Monday, March 23, 2009

Taxpayers will lose if toxic assets deals fail

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By Kathleen Pender

The Treasury Department's plan to form public-private partnerships to buy illiquid assets from banks looks like a much better deal for private investors than public ones.

Under one example provided by the Treasury, the public (i.e. taxpayers) and private investors will buy these assets, hold onto them and hope their value goes up. If they do, the public and private investors will share profits 50-50. If they don't, the public will bear a much bigger share of the losses because the government is guaranteeing a large portion of the money used to buy the assets.

Whether the plan works depends on whether the partnerships and the banks can agree to a price for these so-called legacy assets and whether participating banks will use the money they get to make new loans. Banks aren't required to plow the funds back into new loans, but they most likely will because that's how banks make money, a Treasury spokesman says.

Although investors clearly welcomed the plan, sending Dow Jones industrial average up nearly 500 points Monday, its success is far from certain.

The Treasury announced two types of public-private partnerships Tuesday, one for loans and one for securities backed by mortgages. Here's how the loan plan works:

Suppose a bank wants to sell a pool of mortgages originally worth $100.

The bank approaches the Federal Deposit Insurance Corp. It decides that for every dollar a partnership puts into this pool, the FDIC will guarantee $6 in debt issued by the partnership.

The FDIC then auctions off the pool to a group of private-sector investors such as hedge funds, private equity firms and pension funds.

The highest bid is $84.

Treasury forms a partnership with the high bidder, and each side puts up half of the partnership's capital.

Of the $84 purchase price, Treasury puts in $6, the investor puts in $6 and the partnership sells $72 in debt guaranteed by the FDIC. The investor manages the pool.

If the value of the loan pool goes up, the Treasury and the private investor split the profits and the debt gets repaid.

If the value goes down, the Treasury and the private investors could lose up to - but no more than - their original investment. After that, the FDIC bears the losses.

In practice, every partnership could be different. The government could put in as much as 80 percent of a partnership's capital and the FDIC might finance a much smaller part of the purchase.

The plan for securities is a bit different and involves financing from the Federal Reserve, not the FDIC.

Treasury hopes the plans will end the stalemate between banks that think their loans are worth more than current market prices and investors who think they are worth less.

Guy Benstead, manager of the Forward Long-Short Credit Analysis fund, says Treasury is hoping that the low-cost financing will encourage investors to pay more than they otherwise would. "It's unclear to me whether it is going to work," he says.

Some big investors say they would be interested if the terms are right.

Andrew McCormick, head of securitized products for T. Rowe Price, says the risk/reward proposition looks good for investors and his firm will consider participating. "Most likely, we would work in partnership with some of our larger institutional investors and if we could find a way to make the product viable for retail investors, we would explore that as well," he says.

Ricardo Duran, a spokesman for the California State Teachers' Retirement System, says the system is "ideally situated to take advantage of these types of opportunities." On March 5, its board allocated $1 billion to buy "solid securities from distressed sellers," such as those that offered under the Treasury program. That number could go as high as $6 billion, Duran adds.

Bond giant BlackRock plans to participate in the partnerships. Six weeks ago, it raised $308 million from well-heeled clients for a private, closed-end fund that will invest "in these exact same assets, by and large," says Curtis Arledge, the firm's co-head of fixed income.

BlackRock could not put a lot of these assets in its publicly traded, open-end funds because they can only hold a limited amount of illiquid assets. But its Total Return funds, which own some of these assets, could benefit if the Treasury plan increases their value.

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