US Treasury: "Sample Investment Under the Legacy Loans Program"

[Kurt_and_Hunter]

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they 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 bid from the private sector – in this example, $84 – would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis – using asset managers approved and subject to oversight by the FDIC.

http://www.treas.gov/press/releases/tg65.htm

Whether we think it's a dream plan or a royal scam (or even both) we should discuss it for what it is, quantitatively.

Bank with troubled $100 asset sells it at auction for $84.00. The $84 comes from:

Private investor puts up $6.00
Treasury puts up $6.00
FDIC puts up $72.00 as a no-recourse loan, limiting the private investor's total exposure to $6.00.

Private investor decides when to sell. Splits profits 50-50 with treasury. If sold at a loss, losses above $12 (total: $6 private + $6 treasury) are borne 100% by the FDIC.

[Kurt_and_Hunter]

1. ...

[Kurt_and_Hunter]

2. Additions to OP

Additions in BOLD
___________________________

Whether we think it's a dream plan or a royal scam (or even both) we should discuss it for what it is, quantitatively.

Bank with troubled $100 asset sells it at auction for $84.00. The $84 comes from:

Private investor puts up $6.00
Treasury puts up $6.00
FDIC puts up $72.00 as a no-recourse loan, limiting the private investor's total exposure to $6.00.

If the investor doesn't pay the loan all he loses is the asset and his $6. Similar to a mortgage which is, in most states, a non-recourse loan meaning all you have at risk is the house and your down-payment (and whatever additional equity you may have acrued)

Private investor decides when to sell. Splits profits 50-50 with treasury. If sold at a loss, losses above $12 (total: $6 private + $6 treasury) are borne 100% by the FDIC.

Asset sells for $124.00. FDIC gets $72. Investor gets $26. Treasury gets $26. (investor=$26 return on $6 bet. federal gov't=$98 return on $78 bet)

Asset sells for $44.00. FDIC losses $28.00 Investor loses $6.00. Treasury losses $6.00 (investor out $6. federal gov't out $78)

(Interest not accounted for because I don't know the rate, except that it is a subsidized rate)

[alcibiades_mystery]

3. Two Questions

1) What makes us think the FDIC will authorize a loan if the assets may drop below the $12 threshhold, much less significantly below? Krugman has an answer for this: the FDIC cannot possibly exercise oversight or due diligence on the collateral for these non-recourse loans, because the market has been unable to! This is a rather shocking claim when the other option Krugman is pushing is nationalization of the entire institutions. It is also seemingly false. It's not that the market has been unable to value these assets. It's that they've been unwilling to do so. The banks are keeping these assets in a virtual black box because they're afraid of what will come out. Whether the same dynamic will hold when these assets are in the light of day is another question. There is, of course, merit in the other position, to the extent that the structure seems to incentivize private entities to bet on even bad assets if they can make a 15% return despite FDIC losses. That's an issue, to be sure, but it's an issue that can be solved with decent oversight. I don't know how you can argue, on the one hand, that the government should simply take over the banks, and, on the other, that the government would be unable to exercise oversight or due diligence on these specific loans. Which is it? Is the government capable or incapable of exercising oversight and due diligence? Krugman should make up his mind.

2) What are the comparison costs of the other solutions? It's easy enough to critique this one. I'd like to see a detailed comparison.

[Kurt_and_Hunter]

4. You are assuming the FDIC understands the value better than the investor, but

the whole rationale for the plan is that the investor understands the value better than the FDIC. That is the stated reason for piggy-backing and leveraging private investor decisions.

Why would the FDIC issue the loan on an asset that may decline in value? I dunno... that begs the question how bank balance sheets came to be in trouble in the first place.

People make mistakes sometimes. And if the FDIC knows what these things are worth then we wouldn't need to develop a market. I mean that literally, not snarkily.

These assets are not unpriced. They are dual priced... there are willing buyers at one price and willing sellers at another price. The reason they cannot get together is that the sellers have assumed (correctly) that the government would eventually subsidize the price.

As for alternatives, I hope someone answers your question. It's a sound one.

I am not an enemy of the Geithner plan. I am not outraged by it. Disappointed? Sure, but that's nothing new.

I am, however, an enemy of people just making shit up about the plan on either side.

Hence the post which I tried to keep vanilla. If the OP appears to criticize the plan then the criticisms are inherent in the arithmetic. There are no numbers that could be inserted where the private investor doesn't do way better than the government because that's how the plan is set up.

