An Action Plan for Troubled Assets

Mortgage Banking

May 2009

The $1 trillion Geithner public-private partnership investment plan offers a broad framework for using private-sector capital to enable price discovery and government-backed leverage to boost returns. Policy-makers hope the effort will move troubled mortgage assets off the balance sheets of banks.

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By Robert Stowe England

Firefighters sometimes start a controlled fire ahead of a raging forest fire. The idea is to have the staged fire burn toward the dangerous out-of-control fire with the goal of stopping its advance by denying it a way to spread toward a protected target.

In a similar move, a new federal program-the $1 trillion Public-Private Investment Program (PPIP)-is designed to use leverage and the lure of very high investment returns (the proximate causes of the financial meltdown) to help begin to undo the damage done to the financial system, to banking and to the mortgage markets.

When Treasury Secretary Timothy Geithner first offered a glimpse of a new strategy back in February (but provided few specifics) the markets reacted negatively and sank to new cycle lows. However, when the secretary announced the broad framework of PPIP on March 23, the financial markets roared their approval by rising sharply.

"I think the markets validated the asset purchase program," Federal Deposit Insurance Corporation (FDIC) Chairman Sheila Bair told CNBC's Larry Kudlow, host of The Kudlow Report on March 24. Her view was widely shared among the commentariat.

PPIP is jointly sponsored by Treasury, the FDIC and Federal Reserve. It will rely on $75 billion to $100 billion in capital from Treasury through the Troubled Asset Relief Program (TARP), as well as capital from private investors, joined with government loans or government-backed leverage to generate $500 billion in purchasing power for both troubled mortgage loan pools and troubled mortgage backed securities (MBS). The program has the potential to be expanded to $1 trillion "over time," according to a Treasury fact sheet.

The goal of the PPIP program is to take troubled and toxic mortgage assets off the balance sheets of banks - a goal ardently sought by Treasury since the mortgage meltdown in 2007. As Treasury documents released March 23 explain, "These assets create uncertainty around the balance sheets of these financial institutions, compromising their ability to raise capital and their willingness to increase lending."

The PPIP is divided into two programs: legacy loans and legacy securities. The legacy loan program is designed to sell off pools of troubled mortgage loans via auctions by the FDIC to selected bidders after an initial price-discovery process.

The legacy securities program is for troubled mortgage-backed securities, including residential mortgage-backed securities (RMBS) issued under private labels, commercial mortgage-backed securities (CMBS) and troubled asset-backed securities (ABS), which are securities backed by pools of consumer loans such as auto, credit-card and student loans, and small-business loans.

The program calls for the sale of only those tranches originally rated AAA, some of which have been priced as low as 22 cents on the dollar in distressed sales in spite of the fact that most are backed by pool of loans where the majority of borrowers are paying their loans on time.

The loan side of the program provides for up to 6-to-i debt-to-equity leverage for Public-Private Investment Funds (PPIFs) set up to buy and manage loan portfolios. The securities side of the program provides for up to 2-to-i leverage. The higher leverage increases the return on the investment by the private investors, as well as for the TARP-money government stake.

With financial firms already under the microscope in response to the generous bonuses paid by American International Group Inc. (AIG), there was considerable speculation that the Geithner plan would likely reap outsized returns for a small number of well-placed investors.

"It's highly ironic that this nation set something up that gives Wall Street firms the chance to make a great deal of money with very little risk," says Alex J. Pollock, a senior fellow at the American Enterprise Institute, Washington, D.C.

Yet, Pollock adds, there is likely a rationale to explain the approach taken by Treasury, FDIC and the Fed. He suggests that the theory behind the Geithner plan is probably similar to one voiced to him by former Fed Chairman Alan Greenspan in the early 1990s when the Resolution Trust Corporation (RTC), set up in 1989 to dispose of the assets of failed thrifts, "was fire-selling assets."

Basically, Pollock says, Greenspan told him it was necessary to let investors buy assets cheap in order to get the market going at the time. (That's a paraphrase of Greenspan's remark and not an exact quote, he adds.)

Greenspan's comment was made in reference to the collapse of the junk-bond market prompted by Congress forcing all thrifts to sell off their high-yield corporate bonds or junk bonds, as they were popularly known. Investors snapped them up in the fire sales that ensued, and many became extraordinarily wealthy from the eventual returns on the bonds. In the meantime, however, the fire sales forced some savings-and-loans into insolvency and made others more insolvent, according to Pollock.

Allan H. Meltzer, professor of political economy at Carnegie Mellon University, Pittsburgh, is one of several prominent economists who have faulted the new Geithner proposal. "This is another bailout, because most of the money is coming from the government and not the private sector," he says. "So, while it's called a public-private partnership, the costs of the partnership are heavily skewed to the taxpayers."

