As the Obama Administration's plans to lift toxic assets off bank balance sheets took form, speculation swirled over whether private-sector investors could be enticed to take part. Now another question is looming: Will the banks participate?
On Mar. 23, Treasury Secretary Timothy Geithner unveiled the latest effort by the government to stabilize banks and unlock frozen credit markets. The long-awaited plan would use $75 billion to $100 billion of federal bailout funds—together with an equal amount of private-sector money and federal loans and guarantees that could bring the total investment to $1 trillion over time—to buy questionable, mostly mortgage-backed assets from banks.
The market soared in response, with the Dow Jones industrial average rising nearly 500 points, or 6.8%. The financial industry hailed the plan as a solid fix that could revive a moribund credit market. But while that reaction relieved some of the immediate pressures on Geithner and the Administration, it was hardly unanimous. Critics called it a series of opaque subsidies that, at best, would prop up the banks and their shareholders without doing much to revive lending. And the embattled Treasury secretary clearly knows he faces huge challenges ahead. "One day's [market] reaction does not make a plan," he said, speaking later that evening at a conference on the future of finance sponsored by The Wall Street Journal.
Funds Leveraged Sixfold
In many ways, the plan is straightforward: Private-sector investors will bid to buy a stake in pools of assets—either residential and commercial mortgage loans, or securities tied to a variety of other troubled debt—and their investments will be matched dollar for dollar by the Treasury. Those funds will then be leveraged as much as sixfold through loans backed by either the Federal Deposit Insurance Corp. or the Federal Reserve.
But the same dynamic that has stymied the normal market for these securities could discourage banks from participating, investors and financial experts say.
At the root of it, banks and investors disagree about what the assets are worth. Investors point to the dramatic collapse of the housing market and rising foreclosure rates, among other factors, that mean many of the assets are unlikely to perform as advertised, particularly as a worsening economy puts further pressure on the underlying borrowers.
Banks on Shaky Ground
Banks note that 90% or more of homeowners are current on their mortgages. They argue that most of the assets will ultimately perform—and thus are worth far more than the discounted prices investors are willing to pay. Moreover, many banks are already on shaky financial ground, and recognizing the assets at a lower value could leave them worse off, and potentially insolvent.
But while the program announced Mar. 23 contains sweeteners to entice investors to the table—chief among them government-backed financing—banks may remain reluctant to sell unless the ultimate price matches or exceeds the asset value the banks have recorded on their books. And Sheila Bair, chairman of the FDIC, made clear later in the day that she expects banks to take a hit: "They will have to take losses to sell into this facility," she said.
In that case, warned one bank analyst who works for an investment management company, "there's no incentive for banks to participate."
Pressure from Bank Regulators
Then again, they may not have much choice. The federal government owns significant stakes in most of the big banks, giving Administration officials and key members of Congress a toehold to pressure the banks. And bank regulators hold considerable sway over the assets that banks hold, and sell, even in ordinary times.
Indeed, asked if the FDIC and banking regulators will pressure banks to sell assets under the program, Bair was vague, but suggested they would. "There will be a consultative process with the [banking] supervisors," Bair said, "and yes, this program will be among the tools available" to improve bank finances.
Administration officials said banks may actually be willing to take a hit by selling the assets at a lower price if it lets them clean up their balance sheets and get access to the now-wary capital markets again. "This will make it easier for them to raise private capital," Geithner said.
Plan Praised by Industry Group
That's a point echoed by Scott Talbott, a lobbyist for the Financial Services Roundtable, which represents large financial institutions. The group lauded Monday's proposal. Any losses likely wouldn't be large, Talbott predicted. "This program allows them to strengthen their balance sheet and increase their presence in the lending arena."
