Last Fall, Citigroup (NYSE:C) received over $50 billion from the government and had over $300 billion of its toxic assets insured (‘ring-fenced’), but all that still wasn’t good enough to prevent the former financial supermarket from choking on further losses in the fourth quarter. The firm as we knew it is no more; it has sold its most valuable asset (Smith Barney) and is splitting in two. Meanwhile, the saga of Bank of America (NYSE:BAC) is devolving into a Mexican Novella called “When Kenny Claims He Got Screwed by Johnny” after it became apparent that its ingestion of Merrill Lynch has led to a bad case of internal bleeding despite the due diligence performed back in September when the deal was struck. The government has now thrown another $20 billion at the problem and has ring-fenced nearly $120 billion of its bad assets.
So it turns out that “capital injections plus ring fencing” doesn’t work and that “good bank eats bad bank” doesn’t work and so now it’s back to the future with the idea of creating a government owned Aggregator Bank (‘bad bank’) to purchase and warehouse all the poison, which originally was to be the focus of the Trouble Asset Relief Program. The difficulty here is that we’re still left with the same problems which scuttled the idea in the first place; first, how does the government go about pricing a bunch of paper in which there is no process of price discovery occurring and second, what should the Aggregator Bank do with these assets once it owns them?
As for exactly how these assets will be priced, the question is probably moot, because the aggregator bank will happen one way or the other. As far as the question of what to do with these assets once they are acquired is concerned, what’s likely to happen is that the ‘whole mortgage’ (‘whole’ meaning non-securitized) portions of these securities will go through a modification process similar to what the Fed is currently doing with mortgages owned by Maiden Lane LLC, the entity being run by the New York Fed which is handling the Bear Stearns assets obtained during the former investment banks’ March 2008 takeover.
According to a letter obtained by Bloomberg from Fed Governor Elizabeth Duke to Senate Banking Committee Chairman Christopher Dodd, as of Nov. 30 2008 about 11% of the “whole loans” in Maiden Lane that were “both nonperforming and more than 60 days past due had been permanently modified through a reduction in interest rate, an extension of term, a deferral or reduction in the principal balance, or a combination of such actions.” The letter goes on to say that “the number of permanent loan modifications is expected to increase in the coming months” because the verification period for modified loans takes three months and more delinquent borrowers will be contacted and finish the negotiation process.
Wells Fargo (NYSE:WFC) and EMC Mortgage, a former Bear Stearns unit now part of JPMorgan, are doing the servicing.
Section 110 of the financial bailout bill calls for the Fed and other agencies to “implement a plan that seeks to maximize assistance for homeowners and use its authority” to encourage companies servicing mortgages owned by the government to use certain programs to reduce foreclosures. That means not only will the Fed (and other agencies) have the authority to order banks to make modifications, it will be compelled by law to do so.
It’s now obvious to see why Mr. Bernanke was so adamant in his London School of Economics speech one week ago Monday about having the government purchase troubled mortgages and perhaps why the Congress released the second half of the TARP funds so easily. Once the government takes over the assets, it can force the banks to make the modifications.
Accordingly, “the Board is in the final stages of developing a foreclosure mitigation policy for use by the Federal Reserve Banks,” Duke said. “In addition to applying this policy in situations required by section 110, the Board will consider whether there are situations in which it is appropriate and feasible for the Board to apply the policy voluntarily.”
So it would seem that the idea to purchase troubled assets from the banks will turn into an ‘aggregate and modify’ plan.