Meltzer would prefer that the banking regulators - especially the Federal Reserve - publicly abandon the idea of too-big-to-fail and force large, seriously troubled banks to raise sufficient capital to bring themselves comfortably out of any potential insolvency, with the government matching the required capital dollar-for-dollar in loans at concessionary interest rates and terms. If a troubled bank fails to raise the capital, Meltzer explains, then federal regulators should take over the bank, break it up and sell off the assets under rules set up under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).

Unlike some other economists, Meltzer thinks the Geithner plan will work because it will induce investors to buy the troubled assets and that banks are likely to want to sell some of their assets, since the leverage built into PPIP is likely to raise the prices of assets.

"The subsidy is so great to the investors; it's generally believed it will push the price of these mortgages up. That will help the sellers to unload them," he says. Even so, investors are also likely to reap handsome returns, an outcome that will eventually bring political fallout, Meltzer warns.

The potential for political fallout could also make banks shy about taking part in the programs. The political risks were highlighted April 5, when Geithner told NBC News that the federal government would be willing to fire some bank chief executive officers, if necessary. "Where we have to do important things to provide assistance, we're going to make sure we do so on terms that protect the taxpayer and have these firms emerge stronger," he said.

Business economist Charles Dumas, director of Lombard Street Research, London, has a different take. "Geithner's half-full glass is half-empty," says Dumas. By that, he means Geithner has taken some important steps toward the solution of the problem, but that he has not really done enough. Notably, what's missing so far is a requirement for full disclosure and detailed analysis of the troubled assets on the banks' balance sheets, he says.

"The guys who need to disgorge their [troubled assets] have no incentive to do so under the terms of the [Treasury] plans themselves," Dumas says. The other problem is that "there's no publicly available information to conduct the exercise." Dumas contends that what is absolutely needed is for mortgages to be traced from the original loans through to the mortgage-backed securities into collateralized debt obligations (CDOs), and from there to credit default swaps (CDS), and then on to synthetic derivatives.

"With reasonable scenarios of mortgage defaults, you can create the size of potential losses in these various derivatives," he says. "Then you can make an assess- ment of risk that gives you reason- able discount rates and then achieve valuation." That is what has been needed since the fall of 2007, when former Treasury Secre- tary Henry Paulson first floated the idea of disposing of toxic assets, "and essentially it wasn't done," Dumas says.

Despite the current shortcomings in the Geithner plan as presently constituted, Dumas sees potential upsides. "One is that the government should, and probably will over time, force the weaker brethren to put their troubled assets up for sale because they will be assessing their capital from a regulatory standpoint and reaching the conclusion that they really don't have enough [capital] unless they can achieve a certain price for those CDOs" on their balance sheets, he says.

Then, after pressuring the banks to sell the CDOs, "If they don't achieve the price [needed to bolster their capital to the targeted level, they then tell them] they need to go and get more capital or, in the worst instance, may be insolvent," Dumas says. In that case, "they get taken out by the FDIC."

Dumas also sees some potential upside on the information and analysis that is needed to make a sale of assets possible due to in-house due diligence being done by the banks themselves. "It's a reasonable bet in the better-run banks and the banks with very large exposures to this kind of paper - the Citibanks, Bank of Americas, JPMorgans [that] a lot of necessary analysis will actually have taken place," Dumas says. "They've had a year and a half, for God's sake, so presumably they started to ... do some of it." This means they will likely soon be ready to sell because they have a better idea of the worth of the toxic assets.

"In a way, I'm quite optimistic," Dumas says, but with reservations. He notes that the price of some of the worst of the mortgage assets - the AAA-rated home-equity securities from the first quarter of 2007 on the ABX Index - moved from 24 cents on the dollar to 25.5 cents on the dollar in response to the announcement of the Geithner plan, a cautious but positive response.

Dumas expects the government to make money on its investment in the troubled assets. "It's a positive-sum game for the whole [financial and banking] system. It gets liquidity and it gets the system working," he says. "So in that sense, the banks will benefit, too - so the markets were right to treat it as a plus," he notes.

How will PPIP work?

So, based on what is publicly known, how will PPIP work? Treasury and FDIC documents released the day the plan was announced provide a broad framework of how it would work. Many of the details are yet to be worked out and officials at the Treasury, FDIC and the Fed were mum when pressed for more details. More information is likely to be forthcoming, as officials react to the comments they requested be sent them by April 10.

Here's a thumbnail sketch of what is known.

While the legacy asset and legacy loan programs operate differently, both rely on a heavy dose of government involvement in capital, loans and loan guarantees, along with a small dose of private capital from investors that stand to reap returns as high as 33 percent and, depending on pricing, possibly more than 40 percent, according to estimates made by unnamed analysts from London-based Barclays Capital in Barron's magazine on Mar. 30. (Barclays Capital is the investment banking division of Barclays PLC, also based in London).