[alcibiades_mystery]

6. No, I don't assume that

I assume only that the FDIC will exercise due diligence on the collateral under the oversight provisions, like any reasonable lender. That means that if they are looking at assets whose value is completely unpredictable, they won't authorize the loan. For the FDIC to suffer substantial losses, that due diligence would have to be seriously mistaken. That's certainly possible, but the major catastrophe scenarios of the critiques suggest that it is not merely a possibility, but a probability, and for reasons that contradict the only other options they are providing (i.e., the FDIC cannot possibly assess value where the market failed). I don't believe that making the market is just about finding approximate values. It's about forcing open valuation, which is a different thing. You can look at these tranches and determine which ones have some value and which don't. The problem is that the banks don't want to do that because it could spell insolvency.

[Beetwasher]

7. Right!!

Thank you. I've been making this point over and over and over.

We will FINALLY have dependable valuations of these assets. That in and of itself is NO SMALL THING.

We can get a REAL handle on the scale and scope of the problem.

I cannot stress how important this is.

What people are not realizing is that NATIONALIZATION IS STILL ON THE TABLE. These valuations may in fact be a step in that direction while the auction will hopefully alleviate much of the problems, it at least will buys us some time and stabilization to possibly prepare for nationalization if it comes to that.

Nationalization is a complex, messy process that requires MASSIVE amounts of preparation on the scale that so many here are proposing. Not the least of which is proper evaluations.

[alcibiades_mystery]

9. I absolutely agree that nationalization is and should be on the table

Indeed, I think nationalization, eventually and in certain cases, will be the best solution. It's also useful that many conservatives are being forced to argue for nationalization simply to oppose the Geithner plan. That will come in handy later. I don't think, however, we can really argue for nationalization on the one hand, while simultaneously arguing that the FDIC can't handle the oversight requirements of the non-recourse loans. That strikes me as contradictory on its face.

I think, like you, that the Geithner plan is a preparatory step for other moves, so evaluating it in isolation is short-sighted and incomplete.

[Kurt_and_Hunter]

11. Then the plan will not work, on its face

If the FDIC is conservative and responsible then no market will be established.

This thing is designed to over-pay. That is the entire point. If the FDIC is responsible then the goal will not be accomplished.

And since banks voluntarily bring only assets of their choosing to the auction block I don't get this part: "The problem is that the banks don't want to do that because it could spell insolvency."

What is going to force them now? Participation is entirely voluntary on an asset-by-asset basis. The banks contact the FDIC to offer whatever particular assets the bank wants to auction through the program.

And since the prices are designed to be fake (since they are subsidized) it's an unusually poor model of price discovery. It actually muddies the waters.

And the profits are supposed to arise through secondary sales without the subsidy! That's a grandiose expectation of appreciation. Why would most things bought at above market on a subsidized basis be presumed to be worth more in an un-enhanced secondary sale?

This thing is simply designed to have the government over-pay for toxic assets through a means circuitous enough that the political fall-out is delayed.

And that's cool. I have no gigantic problem with that except one... there is no reason for common stock holders of the money center banks to benefit, which they will.

[Aloha Spirit]

5. I read your first question in a diff. thread and thought it was a good one..

and it reminded me of what I read somewhere that part of the reason the TA's are in a lock box or whatever is because these institutions expect government intervention to deal with them.
I imagine none of them want to put themselves at a disadvantage to any other bank, so it's possible they are willing to sell the assets under their current "value", but just needed to see how much of the loss the government would be absorbing. If that's all true to some degree, then it seems plausible to my uneducated brain that the PPIPs could be a trigger greater liquidity in capital markets.

I haven't seen any cost comparisons, but there was that Brookings report from January which compared different approaches in general terms
http://www.brookings.edu/papers/2009/~/media/Files/rc/papers/2009/0129_banks_elliott/0129_banks_elliott.pdf

I'm skimming their other newer papers right now..
http://www.brookings.edu/papers/2009/0323_investment_program_elliott.aspx

[FrenchieCat]

8. What would the bank otherwise get for this pool of mortgages?

and if it just sat there, and it remained on the books,
when the small business goes into the bank and asks for a loan
but due to lack of capital, the banks says no....

then what?

In otherwords, what's your solution that doesn't end up costing us one way or the other?


TO me, the fact that investors would even want to participate in buying toxic assets is a wonder.

[LittleBlue]

10. I think you've illustrated quite clearly why this is a scam

We (the people) bear 90% of any losses, but they get half of any gain.

Again, this is privatizing gains, and socializing losses. Why should we pay for the greedy banks' mistakes? The Treasury Secretary apparently thinks we're too stupid to understand how badly we get screwed for the benefit of large banks, insurance companies, and hedge funds.