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Even with $700 billion, the Treasury Secretary must selectively target banks and toxic assets to get the maximum impact
With the House of Representatives' Oct. 3 passage of the Treasury's $700 billion plan to stabilize the financial markets by buying up troubled mortgage-related assets, you could almost hear the sigh of relief spreading throughout Washington and Wall Street. After two weeks of nearly nonstop negotiations in which the bill repeatedly appeared to flounder, it was quickly passed on to President George W. Bush, who signed it into law within hours.
Now comes the hard part: getting the Mother of All Buyout Funds up and running.
Treasury officials have made clear they want to do that as soon as possible, and have told congressional leaders and Wall Street executives that they will conduct the first auction to buy assets within four weeks. The work needed to accomplish that is well under way, by a team of Treasury officials led by Ed Forst, a Goldman Sachs (GS) alumnus who left the firm this summer to become a senior administrator at Harvard University. In late September, Paulson asked him to come to Treasury to work on the bailout program. Forst, who is on a temporary contract, began to outline the plans for implementation even as Congress wrangled over the details. With the deal now done, Treasury hopes to hire five to 10 asset managers to oversee the purchases, each of whom will manage up to $50 billion in assets. It also hopes to hire another couple of dozen bankers, lawyers, and accountants needed to run the program, with much of the hiring expected within the month.
"Treasury is acutely aware that it must build an early record of success in order to maintain market and political confidence," says Howard Glaser, a high-ranking housing official in the Clinton Administration and former chief lobbyist for the Mortgage Bankers Association who now runs the Glaser Group consulting firm. "Paulson did not want to lose precious days waiting for Congress to pass the final bill before putting together the implementation plan."
Already, Paulson's priorities are becoming clear. It will have to decide which assets to go after first, and who to buy them from. Congress has given Treasury wide discretion to decide what assets to target. Although most of the funding is likely to go toward buying up mortgage-backed securities and whole home loans still held on the books of the lenders who originated them, Treasury can also buy up construction loans, home equity loans, or even credit-card debt or car loans if it decides that is necessary.
Treasury also has plenty of room to determine which types of institutions to buy from. Though banks, investment banks, and insurers are high on the list, the purchases could also be extended to hedge funds and others if need be.
Sources closely following the plans say that Paulson is intently focused on making sure Treasury gets the biggest bang for its billions. "It can't do anything too exotic right off the bat," says Tom Gallagher, the head of Washington policy research for institutional broker ISI Group. "It needs to have a quick impact."
So the first order of business will be ensuring that the initial auctions it holds to buy up assets are a big success—indeed, some say Treasury wants to see that they are oversubscribed. Those will be "reverse" auctions, in which sellers compete by submitting prices they would be willing to accept, generally allowing the buyer to select the lowest. So rather than Treasury bidding a certain amount to buy up a bundle of mortgage-backed securities, for example, the agency would tell financial institutions that it wanted to buy up a particular type of mortgage-related debt. Then it would buy those securities from whichever seller offered them for the lowest price.
Signal to Markets
In a report issued the morning of Friday, Oct. 3, Glaser said Treasury officials are close to deciding which asset classes to purchase first. They are also combing through data on financial institutions so that whatever initial purchases they make will signal to the markets that Treasury helped the "right" institutions—in other words, that the taxpayers' money is going toward those institutions whose financial stability will give the biggest boost to market confidence and whose prospects can most realistically be improved by Treasury purchases.
Scott Talbott, a senior vice-president for the Financial Services Roundtable, an industry group, puts it more bluntly: "They will target the firms that have liquidity trouble, but no so much trouble that they are essentially nonoperational. If a company is beyond repair, the Treasury plan is not going to save them."
That means Treasury is likely to start out buying from banks, in an effort to shake the credit markets back into shape. "I think he's going to go after the biggest [banks] first," said Stephen Auth, chief investment officer of equities for Federated Investors, a mutual fund and investment manager that manages more than $300 billion. "He wants to get them back in the business of lending."