The high returns are possible even though buyers will bid up the price of assets, thanks to the leverage that can be structured into the deals.

And who can get in on this potential gravy train? On the securities side, the Geithner proposal calls for up to five firms to purchase the assets and hold them in PPIFs. Only firms with at least $10 billion in similar assets already under management are eligible to apply as fund managers. Thus, it will likely be an exclusive club of high rollers, such as BlackRock Inc., New York, and the Pacific Investment Management Company LLC (PIMCO), Newport Beach, California (both praised the program when it was announced).

As for pools of loans, there could potentially be far more private investors. Those that want to purchase loan portfolios will be pre-qualified by the FDIC to participate in an eligible asset pool auction.

A fact sheet identifies a number of institutional investors as likely potential investors in the troubled mortgage loans program - pension funds, mutual funds and insurance companies. Indeed, the participation of these institutional investors is "particularly encouraged," according to the fact sheet. Wealthy retail investors likely limited to so-called sophisticated investors, as defined by the Securities and Exchange Commission (SEC) - may also be able to bid for the loans, if they are pre-qualified by the FDIC.

Ordinary taxpayers, who bear a lot of the risk, may possibly be able to participate in the sale of troubled securities and troubled loans by buying shares in a mutual fund or some other investment vehicle from a participating institutional investor or a PPIF.

The loan program

The legacy loan program is one sponsored jointly by Treasury and the FDIC. Treasury expects to use half of the $75 billion to $100 billion in TARP money earmarked for the Geithner plan to invest in troubled loans, with one dollar of TARP equity invested for each dollar of private equity.

Treasury contends that the presence of private investors competing by bid at an FDIC auction "will reduce the likelihood that the government will overpay for these assets." The government will not participate in the bidding process at all, which means that the entire price-discovery process occurs between banks and private-sector investors.

Before a loan portfolio is put up for bid, the FDIC would determine through its evaluation of a loan-pool sale whether or not the FDIC would be willing to support leveraging the pool at a 6-to-i debt-to-equity ratio. Once a private investor successfully bids for a pool of mortgages, the seller (the bank) can still reject the sale if the price is too low. Once the seller accepts the bid, the investor will set up a PPIF to purchase that specific pool of mortgage loans.

The private investor would put up half the equity, while Treasury would provide the remaining half of the equity funding from TARP. FDIC would provide loan guarantees for up to six times the equity investment. The PPIF would issue the guaranteed debt securities. Given that the private investor is only putting up half the equity, it means the private investor is putting up only one-twelfth the successful bid price.

Depending on the willingness of banks to sell assets and buyers to bid for them, I estimate this program could potentially involve between $450 billion and $600 billion in purchase of loan portfolios. That calculation is arrived at as follows: Treasury is estimating $75 billion to $100 billion in TARP funds for the whole program and has estimated that half of that will go for troubled legacy loans ($37. 5 billion to $50 billion). Because TARP is only half the equity, the combined public-private equity portion for each PPIF deal in the loan program will be between $75 billion and $100 billion. Multiply that range by six because of the additional debt financing, and you arrive at the $450 billion to $600 billion range.

For individuals, the return on investment in the loan program can be very attractive, provided banks are willing to sell and the price at auction does not get too high.

"While a few details still need to be worked out, PPIP is a very well-thought-out plan that is very positive for the marketplace," says David Spector, chief investment officer at National Mortgage Acceptance Company LLC, Calabasas, California. PennyMac, as the company is known, is a specialty asset-management firm set up in 2008 to purchase and manage distressed assets in the U.S. mortgage market on behalf of its investors. PennyMac's strategic partners are BlackRock Inc. and Highfields Capital Management LP, Boston.

One needs to view PPIP (both its loan and securities programs) in concert with another major initiative of Washington regulators and administrators - namely the Capital Assistance Program (CAP), which includes a plan to stresstest banks to see if they are adequately capitalized. This is a process that began Feb. 25.

CAP was jointly announced by Treasury, the FDIC and the Federal Reserve on Feb. 10. Under the program, major U.S. banks will be stress-tested under a more adverse economic environment than the current deep recession. If the stress test finds the institution does not have enough capital to survive what officials have called "a more challenging economic environment," regulators would be expected to require the bank to increase its capital buffer.

Banks would be given an opportunity to go to the private markets to raise capital. "Otherwise," a government press release states, "the temporary capital buffer will be made available from the government." Government capital, if required, will be in the form of mandatory convertible preferred shares, which would be converted to common shares "only as needed over time to keep banks in a wellcapitalized position." The capital can be retired under improved financial conditions before the conversion becomes mandatory.

