money it borrows first and foremost deposits but also bonds. Those have to be paid back, regardless of what the assets are worth. Thus, it really can't sell the assets for the price being offered in the market, even if that is the true value of them.
In other words, the problem that Citigroup (this problem includes Citigroup but is not limited to it) has is a solvency issue, not a liquidity issue. If that is the case, then this plan will simply be throwing taxpayer money down the rat hole.
The advantage of this plan is that compared to previous plans to buy up the toxic assets, this one has a better chance to actually arrive at what the "true value" of these assets are. The problem is that the private side of the public-private partnership will not have much skin in the game. They stand to make huge profits and take relatively low risks. The government will be shouldering most of the risk, but will have much less upside.
Ultimately, the biggest unknown is how high the bidding war will go for these assets. If it goes only up to $50 million, then the banks will still decide to not sell, and the program will go unused. No damage done, really, but the problem is not solved and we still have a zombie bank that is unable to lend because its balance sheet is stuffed with trash.
If it goes too high, say to $85 million, the effect will be to help out the banks, which will then be able to report a $5 million profit, but the government will end up losing lots of money. With multiple players in the game, though, each with the incentive to buy as much of the assets at as low a price possible, we may get closer to a real answer as to how much these assets are "really worth."
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So I now have a private investor ( hedgies) owning 07% of my home looking to make a big profit. 250%
I have the immediate taxpayer (crooked congressmen) owning .07% of my home looking to make a big profit for us. 250%
I have the Federal Government backing the balance of $86,000.00. At cheap interest. Looking to improve the economy, and help the banks show a profit.
Making the guys who got us in trouble. The Congress. The SEC. The FDIC. ,and the mortgage bankers, who allowed this mess to happen look like good guys. With the bankers being the worst positioned to succeed.
So my question is; Why doesnt the Fed, let we the taxpayers be the private investor and knock .07% off our mortgages. ( nation wide) reducing my loan to $93,000.00 .
Then let we the taxpayers knock another .07% off our mortgage by becoming a private lien holder / investor. Buying down on our own mortgage paying .07% down payment on our toxic mortgage, further reducing our mortgage to $86,000.00. With the hopes of seeing our .07% down payment / investment, return 250%.
Through this private investment of .07% down payment, we could then buy down our mortgage by another potential of 250%. Reducing our debt incredibly to the banks.
On the $86,000.00 which could be auction rated and sold at $70,000 that the fed is going to back. Give us their same cheap interest rate they are giving the banks. (nationwide)
Based on the auction discounted balance. Further reducing our amount owed and payoff time.
As is we as mortgage holders are going to have to go to the bank. (shamefully) with a .25% down payment in hand. leaving the Fed and the private investors .14% invested-- .25% return. Close to 100%. Riding freely on my .25% hard earned cash.
I will then be paying the bank on $100,000. non toxic mortgage for thirty years ( that has been written down at auction to whatever) at what ever interest rate the bank deems my credit score can be shamed to pay. (You can bet the banks are going to be brutal as they are the whipping boy in this scheme of greed.)
This scheme is not about keeping us in our homes or benifiting from these trillions of dollars. We as taxpayers will also be paying back.
It is about being tenants to a new slum Lord ( hedgies, corrupt congressmen) that are local, rather than the Japanese, or chinese, or Saudi's. God knows hedgies, through the Market have stolen enough of thier money.
So we will pay on to big brother. Full rate. With no relief from debt in our mark to market toxic mortgage.
As well as pay on to big brother through a tax burden we can never as a Nation repay.
When we as taxpayers could have been treated as citizens worthy of a great Nation in trouble. ( by the greedy hands of corrupt congress, bankers, and hedge funders. As well as our own laziness as citizens)
Helping our fellow American's equally and collectively through fair tax programs that benifit all. As our forefathers would have been proud to see us do.
We owe our forefathers, and fathers a huge debt of gratitude for their dream and vision.
We are allowing a corrupt Congress, and hedgefunds to ruin our gift of a free nation. Freedom is just a word without action. As a Nation we have let down the dream and success of freedom. We need to get it back.
The Eagle was rightfully chosen as our Nations symbol. A lazy scavenger .
But, the point is that even if only 20% of the bankers (and forget the gargantuans) wanted to get rid of a portfolio, they have to become sellers in one of the worst-bid markets you could think of. Please name a readily available alternative if management decides to "just get the damn stuff GONE FOR GOOD." Wise, foolish, cheap or fair - here's a new "out in the daylight" alternative that just wasn't there before, so that the average bankers, aiming to get back to basic banking, can execute a plan. This is why the plan is so important, warts and all. Use it, ignore it, scream the risks from the highest blog - but don't fail to recognize that this provides a viable alternative for a long list of banks whose names are not in the newspaper every day, don't have jets in a hangar but do know their local FDIC rep all too well...
--rq