It is looking like the Public Private Investment Partnership (PPIP) asset managers will not include a big bank or investment bank, but no one can be sure until the announcement, which was delayed from last week. I’m not convinced that the PPIP will be a boon to asset managers, but as long as the toxic asset program is voluntary it does help the banks. How much asset managers like Angelo Gordon & Co. benefit depends on the competitiveness of the bidding process. It is reportedly starting out at a paltry $20 billion by TARP standards. That is down from as much as $1,000 billion when anounced and $50 billion last week. Unfortunately, sometimes things that start small have a way of getting a lot bigger.
The PPIP seems to have two sometimes conflicting goals:
- Restart the securitization market for home loans by creating buyers for residential mortgage backed securities without government guarantees.
- Remove volatile toxic mortgages from the balance sheets of the banks.
I think Geithner & Co. are focused primarily on goal one. It is hard to be sure, since they already have the money, they don’t need to explain themselves so much. With respect to goal one it is not entirely clear why investors will be eager for securitized debt when the cheap government leverage stops. If the market for toxic assets is merely illiquid, the cheap financing of the PPIP is not necessary. Even expensive financing in an illiquid market should lead to a pick up in securitization activity.
The second goal of cleaning up banks' balance sheets requires that banks that sell their toxic home loans cannot turn around and buy more toxic home loans. That may require more oversight than regulators can muster. If banks’ balance sheets are less volatile, then my solo and joint research shows they will make better loans going forward, Preventing banks from buying other banks’ toxic waste will oddly hurt goal one. When banks are no longer buyers of toxic debt, the secondary market demand for those securities should fall somewhat.
There is a third goal, which has been posited by some commentators, but no policy makers that I am aware of.
- Recapitalize banks by overpaying for trash assets.
My paper “A Binomial Model of Geithner’s Toxic Asset Plan” shows that healthy banks are the banks that will most benefit from “goal” three. They don’t care about losing volatility. Their stock price will get a bump from the fact that the legacy securities are sold for more than their marked at or worth. Incorrigible zombie banks with deeply negative equity will not participate at all even if it means marking up assets. As the “Put Problem for Buying Toxic Assets” and the previous paper explain, near zombies will weigh the overpayment for assets against the lost volatility. The real winners in the later case will be the near zombies’ bondholders. Bondholders like the rising equity value and falling equity volatility. The former paper shows that toxic asset trades can occur, but only by exposing taxpayers to losses that will not show up until several years down the road when the PPIP loans mature.