The stress test is something the government can use to further its efforts to get banks to boost their capital and rid themselves of troubled assets. When the stress test finds them falling short of buffer capital, they could come under pressure both to raise additional capital and to sell troubled assets.

"I don't think this is a bid-ask-spread issue anymore," Spector says, referring to the fact that bids for troubled assets have so far been well below what banks are willing to ask if they were going to put the assets up for sale - at times as wide as 25 cents and 80 cents on bid and ask.

"This is not a trade issue. This is a strategic issue, and that is, do you have enough capital?," Spector says. "And if you don't have enough capital, you're going to have to raise capital. And the only way you're going to raise capital [in the private markets) is by ridding yourself of these assets."

Federal regulators might tell banks "your capital deficiency, if it's not too great, will be taken care of through the FDIC and/or TARP, such that ultimately you can go out and raise private capital to replace the government capital," Spector says. "That's kind of how I see the flow occurring here."

Spector expects that the initial PPIF deal to buy troubled legacy loans will occur as soon as early summer. His confidence is based in part on what he sees in the considerable expertise at the FDIC for setting up and executing successful auctions of bank assets. PennyMac has been a successful bidder for bank assets at an FDIC auction.

Spector notes that banks may be eager to address pending losses in their loan portfolios, where, unlike in the accounting for securities, performing loans are not marked to market. Thus, expected losses have not yet been recognized on bank income statements. Markdowns on loans can only be booked when they become delinquent, he says, and banks may want to mitigate those expected markdowns by selling off some loan portfolios.

The securities program

The details on how Treasury will handle the sales of securities are sketchier than the descriptions provided for troubled loans in documents released so far. Even so, Treasury, FDIC and the Fed laid out some of the elements of a broad framework on how banks can ultimately relieve themselves of some of their troubled legacy mortgage securities.

One of the important goals of the legacy securities program within PPIP is to restart trading in the market for mortgage-backed securities. If that trading were to resume, it would also help move along efforts by a number of parties to restart the mortgage securitization market for new issues.

The securities program is, to some extent, an outgrowth of the $1 trillion Term Asset-Backed Securities Loan Facility (TALF) set up by the Federal Reserve to renew the asset-backed securitization market for credit cards, auto loans, student loans and small-business loans. The New York Fed kicked off the TALF program in March with loans to investors buying $4.7 billion in AAA-rated asset-backed securities backed by auto loans, including a $2.95 billion package of securities from Dearborn, Michigan-based Ford Motor Co. s finance division and a $1.3 billion securities package from Franklin, Tennessee-based Nissan North America Inc.

The Geithner plan extends TALF to private-label RMBS, CMBS and ABS originally rated AAA. The securities program, like the loan program, will rely on TARP funds so that Treasury will be investing alongside private investors to purchase securities. As with the loan program, Treasury will invest 50 percent of total equity in the fund or PPIF that purchases the securities.

Treasury will also provide a loan for up to 100 percent of its equity stake, and will consider requests from the fund managers for an additional loan for another 100 percent of the private sector's equity stake. Thus, as the fact sheets explain, an initial $100 investment by the private sector would be matched by $100 in equity from TARP and another $100 to $200 in loans to the PPIF from Treasury.

Notably, while FDIC will guarantee loans to PPIFs in the loan program, Treasury itself is making loans to PPIFs in the securities program. If Treasury extends loans that are double the size of the equity, this will give the PPIFs in the securities pro- gram a 2-to-i leverage - consider- ably lower than the 6-to-i lever- age in the loan program. Treasury expects that it will approve appli- cations for up to five PPIFs for the securities program, each with $10 billion already under manage- ment, as noted earlier. On April 4, Treasury extended the deadline from April 10 to April 24 and increased the flexibility of the program. Treasury also said that failure to meet one of the criteria would not necessarily disqualify an applicant, and added that it was interested in the participation by small, minority and women-owned businesses. This additional language reflects some flexibility around the $10 billion requirement and political pressure from some interest groups to shape the program.

No details are known publicly at this point about how the securities will be assembled and packaged for sale and how the sale will be conducted.

In summary, while so far the plan is nothing more than another framework, it has moved forward the process of getting troubled assets off bank balance sheets. "It's big plus, because it starts the price-discovery process, however imperfect," says Robert Albertson, principal and chief strategist at New York-based Sandler O'Neill & Partners LC.

"There are a lot of financial institutions that are simply tired of being told their triple-A MBS are worth 30 cents on the dollar. They will be quite willing to entertain bids that are more rational," he adds. Albertson does not expect any sales to occur until mid-summer as details on the Geithner proposal are hammered out.

END

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1 May 2009

Mortgage Banking

Volume 69; Issue 8; ISSN: 07300212

English