Banks Prepare for the Toxic Asset Buying Spree

Includes: BAC, GS, IVZ, MS, XLF
by: Linus Wilson

Bloomberg reports that many of the big banks have been increasing their holdings of toxic mortgage related assets as the government prepared to go on a trash asset buying spree. The U.S. Treasury plans to use as much as $30 billion of taxpayer money to buy toxic assets to "purge" these assets from banks' balance sheets.

My research shows that the Public Private Investment Partnership (PPIP) uses non-recourse loans to encourage asset managers to rationally overbid for trash assets. The private asset managers do this because they get a big portion of the upside, but little of the downside. The net increase in Bank of America's (NYSE:BAC), Goldman Sachs' (NYSE:GS), and Morgan Stanley's (NYSE:MS) holdings are modest (just over $3.36 billion for banks with trillions of dollars of assets).

Nevertheless, the purchases of toxic securities in advance of the PPIP by the too-big-to-fail banks illustrates why it is so hard to use government sponsored toxic asset purchases to "clean" banks' balance sheets.

A much better approach is to require consistent capital standards that increase at an increasing rate with bank assets. My solo and joint research shows that higher common equity capital ratios are substitutes for toxic asset purchases. (This is also the rationale behind risk-based capital ratios such as the Basel standards.) It is much easier to police a capital ratio than it is to micro-manage thousands of asset purchases and sales.

The regulators are not watching the banks' toxic asset purchases and it seems that no one is looking to see how many toxic assets taxpayers are buying either. The U.S. Treasury has not been disclosing the legacy securities transactions. Wilbur Ross whose investment company is part of Invesco (NYSE:IVZ) said to Bloomberg in October that his firm bought some legacy securities.

Yet the first disclosure of this transaction (on page 18) was that Invesco started paying monthly interest to the Legacy Securities Program in November 2009 of $118,877 in data released just before Christmas. We don't know

(a) how much Invesco purchased,

(b) who did they buy the securities from,

and (c) what were the terms of the non-recourse loans.

These questions need to be answered if the asset managers are spending taxpayers' money.

Disclosure: I only have long positions in broad-based index funds. I do not own individual securities in the companies mentioned.