Cut the Congressman some slack, please. U. S. Representative Spencer Bachus of Alabama, the ranking Republican on the House Financial Services Committee, is extra cranky these days from massive indigestion--dysPPIPsia, if you will. He has been reviewing the Treasury Secretary's latest plan to relieve America's biggest banks of toxic assets, and he smells a rat. The last straw came last night when a Financial Times reporter intimated that banks were seriously considering buying such assets, not selling them. Or maybe buying and selling them. Bachus is outraged, and you are...confused?
O.K., let's walk through this slowly. First, some background. Recall that last July Merrill Lynch tried to find a buyer for $30 billion worth of toxic assets that the company was carrying on its books. Lo and behold, they found one: Lone Star Funds, a private-equity firm based in Dallas. Lone Star agreed to pay 22 cents on the dollar for this crap, but only if Merrill would finance 75% of the purchase with no added collateral. In effect, Lone Star was risking only 5.5 cents on the dollar. Merrill, however, got to book 22, a price inflated by the leverage involved.
Tim Geithner's PPIP (acronym for "Piss-poor Plan for Inflated Pricing"--no, just kidding) attempts to jump-start the moribund toxic-assets market with the exact same mechanism: use leverage to mark up the asset prices. Let's go back to the Merrill example. Merrill had more toxic assets than the $30 billion it sold to Lone Star, a lot more. Now Bank of America has them after agreeing to take out Merrill in September. Upon closer inspection, Bank of America found Merrill's portfolio to be so toxic that it tried to back out of the deal in December. But Treasury had the shotgun, and Bank of America had to acquiesce (though Treasury sweetened the deal with another $20 billion in TARP dough).
So how is Bank of America going to find buyers for the old Merrill junk? Simple. Use PPIP. Bank of America agrees to finance up to 86% of the purchase, the same way Merrill did with Lone Star. One major difference: the FDIC guarantees the loan, which means Bank of America will never have to write it off. Second major difference: the U.S. Treasury partners with the private-sector buyer 50:50. Third major difference: the Federal Reserve finances a portion (exact percentage to be determined) of the private-sector equity offer. The whole scheme is a Rube-Goldberg contraption designed to lever up an itty-bitty private-partner bet into an artificially high sticker price that Bank of America and its peers can then use to mark up their portfolios and boost their tangible capital ratios.
Also benefitting will be the Pimcos and BlackRocks of the world who hold corporate bonds issued by Bank of America et al. In fact, they are among the privileged few handpicked by Treasury to bid for toxic assets, some of which they already own. The worst thing that can happen to them is that they place their bets on mortgage-backed securities, collect the coupon while they wait for price appreciation, and walk away from their loans if the assets tank further (not unlikely). They still profit on the turn-around, and meanwhile their bond positions have recovered. The banks, their balance sheets fortified, take a giant step back from insolvency. Pimco's Bill Gross calls it a win-win-win. [update, 07-09-09: make that win-lose-draw. Pimco has withdrawn from the PPIP auction amid new "uncertainties" about the program's design.]
The third winner in that equation is supposed to be the taxpayer. But this is a zero-sum game, with no new wealth created. Somewhere, somehow, there has to be a loser. Minyanville's Mr. Practical points to the taxpayer: "banks on average have most of their illiquid assets marked at $.60 on the dollar, while a private investor in order to risk money might be willing to pay $.30 on the dollar. If this is going to work, the government (you) will have to make up the difference, which could be around $3 trillion....so while the program will show initial success (it’s most likely all pre-arranged) on a small amount of assets, it will eventually expose more losses down the road and more need for capital."
Private-equity managers are salivating at the opportunity. Tom Barrack, founder of Colony Capital, wants to raise $4 billion to buy distressed banking assets. In an interview with the Financial Times, Barrack opines that the traditional private-equity model just doesn't work like it used to. “Private capital needs to change its thinking. Today, the opportunity is to become a regulated institution, not to run away from regulation,” he said. Translation: the only suckers left are taxpayers. As Dr. John Hussman of Hussman Funds explains: "You can play hot potato with the toxic assets all day long, and the only outcome will be that the public will suffer the losses that would otherwise have been properly taken by the banks' own bondholders."
But taxpayers, as well as their duly elected representatives, are starting to wise up. The claw-backs of bonuses awarded to AIG managers are a warning that obscene profits under PPIP will not go unnoticed and may be subject to punitive retroactive taxation. Rep. Bachus promises to do what he can to stop Wall Street from "gaming the system to reap taxpayer-subsidized windfalls.” Make sure your rep does as well.
[update, 04-07-09:]
The Wall Street Journal is reporting this morning that the Treasury Department, following criticism that PPIP 1.0 practically guarantees premium prices for toxic assets, will open up the bidding process to smaller investors. More competition means better pricing--and better protection for taxpayers. Also depressing prices is the sheer supply of toxic debt, which is increasing faster than Treasury can auction it off. The International Monetary Fund now estimates that toxic debt will balloon to over $4 trillion in the months ahead. That's more than the Obama budget!
[update, 05-27-09:]
In a rather belated response to Sen. Bachus's concern that Wall Street banks might use PPIP to offload exposure onto the taxpayer while keeping the assets, FDIC Chair Sheila Bair (according to Bloomberg) said at a news briefing today that banks will not be allowed to bid on their own assets. JPMorgan Chase & Co. and Bank of America Corp. are among the banks yearning to do just that. Left unanswered was the question as to whether banks can buy assets from other banks. I wouldn't put it past the robber barons to devise paired transactions solely to mark up their inventory--I'll overpay for yours, you overpay for mine, quid pro quo. A suddenly suspicious Congress has added to the legislation authorizing PPIP an amendment imposing conflict-of-interest rules and demanding that purchases of toxic securities be arms-length transactions.
[update, 06-03-09:]
The FDIC has placed its Legacy Loan Program on hold. In a statement today, Chair Bair said: "Banks have been able to raise capital without having to sell bad assets through the LLP, which reflects renewed investor confidence in our banking system. As a consequence, banks and their supervisors will take additional time to assess the magnitude and timing of troubled assets sales as part of our larger efforts to strengthen the banking sector."
Mama Bair.
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