edited by Carsten Philipson, Managing Director Communications Equity Associates

The U.S. stimulus plan is partly designed to increase consumer lending.  However, these loans must eventually be repaid by consumers so the idea seems a little flawed.   While that statement is true, by making loans to consumers through the banks, the U.S. government can effectively speed up the recovery of the economy and eventually restore faith in the system.

Increasing the confidence of consumers in the economy and in the financial system increases their propensity to spend and deposit funds with the bank, which leads to savings and consequentially investment in real assets. Money in circulation is more productive than money under a mattress, which is why lending increases the amount of money in circulation, jump-starting the flow of funds from the banks to consumers who spend it on goods and services. (Anyone eager to learn more about the process with a little satire should watch the South Park episode “Margaritavillie.”) Further, businesses utilize credit to make pay roll, buy raw materials and cover day-to-day operating costs. Without credit, firms would be forced to slow down operations, thus reducing output leading to a cycle of depression. Today, the economy is in a period where credit is hard to find as most banks are on the brink of insolvency.

So how is this relevant to the Treasury Secretary Tim Geithners Public-Private partnership? In order to kick start consumer spending and the flow of funds, the banks have to be in a position to lend. (Essentially, a Catch-22 situation, since the banks have to choose between making loans and keeping their capital ratios healthy for the “stress tests” the government is running.) The banks are currently cash poor and, due to massive write downs on their pool of mortgage investments, may also be leaning towards negative equity. So really, the only way to fix this problem is to replace these messy assets with cash so the bank can safely meet both its objectives.  

Now you might ask yourself “But, in an efficient market, the toxic assets held by these banks should be worth very little.  So selling them would bring in an amount that’s far less than what the loans were originally worth. What do you say about that?” Clearly, this is not something the banks would like to do, so we are faced with yet another problem - let’s say the bank has one toxic asset that it bought for $100, using $40 in equity and $60 in debt (Normal commercial bank has a tier 1 capital ratio of 7 to 9%, which means that 91% to 93% of a banks balance sheet is leverage. For the sake of this example, let’s assume a 60 – 40 debt to equity ratio). The bank cannot sell is for less than $60, or else it will have negative equity. At the same time investors now know that the asset isn’t worth $100 and have priced in the risk of default, so they are willing to pay 30 cents on the dollar for the asset. As you can see there is a problem because all of the bank’s cash is tied up and maintaining their tier one capital ratio becomes difficult.

The example mentioned above is an over simplified version of what is really happening. In reality, under GAAP accounting rules, the bank must write down the “toxic asset” to market value in its books (mark to market), unless that bank intends to hold the asset until maturity. Consequently, most toxic assets are already reflected in the books of the bank at a few cents on the dollar and a charge off (loss provision) for the difference between purchase price and the book value has been made on the liability side of the balance sheet. Hence, a sale of the toxic asset (as long as the sale is equal to the current market value reflected in the books of the bank) does in theory not change the bank’s tier one capital ratio. However, in practice, shareholders always worry that the bank has not correctly priced the reduced value of the toxic asset on its books and therefore has not allocated enough funds in its loss provision book entry. An actual sale of the toxic asset provides clarity to shareholders and the bank and consequently eliminates any shareholder uncertainty as to the adequacy of the loss provision. This normally leads to a rising stock price for the bank. Hence, the desire to move these toxic assts off the books of the banks.

(Japan choose not to recognize its toxic losses in their banking crisis in the 1990’s and consequently, Japanese banking stocks are still trading well below their stock prices 10 to 15 years back, because the banks were allowed to carry their toxic assets at purchase price and not market value. Investors are therefore uncertain as to what the true value of these toxic are and are discounting the share price of the Japanese banks according.)   

The new public-private partnership that will be created as part of Geithner’s plan[1] enable the new entity to purchase these assets at a price both the bank and the private investors agree on. Following that same example above, let’s assume this price is $70. This will put cash on the banks balance sheet and keep them solvent while also giving them an extra $10 in equity to start rebuilding profitable divisions of the bank. At the same time, this new entity provides an incentive for private investors to buy these assets.

Now, why on earth would anybody want to buy these toxic... no wait, sorry, these “legacy loans”? Well, for starters, high risk means high reward and where this risk, there’s bound to be a banker! But first we must understand the relationship between the US Treasury, the Federal Reserve and Private investors. Both the Treasury and private investors are going to put up an equal amount of equity capital in a special purpose acquisition company, which will then be given access to Federal Reserve loans at a favourable rate with flexible repayment. These new special purpose entities will then collectively buy $1 Trillion in toxic assets from the banks, where the private investors would put up $150 Billion. This structure provides an incentive to private investors since they can partake in all of the upside, with minimum risk as the most they can lose is the initial investment (see graphic below). If they paid $1 Trillion for the assets and the value dropped to below that amount, the investors lose a maximum of their initial investment; a fraction of the total purchase price. To paint you a picture, if the $1 Trillion drops to $850 billion, the private investors would loose all its capital and the government would only pick up the losses below the private investment capital layer (the $150 billion).  The private capital is the “equity capital”, which implies that it carries the risk before the government starts sharing the risk. This amount is still a quarter of the acquisition price and the loans given by the Federal Reserve are backed by the toxic assets now on the SPAC’s balance sheet. The government takes the bad asset as collateral making this deal quite attractive.

On the other hand if the asset went up in value (nobody knows their true worth) to $1.2 trillion (example below), the $200 billion in profit would go to the Treasury and the private investors, while the Fed gets its principal back. The loan and loan guarantees are essentially a Leveraged Buyout of troubled assets from the banks onto the books of these new PPIF’s.

Of course Geithners plan isn’t flaw less. Businessweek’s Theo Francis and Mara Der Hovanesian wrote an article titled “Geithner's Plan: Loopholes Galore” that highlights five ways that Investment Banks and Hedge Funds can exploit the Treasury's toxic-asset recovery plan. The full article is available online and I highly recommend you read it. To give a one quick example, let’s say a hedge fund owns a large amount of Citigroup stock. By keeping the government far way from valuation and bidding up the price of the troubled assets during the time of purchase, the hedge fund can strengthen Citi’s books by replacing the toxic asset with more cash than it was worth, leaving the public private entity with an asset that they clearly overpaid for. Bottom line: the government absorbs 85% of the loss, while the hedge fund makes a killing on the increase in value of the stock. Other moves such as seller financing essentially replaces junky mortgages on the bank's books with an FDIC-guaranteed loan.

I am by default a fan of private enterprise, so despite some of these loop holes in Geithner’s plan, I am still pretty optimistic about this undertaking. I wanted to end this with a quote from Paul Krugman’s Op-Ed column[2], “The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.”

 NOTE: All graphics were created by Sidharth Wahi.