A Partnership To Buy Toxic Assets - Q&A

by Tom Gjelten A Sample Investment In Toxic Assets Step 1: A bank has a pool of residential mortgages with $100 million face value that it's seeking to divest. The bank would approach the Federal Deposit Insurance Corp. Step 2: After conducting an analysis, the FDIC would determine that it would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio. Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest private bid — in this example, $84 million — would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages. Step 4: Of this $84 million purchase price, the FDIC would provide guarantees for $72 million of financing, leaving $12 million of equity. Step 5: The Treasury would then provide half of the equity funding, or $6 million, and the private investor would contribute $6 million. Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition using asset managers approved by and subject to FDIC oversight NPR.org, March 23, 2009 · The Obama administration Monday released its plan to remove billions of dollars of tarnished mortgage-backed securities and other toxic assets from banks' balance sheets so that they resume lending. Treasury Secretary Timothy Geithner said the plan would use government and private resources to purchase $500 billion of toxic assets, but he said the program eventually could grow to $1 trillion. Below, a look at some of the details and questions remaining to be answered about the proposal: How is this plan different from previous plans to deal with toxic assets? The original plan was for the U.S. government to purchase those bad assets from the banks. This plan adds a significant role for private investors. The assets will be purchased by Public-Private Investment Funds (PPIFs), using both private and government money. With the inclusion of private investors in the process, it will be easier to create a market for these securities. That hasn't existed for months, largely because no one was sure what the securities were really worth. The banks and other financial institutions that held these bad mortgages and other loan products didn't want to give them away, while buyers were wary of paying too much. With so much uncertainty over their value, the market was essentially frozen. Why couldn't the government set the value? The government couldn't on its own establish market prices for those assets, because without competition from other possible investors, the price would be set arbitrarily. For their part, private investors haven't been willing to establish a market for the assets, because they have regarded it as too risky. Under this new plan, the government takes away much of the risk for the private sector, but the investors who participate should still have enough at stake that they will compete seriously to buy the assets. Some semblance of a market price for the securities should thereby be established, at least in theory. How exactly will the plan work? The centerpiece of the program is the creation of the Public-Private Investment Funds. Those PPIFs will then purchase bad loans and mortgage securities from the banks that hold them. Private investors will actually manage the funds and direct the bidding for the securities, but they will have access to government money and financing. The government will also promise to cover a significant portion of the potential losses that investors could face. Should a toxic asset investment prove worthless, the private investor may lose only his cash down payment. How much will this plan cost U.S. taxpayers? The Treasury will immediately contribute $75 billion to $100 billion it has remaining from the Troubled Assets Relief Program (TARP) that Congress approved last fall. That money, which can be tapped without congressional approval, will go to provide the government share of the initial equity in the PPIFs. The federal role and potential risk to taxpayers don't end there, however. The federal government promises to guarantee most of the financing for the toxic asset purchases. That stands to be hundreds of billions of dollars if the plan achieves its goal of absorbing up to $1 trillion in bad debt. What's a specific example of how this would work? Let's say the Treasury finds a private investment partner to purchase a pool of mortgages for $84 million. The Federal Deposit Insurance Corp. would guarantee $72 million of the financing. Treasury puts up $6 million; the private investor does the same. So they put down a comparatively small cash down payment that's backed up by the much larger FDIC guarantee. All is well and good if that pool of mortgages winds up being worth more than $84 million. But if that's not the case, the taxpayers are on the hook. What key developments should taxpayers watch for as this program moves forward? One of the most important is the price that these securities fetch in the marketplace. At the moment they are hardly ever traded. And when they are, they're sold at depressed prices of pennies on the dollar. Getting the pricing right is absolutely crucial. If the offers for toxic assets are very low, banks won't sell because they would absorb even bigger losses and put their solvency at risk. And if the investors pay too much for the assets, it puts the taxpayer investment at risk. The Treasury is hopeful that private investors will get the prices right: They won't pay too much because that's not in their interest. And they won't make offers that are ridiculously low because there are profits to be made on assets whose values may have plummeted too far in a climate of fear and panic. Is there any indication yet how the private sector will respond? The early reaction from the stock market was quite positive. The Dow Jones industrial average shot up at the opening bell, with bank shares in particular rising sharply. The market retained its gains, with the Dow closing up 497 points, or nearly 7 percent. Bill Gross, the founder and chief investment officer of PIMCO (the world's largest bond fund family) immediately praised the program and said that his fund will participate and compete to manage one of the private investment funds to be set up under the program. Aren't there concerns that the government would be going too far in adopting a congressional measure to tax bonuses for executives of American International Group and other companies that have received government bailouts? Some Wall Street executives — notably Kenneth Lewis, the Bank of America CEO — have warned that investors may be reluctant to sign up as partners with the government if they see a possibility Congress might decide down the road to change the rules and enact new taxes on them as a consequence of their receiving taxpayer dollars. The Obama administration is clearly worried that these tax proposals will undermine the public-private partnership. When President Obama was asked about the bonus tax plan passed last week by the House, he made clear he didn't like it. "We can't govern out of anger," he said. He even suggested that the tax plan approved by the House may be unconstitutional, in the way it targeted a very specific class of individuals. Would President Obama actually veto the legislation to tax bonuses if it passes? He wouldn't say. The Senate still has to consider it, and we can assume that if a bill does emerge it will in all likelihood be a different version of what the House passed. There will clearly be some new pressure on Wall Street executives to take more responsibility than they have taken so far. Obama, in an interview on 60 Minutes, said he thinks some people on Wall Street haven't yet realized that if they want the taxpayers to help them, they can't enjoy all the benefits they had before the crisis. "You get a sense that at some of the institutions, that has not sunk in," Obama said. It appears that the administration would like to distinguish between "good executives" and "bad executives." The bad guys are the ones who are becoming a burden on the taxpayers, taking both big government bailouts and big pay bonuses. The good guys are the executives who are acting more responsibly and are willing to work with the government to get the ball rolling again. "What we're talking about now are private firms that are kind of doing us a favor," Cristina Romer, the chairman of the President's Council of Economic Advisers, said Sunday on Fox News. "And I think they understand that the president realizes they're in a different category." She seemed to be suggesting that if Wall Street executives cooperate with the government, the Obama administration will try to protect them from the backlash that's being directed at Wall Street more generally. What's the biggest complaint about the toxic asset cleanup program? Critics such as New York Times columnist Paul Krugman say the program is overly generous to Wall Street. If the value of the assets purchased by the PPIFs go up, the private investors make a hefty profit. If on the other hand the assets prove to be worthless, the private investors will lose only their cash contribution. Their debt will be excused. From this perspective, U.S. taxpayers are subsidizing the private investors' purchase of the toxic assets, the critics say. If this toxic-asset cleanup works, will the banking sector become healthy again? The problems in the banking sector are too large for this program to solve on its own. Even if the PPIFs work as planned, they will absorb only about $1 trillion worth of bad assets. But analysts believe the total value of toxic assets in the banking system is close to $5 trillion. This program is at best only a start.