Here’s an interesting article from the NY Post, quoting a shareholder letter from Bridgewater’s Ray Dalio. It suggests one half of the Geithner plan is likely to attract far less private interest than the other:
Bridgewater Associates, the $71 billion money-management firm, has come out against participating in Treasury Secretary Tim Geithner’s plan to get private investors to buy banks’ toxic assets — a week after saying it was interested in it.
What’s Dalio’s problem with the Geithner plan? It doesn’t provide enough leverage:
"When the program was first announced, we were originally interested” because the leverage the government was promising made the assets cheaper. “However, as things now stand, very little leverage is actually being offered via the ‘Legacy Securities Program,’ ” Dalio wrote, pointing out that the leverage offered is just 1-to-1.
It’s important to remember that there are two sides to Geithner’s public-private partnerships. First there’s the legacy loan program, meant to finance the purchase of toxic loans. This is the program that would be financed with FDIC-backed debt, allowing private investors to put up $1 for every $13 of government cash.
There’s a second head to the monster, the “legacy securities program,” which is designed to finance the purchase of toxic residential and commercial mortgage-backed securities. It’s this second program that, according to Dalio, isn’t offering enough leverage.
When OA first got a look at the Geithner plan, we were struck that the legacy securities partnerships didn’t seem to offer nearly as much leverage as the legacy loans partnerships, but the details were hazy. If the NY Post story is correct, this is confirmed by Dalio, who is obviously much closer to the situation. Indeed, he notes that the legacy loans program offers plenty of leverage:
To be sure, Dalio doesn’t slam everything about PIPP. Indeed, he doesn’t slam the legacy-loan program, in which investors buy loans instead of securities and offers leverage of between 6-to-1 and 12-to-1. But, “we aren’t interested in illiquid loans,” he said in his note.
The difference in leverage has large ramifications for these programs, and for taxpayers. The more cash that private investors have to put up in order to participate in a partnership, the less likely they’ll do so. It increases their capital at risk and reduces their potential return on equity. They’re more interested in a free-ride courtesy of taxpayers, which the legacy securities partnerships may not provide…
An example, comparing the impact of differing amounts of leverage available under the legacy loans program and the legacy securities program:
- A bank has a toxic loan available for sale for $100. In one year, the loan has a 50% chance of being worth $200 and a 50% chance of being worth $0. If the investor has to put up all $100 to buy the loan today, then the expected return on his investment is 0%. (50% chance of being worth $200) + (50% chance of being worth $0) = $100 expected value in one year.
Add leverage to the equation and the investor’s incentives are changed dramatically. First, let’s compute expected return using leverage offered under the legacy loans program…
- The private investor can borrow $85 from FDIC to fund the purchase of the loan. Also Treasury will put up $7.50 to invest along with him. So the investor only puts up $7.50…
- Under the “Good” Scenario, the loan is worth $200 one year hence. The investor makes $50 on his $7.50 investment. (Treasury, having invested $7.50 along with him, makes the other $50). The $85 FDIC loan is paid off and the investor walks away having nearly septupled his cash.
- The government’s return is a far more modest 54%. Counting the capital put at risk via the FDIC loan, the government has $92.50 at stake and earns a $50 profit.
- Under the “Bad” Scenario, the loan is worth $0 in a year’s time. The investor loses $7.50 and the government loses $92.50.
Bottom line: the investor risks only $7.50 and has an expected return of 233%. (50% chance of making $50) + (50% chance of making $0) = $25 expected return. $25 / $7.50 = 233% return.
If we change the leverage ratio from 12:1 to 1:1, the investor still benefits from government leverage, but not nearly so much…
- Investor puts $50 down and borrows $50 from the government in order to purchase the $100 asset.
- Under the Good Scenario, the asset is worth $200 and the investor’s profit is $150. The investor still earns a good return—he triples his money—but he’s far short compared to the example above.
- Under the Bad Scenario, the asset is worth $0 and the investor loses $50.
Bottom line: the investor risks $50 and has an expected return of only 50%. (50% chance of making $150) + (50% chance of making $0) = $75 expected return. $75 / $50 = 50% return.
Is it any wonder Dalio would like the government to extend the same kind of leverage to the legacy securities program that’s being offered for the legacy loans program?
Now, if you read the example provided by Treasury regarding the legacy securities program, it suggests that more government leverage is being made available than Dalio suggests, but the profit available seems negligible…
The fund manager commences the sales process for the investment fund and is able to raise $100 of private capital for the fund. Treasury provides $100 equity co-investment on a side-by-side basis with private capital and will provide a $100 loan to the Public-Private Investment Fund. Treasury will also consider requests from the fund manager for an additional loan of up to $100 to the fund.
As a result, the fund manager has $300 (or, in some cases, up to $400) in total capital and commences a purchase program for targeted securities.
I never really understood the appeal of this structure for private investors, which may be why Dalio is hesitant. I’d be curious to hear readers opinions, but it seems to me that this structure would imply a 0% expected return for the private investor, using our scenarios above.
Assume $50 of borrowed government capital + $25 of government equity + $25 of private equity. If the asset increases to $200, the private investor’s return is $50 (he splits the upside with Treasury). But the asset could also fall to $0. Assuming an equal probability for both scenarios, the investor comes out flat, right? (50% chance of making $50) + (50% chance of making $0) = $25 expected return. $25 / $25 = 0%.
Why would private investors get involved?
If indeed there isn’t enough leverage to get them interested, it’s possible (at least half of) the Geithner plan will die in its crib. That’s good news for taxpayers and for the economy in the long run. The only way to provide a healthy foundation for economic growth is to properly recapitalize the banking sector, which means taking necessary writedowns on impaired assets and forcing losses onto bank creditors, not the public.