By Christopher Condon and Jody Shenn
(Bloomberg) — To understand the meaning of no good deed goes unpunished, Treasury Secretary Timothy F. Geithner can look no further than Wall Street where the banks that received the biggest taxpayer bailouts are seeking to reap trading profits from securities rescued by the government.
Only months after it was started, the U.S. program designed to purge debts of no immediate discernable value from the balance sheets of troubled banks has helped transform the frozen debt into a money-maker as the bonds have rallied. Bank of America Corp. (BAC) and Citigroup Inc. (C), who received 22 percent of the $418.7 billion American taxpayers loaned to troubled financial institutions, boosted holdings on their trading books of home- loan bonds that lack government guarantees while investors were raising cash for the program, according to Federal Reserve data.
Charlotte, North Carolina-based Bank of America along with Citigroup, Morgan Stanley (MS), and Goldman Sachs Group Inc. (GS), all based in New York, added a combined $2.74 billion of the debt, for which there were few buyers as recently as March, to their short-term trading assets during the third quarter, up 13 percent from the second quarter, the most-recent data show.
Prices of these securities may slump again, leaving the banks exposed to potential losses that the Treasury Department's rescue plan was designed to mitigate, said Joshua Rosner, a managing director at New York-based Graham Fisher & Co., which advises regulators and institutional investors.
"It's a trade that will likely work out, but it's still a speculative trade, which is not what a taxpayer should want from firms that have only recently come out of critical care," Rosner said.
'Making a Killing'
The Public-Private Investment Program was introduced in March by Geithner as a means of helping struggling banks by reviving the market for unpackaged loans and mortgage securities that aren't backed by government-supported institutions, such as Fannie Mae or Freddie Mac. Under the program, asset managers were supposed to raise money from investors and, with additional capital and loans from taxpayers, buy as much as $1 trillion in toxic assets from U.S. banks, freeing up money for lending.
It's "absolutely ridiculous" that banks, which were expected to reduce their holding of such volatile mortgage securities, bought them before the government program was running and may now profit, said Michael Schlachter, managing director of Wilshire Associates, the Santa Monica, California- based investment-consulting firm. "Some of them created this mess, and they are making a killing undoing it."
Officials for Bank of America, Citigroup, Goldman Sachs and Morgan Stanley declined to comment on the Fed data, as did Treasury spokeswoman Meg Reilly.
Geithner, 48, scaled back PPIP as the Fed declined to provide additional financing and banks balked at selling non- agency mortgages at a loss. It wasn't until July that the Treasury chose New York-based BlackRock Inc., Invesco Ltd. in Atlanta and seven other firms to start PPIP funds.
To date, funds participating in the program have raised about $6 billion of equity capital from private investors, which the government has matched. The Treasury also provided $12 billion of debt capital, bringing the funds' purchasing power to $24 billion. Neither the Treasury nor the funds have disclosed how much and what debt has been bought.
Prices for some of the securities that the funds were supposed to buy have almost doubled since March. The rally was fueled in part by traders jumping in before PPIP funds could get off the ground, said Steve Kuhn, who helps oversee about $440 million of mortgage-bond investments for Pine River Capital Management LLC in Minnetonka, Minnesota.
"Anytime people know there's a buyer coming, they position for that, and that's clearly what happened here," said Kuhn, who is co-manager of the Nisswa Fixed Income Fund.
The rally was boosted further by investors seeking riskier fixed-income assets to offset record low yields on Treasuries and by the stabilization of the housing market, he said.
Typical prices for the most-senior bonds backed by hybrid Alt-A mortgages stood at about 58 cents on the dollar by mid- December, up from lows of around 35 cents in mid-March, according to Barclays Capital data.
Prices rose as high as 60 cents on the dollar in November. Fixed-rate prime jumbo mortgage securities were at 84 cents, up from 63 cents in March.
Before the credit crisis, senior non-agency home-loan securities didn't typically trade below 95 cents on the dollar, JPMorgan Chase & Co. (JPM) data show.
Alt-A loans fall between prime and subprime in terms of projected defaults. Jumbo mortgages are larger than government- supported Fannie Mae and Freddie Mac are allowed to finance.
The Fed data on bank holdings of mortgage securities don't distinguish between changes in value from buying or selling and those that result from rising or falling market prices. The higher values at Citigroup and Bank of America reflect in part purchases of non-agency debt, according to people familiar with each bank's positions.
The value of non-agency debt designated by the four banks as held to maturity or available for sale fell a combined $593 million to $70.8 billion in the third quarter from the previous three months. Under accounting rules, securities in these categories are usually held for longer than those designated as trading investments, helping to avoid writedowns. Debt available for sale can be sold more easily at a later stage than notes held to maturity.