Auth also figures that Treasury will concentrate on mortgage-backed securities that are widely held, rather than unusual or one-of-a-kind issues. That should have a multiplier effect in helping bolster other banks, even if they don't take part in the auctions. By purchasing assets similar to those that other institutions hold, Treasury would essentially establish a new market price, which the nonparticipating banks could use to improve their balance sheets. That might also reassure other investors enough that they start buying as well.
But big banks may not be the only initial target. To build congressional and popular support, Treasury officials are also said to be acutely aware of the need to demonstrate that the benefits of the program go beyond Wall Street, to Main Street. Glaser believes that means Treasury will also quickly ramp up direct purchases of assets, including whole loans, from troubled regional thrifts and banks. Many of these institutions, which are economically critical in smaller local communities as well as politically influential in many congressional districts, are struggling under the weight of poorly performing home equity loans and construction loans made to builders who've now gone belly up. To keep both constituencies happy, Treasury will likely buy up lots of those assets from strategically targeted markets around the country.
"I don't know who the 117 banks are on the FDIC's 'at-risk bank' list, but I'd bet the bulk of them are regional institutions, and the bulk of their problems are in loans to developers," says Glaser. "That's a huge drag on these communities, and if the Treasury can free up their capital, the political benefits would be huge."
Whoever Treasury buys from initially, the biggest issue is going to be how it prices the assets. After all, part of the problem is that the market for these securities has dried up, making it hard to figure out what any of them are worth amid fears that the underlying mortgages have gone sour faster than expected. Here, Treasury has to walk a fine line. The point of the plan is to recapitalize the banks and other institutions by taking bad loans off their books in exchange for cash. If Treasury pays fire-sale prices, that will do little to relieve the pressure on the banks' balance sheets. But the more it pays, the greater the risks to taxpayers.
Can Treasury Profit?
"Valuation is going to be extremely hard," says Rod Dubitsky, managing director for asset-backed securities research at Credit Suisse (CS). "It they set the price too low, there won't be any sellers, but if they set them too high, the government will take too big a hit."
Dubitsky points out that the task will be somewhat simpler when Treasury buys assets from firms that have already marked down the value of their assets to current fire-sale prices. Those companies may well be more willing to sell—and willing to accept a price lower than competitors might—because they've already taken the hit to capital that banks continuing to carry mortgage assets at book value haven't. At the same time, Treasury's own low funding costs, combined with the fact that it can accept a lower profit than a private buyer likely would, mean that Treasury would be able to pay more for such assets than would a private buyer and still potentially turn a profit. The bottom line: Many initial purchases are likely to come from institutions that have already taken big writedowns on the value of their mortgage-related securities.
In other cases, however, Treasury may have little choice but to overpay, in the interest of preserving liquidity and reducing systemic risk. If, for example, a bank can't take the big hit to its balance sheet that would come from selling to Treasury at more realistic current prices but the risks to letting it fail are too large, Dubitsky argues that Treasury will likely pay up to prevent a failure from happening. And whole loans held on the originating banks' books are rarely marked to market. So in both those instances, Treasury may essentially overpay for the assets, but it will likely demand a larger chunk of equity warrants from the institution in return.
Of course, to get any of this under way, Treasury will have to staff up quickly. It has plenty of decisions to make there as well. The Department is still working on the pay scales it will offer, for example, and the conflict-of-interest rules it will put in place to protect the public interest. That will be critical in winning support for the program, since the government has little choice but to hire mortgage-securities experts from many of the same firms that need help getting the junky assets off of their balance sheets. They are the only people who really understand trading in the complex markets for mortgage-backed securities and the derivatives created from them.
Treasury officials did not respond to calls concerning implementation on Friday afternoon, and in a press briefing held the previous weekend to outline the initial plan (the core of which remains in the final law) they refused to discuss how they planned to proceed.
"The irony is, Paulson will not be able to find asset managers to run this that don't already have distressed assets on their own books; there's no one else to do it," says one source who is closely following the talks. This person warns that Paulson has to be careful in how he brings those people in, ensuring there are strong enough firewalls and other safeguards to avoid a further public backlash: "If Main Street was already concerned about writing a big check to Wall Street, imagine how they are going to feel when they hear the government is now hiring the guys who created the problem in the first place, and, by the way, their firms will benefit?"