Bair's comments on the plan suggested that the Administration fundamentally agrees with banks in the debate over how much the assets are worth. She referred at times to a "liquidity discount" that she said was present in the depressed market prices of the troubled assets. Bair also described "prices that are much, much lower than credit losses would suggest." That has prompted disbelief from some investors, who argue the market prices accurately reflect the assets' values, and say many banks are in fact already insolvent as a result. "It's not a liquidity problem—it's always been a solvency problem," said Bob Eisenbeis, chief monetary economist for Cumberland Advisors.
Critics raised other concerns as well, primarily noting that the government may well end up overpaying for the assets. Private-sector investors will set the selling prices by bidding on pools of assets; that will determine the amount the Treasury invests, and, ultimately, help determine the amount of leverage backed by the Fed or the FDIC.
Transfer of Wealth to Stockholders
But that government-backed lending will lower the risk that the investors face, which in turn will help raise the price that investors are willing to pay for a given set of assets. "It represents a huge transfer of taxpayer wealth from the taxpayers to the shareholders of financial stocks," said Albert "Pete" Kyle, a University of Maryland finance professor.
Others question the small part of the total investment the private sector will provide under the program—as little as 6% for some asset pools. But Geithner stressed that investors stand to lose everything before the government takes a hit.
Investors' "entire capital will be at risk, that's the important thing," he said. "If there's a return over time, which we expect there will be, taxpayers will share in that return."
At the evening conference, Geithner also stressed that the potential risks are far better than the other two alternatives: that either the government do nothing and let the dangerous process of deleveraging continue uninterrupted, or that the government step in on its own. That, he argues, would increasing the likelihood of overpaying for the bad assets.
"All financial crises are ultimately a debate about how much risk the government should take on," he said. To have the government shoulder the risk of cleaning up the banks on its own, he added, "is not healthy for the economy."
Fraud Is Another Risk
Bair emphasized that her agency's risk would be low. First, the FDIC's loans would be separate from its flagship deposit-insurance program, and the fees the agency will charge for its loan guarantees could even bolster its finances. Meantime, she noted that any given pool of assets would have to lose at least 15%—the amount put up by the Treasury and private investors—before the FDIC would be at risk of having to make good on its guarantee.
"I actually think the credit risks are pretty good for us," she said, saying several times that she expects the arrangement "to make money" for the FDIC.
Kyle argues that the relatively modest private-sector participation carries another risk: fraud. A large increase in the purchase price for a pool of assets will only cost the investors a small amount—an additional $100 million bid for a pool could cost the investors just $7 million, for example. And, because investors control the bidding, they could collude with the bank selling the assets to inflate prices and be reimbursed by the bank reaping the gains, Kyle said.
Pimco's Bill Gross Hails Plan
Treasury officials are aware of the risk, and are working with the federal bailout's Special Inspector General's office and consultants to prevent fraud, a person familiar with the matter said.
Institutional investors, however, were generally supportive of the plan. Some of them hailed it as the kind of clear, bold step that could mark a turning point in the financial crisis. Bill Gross, the high-profile bond fund manager at Pacific Investment Management Co., or Pimco, told Reuters that "this is perhaps the first win-win-win policy to be put on the table and it should be welcomed enthusiastically."
But a serious hitch could be the white-hot anger that taxpayers and their congressional representatives feel over earlier bailouts, warned Stephen Auth, chief investment officer for global equity at Federated Investors (FII). Last week, outrage boiled over regarding bonuses paid out by American International Group (AIG), the huge insurance company that has received billions of taxpayer dollars to avoid collapse. That was capped by the House of Representatives passing a 90% tax on many bonuses paid by big financial firms receiving federal aid. The possibility of becoming a similar target could spook companies that otherwise would be willing to invest alongside the government, or sell toxic assets under the new program.
A Lot Riding on the Senate
Although Treasury and FDIC officials have said the range of executive-comp rules applied to companies receiving bailout funds wouldn't be applied to participants in the new program, Auth said investors might not trust those assurances. Much depends on whether the Senate adopts the House bonus tax, or tones it down significantly, he said.
"If they put that thing through the way it's drafted now, you can forget Geithner's plan," Auth said.