Bank of America's Wager
Bank of America, the largest U.S. bank by assets and deposits, added the most non-agency debt on its trading book in the third quarter, with an increase of $945 million, or 34 percent. The value of securities designated held-to-maturity or available-for-sale also rose, by 8.2 percent to $37.3 billion.
The Charlotte, North Carolina-based firm, now led by Chief Executive Officer Brian Moynihan, reported $80 billion in writedowns and losses from the credit crisis, much of it related to defaulted home loans and bonds backed by them. The lender received $45 billion in federal bailout funds in October 2008 under the Treasury's Troubled Asset Relief Program, which it repaid Dec. 9. The U.S. still holds warrants in the bank.
Without new purchases, bank holdings tracked by the Fed usually decline as the underlying loans are refinanced or default. That shrank the overall market by 5 percent in the third quarter and by 30 percent since its peak in mid-2007, separate Fed data show.
Citigroup's holdings of non-agency residential mortgage bonds designated for trading rose by $421 million to $13.5 billion in the third quarter, the Fed data show. Other holdings fell $2.3 billion, or 6.9 percent, to $33 billion.
$117.8 Billion Loss
The New York-based bank was among the largest and earliest losers on toxic home-loan securities and has posted $117.8 billion of writedowns and credit losses. The U.S. injected $45 billion of taxpayer capital into the company and extended guarantees for $301 billion of its assets, including mortgage debt. Citigroup, led by CEO Vikram Pandit, agreed last month to pay back $20 billion and cancel the insurance. The U.S. owns 27 percent of the bank's common shares.
At Goldman Sachs, CEO Lloyd Blankfein increased non-agency home mortgage bonds designated for trading by $593 million in the third quarter, to $2.71 billion, and Morgan Stanley's jumped $785 million to $4.25 billion, the Fed data show. Goldman Sachs's other holdings climbed $76 million to $449 million. Morgan Stanley, now overseen by CEO James Gorman, classified all its holdings as trading assets, according to the Fed data. Both companies are based in New York.
Of the seven biggest owners of residential mortgage-backed securities, only San Francisco-based Wells Fargo & Co. reduced holdings of the debt on its trading book, by $130 million to $44 million. JPMorgan added $49 million to the trading book, while cutting its other holdings of the securities by $1.47 billion to $12.7 billion, according to the Fed data.
Eric Petroff, director of research at Wurts & Associates, a Seattle-based firm that advises institutions on $30 billion in investments, said it's no surprise that banks added to their holdings following the unveiling of PPIP.
"Any time the government says, 'We're going to buy something in the securities market,' they're putting out a sign that says, 'Free money, come and get it'," he said.
The renewed interest by banks in holding the bonds has helped restore liquidity, said Scott Buchta, head of investment strategy at Guggenheim Securities LLC in Chicago. Higher prices have also eroded potential profits of PPIP funds and increased the risk of losses, making it harder for asset managers participating in the program to attract investors, he said.
Four of the nine PPIP managers missed the original Sept. 30 deadline for raising the minimum $500 million by more than a month. One manager, Marathon Asset Management, was allowed to make its initial closing after raising $400 million.
"If you were looking at returns in the high teens to low twenties in PPIP, now you're looking at the low-to-mid teens," said Joel Paula, senior analyst at Cambridge, Massachusetts- based NEPC LLC, which advised Connecticut's state pension board on its decision to invest $200 million with three PPIP managers.
Higher prices are also slowing the pace at which PPIP managers can and want to buy, because they must be more careful when examining securities and their underlying collateral, NEPC's Paula said.
"If you do your homework, you can still find value, but you're not getting 20 percent for doing nothing anymore," Paula said in an interview.
While fundraising and investing is moving slowly, time could ultimately play to the PPIP investor's advantage, said Alan Papier, of consulting firm Mercer, a unit of New York-based Marsh & McLennan Cos. Under PPIP's terms, investors are locked in for eight years and managers have up to two years from their initial closings to invest the money, giving them time to wait for prices to drop.
"Managers are trying to figure out whether the rally in residential mortgage-backed securities is sustainable, or if there will be some sort of pullback," Papier said.
Bill Eigen, manager of the $5.4 billion JPMorgan Strategic Income Opportunities Fund, said he bought residential mortgage- backed securities in the spring. Since then, he has sold and begun shorting both residential and commercial mortgage-backed securities, anticipating that their price would fall.
"This stuff was supposed to trade on fundamentals and will again trade on fundamentals," he said in an interview. "PPIP is not going to fill up buildings."
To contact the reporter on this story: Christopher Condon in Boston at firstname.lastname@example.org. Jody Shenn in New York at email@example.com