Treasury Secretary Timothy Geithner's long-awaited public-private investment program, announced on Mar. 23, has fueled hopes that it will solve one of the most nettlesome problems of the financial crisis: reasonably pricing illiquid assets and getting them off banks' balance sheets once and for all.
But the plan may not be the slam-dunk hoped for by the market. The only clear beneficiaries at this point appear to be the handful of asset managers to be picked by the government to oversee the sale of the toxic "legacy" securities that have dogged U.S. banks since the start of the housing downturn.
Indeed, though the plan was received rapturously by Wall Street on Mar. 23, with major stock indexes shooting higher by nearly 7%, some critics are saying they don't see the PPIP as a silver bullet that will get credit flowing again soon. If anything, the events on Capitol Hill of the past couple weeks—including the AIG (AIG) bonus controversy—may make it that much more difficult for potential investors to get on board.
Uncle Sam Faces the Most Risk
An earlier plan for the Bush Administration to use Troubled Asset Relief Program (TARP) money to directly buy illiquid assets off the banks' balance sheets ran aground amid worries that taxpayers would end up overpaying for the assets. That's still a possibility some warn, since the government is taking on the lion's share of the downside risk by being willing to put up half the equity investment and up to six times leverage to buy legacy loans. The Treasury is willing to put up $75 billion to $100 billion of the remaining TARP funds to help pay for these assets.
The benefit of the program is that to the extent private money is profitable, Uncle Sam's money will be profitable and it's a way to recoup part of the money the government is providing, says Dan Alpert, managing director of Westwood Capital, an investment bank in New York.
There are certain to be some banks that would end up being undercapitalized if they sold their assets at a true markdown, and it's to be expected that they will try to resist that as much as possible, he says. "It's going to take as much pressure by regulators to say 'We'll either seize you or recapitalize you if you're a bank that's too big to fail,'" he says.
Risk of Overpricing
The legacy loan program will probably need some inducement from regulators such as the Federal Deposit Insurance Corp. (FDIC) since banks won't readily allow loans to come to market that have the potential to put the bank's balance sheet underwater, he adds. And even using a government-assisted market mechanism to set prices, there's still a real risk of overpricing simply because investors are likely to be willing to pay more for assets with all the government leverage available than they would in a normal market environment, says Alpert.
"The check on this whole structure is that private capital and public capital are pari passu—side by side," with neither side getting preferential treatment, he says. If the leverage encourages people to overbid, that tendency is likely to be tempered by investors' realization that they'd be putting their private equity at risk.
The foremost obstacle in people's minds is the political risk of taking money in any form from the government. As the parade of Congressional hearings in which CEOs of big-name TARP recipients hauled up for interrogation attests, would-be investors know what they can expect if the public-private investment program doesn't deliver on the promise of cleansing banks' balance sheets, or worse, delivers too much profit for big investors. The rush by Congress to tax 90% of bonuses doled out to certain AIG execs has investors running scared.
Carlyle Group Aims High
"We saw what happened with executive comp rules [in the AIG controversy]. As a manager, how do I account for that risk?" asks Harold Reichwald, a partner at Manatt, Phelps & Phillips in Los Angeles and co-head of the law firm's banking and specialty finance practice group.
David Rubenstein, co-founder and managing director of the Carlyle Group, said at a financial industry conference that Carlyle needed an internal rate of return of 20% to make up for the uncertainty around whether Congress might try to take back some profits later on, according to a blog post by Robert Wenzel, editor and publisher of EconomicPolicyJournal.com.
The mistrust among some investors toward the so-called gatekeepers—the handful of firms that are seen as most likely to be selected by the Treasury to raise money for and serve as asset managers for the investment funds to be created under the public-private partnership—runs deep. Some hedge fund managers cite the failure of large investment firms that acted as servicers of securitized mortgages to speak up against provisions in President Obama's Home Affordability and Stabilization Plan that indemnify servicers from claims by impaired investors. They say they expect the asset managers the Treasury chooses to be similarly incentivized to go along with any rule changes the government may impose down the road.
Tough to Get a Clear Read
The more substantial issue, however, is how clear investors will be about the assets on which they are bidding. To date, financial institutions haven't provided much transparency about the quality of the loans in the assets they are holding. Even if investors are granted the opportunity to closely evaluate these securities, it's not easy to understand most of them. The multiple layers of collateralized debt obligations, residential mortgage-backed securities, and other exotic instruments make it hard for even seasoned financial pros to get a clear read on the quality of the securitized assets that may be found on a bank's balance sheet.
One other potential sticking point: There's no certainty that banks will participate in the program. The ones that do could choose to play it in a couple of different ways. One is to bet the market will improve a few months out, in which case they're likely to put up lesser-quality assets for sale now and save the better assets for later, according to Mike Carlson, a partner in the finance and restructuring group at Faegre & Benson, a law firm in Minneapolis.
The other way is to put a floor on the price they can afford to accept for assets and if they don't get the bid, they won't sell, he adds.
Big Opportunity for FDIC
The FDIC has a critical role to play in helping to establish a market value for the legacy loan assets that have not been securitized, says Reichwald, The more engaged the FDIC is in working with banks to price their assets as realistically as possible, the better position it will be in to persuade investors to accept those prices and not try to lowball them, he says.
Although banks won't be forced to participate, the FDIC's examination process of their fiscal soundness is very dynamic, he says. "The FDIC has a lot of opportunity during that process to whisper in the ear of that [bank] manager," he says. "If you're a smart manager, you understand what's at stake and you understand that the FDIC wields a lot of power and you understand that when they make recommendation, there's something behind it and you can't just dismiss it."
Still, banks that have not marked their assets down to conservative enough levels, and whose solvency is riding on a balance sheet capitalized based on the higher asset values, aren't likely to sell many of those assets into the program, says a hedge fund manager who spoke to BusinessWeek on condition of anonymity. He sees the public-private partnership program as positive but only on the margin, in terms of the impact it could have on closing the gap between market clearing prices and the values at which illiquid assets are marked on banks' balance sheets for legacy assets already trading in the secondary market.
Let the Lending Begin
Ultimately, the goal of the program is to clear banks' balance sheets so they can afford to start lending again. If that objective isn't met, then the PPIP may turn out to be yet another disappointment in the government's efforts to get a handle on the financial crisis.
Bogoslaw is a reporter for BusinessWeek's Investing channel.