both plans involve Treasury twisting the banks’ arms to force them to do what is ultimately in their own best interest

From Reuters:

"The Geithner plan vs the Brady plan

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Posted by: Felix Salmon

Tags: bailouts, bonds and loans

Mohamed El-Erian is interviewed over at FT.com, and at the beginning of the first interview, at about 1:45, he says this:

I think you’re going to need a little bit of moral suasion. This is very similar to what we saw with the Brady plan at the end of the 80s. You had the overhang of the developing country debt, and you had a mechanism to lift it, but at the end of the day, you also need some moral suasion to get the banks to participate, and to clean up their balance sheet.

It’s an interesting analogy. But in one important respect there’s a huge difference. In the Brady plan, the banks had illiquid loans on their balance sheet which they swore up and down they were holding to maturity (because if they sold them they’d take a loss they couldn’t afford). The solution was to turn those illiquid loans into liquid bonds, add a few sweeteners in the form of zero-coupon Treasuries, and create a mechanism for allowing the banks to slowly let those toxic assets trickle off their balance sheets by selling them in the liquid secondary market as and when they could afford to.

The PPIP, by contrast — or at least the Legacy Securities Program — works the other way around. The banks have liquid bonds on their balance sheet, which they can sell in the secondary market if they want, but only at very low prices. Under the Geithner plan, those liquid bonds will be transformed into highly-illiquid public-private investment funds, with both the ability and the intention to hold the bonds to maturity.

And, of course, the fiscal cost of the Brady plan was wholly transparent and up-front. Under the Geithner plan, no one has a clue what the cost to the government is going to end up being.

But El-Erian is right that both plans involve Treasury twisting the banks’ arms to force them to do what is ultimately in their own best interest. But in one way the Geithner plan can’t ever be as successful as the Brady plan. Under the Brady plan, the main indicator of success was that the developing-country governments in question regained access to private-sector capital. Under the Geithner plan, the plight of the borrowers is not really part of the problem, since most of the debts in question were issued by some kind of special-purpose vehicle. Maybe the resuscitation of the securitization market as a whole is one of the objectives of the plan. But it’s not at the top of the list."

Me:

“with both the ability and the intention to hold the bonds to maturity.”

Yes, and that’s a part of the plan. The point is to have the TAs be seen as investments. If hedge fund buyers, Pimco,etc., do buy these TAs, since they’re well know investors, it will help the government transform the TAs into long term investments in the eyes of the public. It’s a forward looking plan, showing confidence in our future, intended to attack the fear and aversion to risk. In that sense, it’s like infrastructure investment in the stimulus. It shows confidence in the future, and helps attack the notion of toxicity. That’s also why it’s going to be offered to average investors through mutual funds. By the way, if John Paulson is buying them, then they are investments. It’s simply a question of whether they are good or bad investments.

Also, the subsidy part of the PPIP, which is inherent in any hybrid plan, is inflationary, and will also help with QE, since the government will be perceived as having to print money if this all goes sideways.

Since I’m saying a lot of crap to most people, and partly to myself as well, I think that the FDIC is saying that the banks are going to have to pay for the PPIP in the end. They’ll raise their fees, and seize them, just to piss of Hempton, proactively, if they have to going forward. Since the PPIP is intended to save the banking system, as Caballero seems to believe, then they banks are going to have to pay for the plan in the end. It’s starting to sound damned clever.

- Posted by Don the libertarian Democrat

"there will be reasons for politicians to complain and to focus on the five winners to see how they 'abused' the system,"

TO BE NOTED:



NO PRIVATE HEDGE

By KAJA WHITEHOUSE Bridgewater Associates, the $71 billion money-management firm, has come out against participating in Treasury Secretary Tim Geithner's plan to get private investors to buy banks' toxic assets -- a week after saying it was interested in it.

In an investor note obtained by The Post, Bridgewater founder Ray Dalio gave Geithner's plan two thumbs-down, arguing that the hopes of would-be buyers probably won't be met by what the government is offering, especially when it comes to the sale of so-called legacy securities.

In the note, which is entitled, "Why We Decided Against Buying in the PPIP and Why We Doubt That It Will be Broadly Subscribed," Dalio cited economic and political concerns with Geithner's Public-Private Investment Program, dubbed PPIP, saying the numbers just don't add up -- at least when it comes to PIPP's legacy-securities program.

PPIP aims to remove toxic assets from the system by giving private investors, such as hedge funds and mutual funds, leverage to buy assets through two programs. The legacy-securities program enables those investors to buy older residential and commercial mortgage-backed securities that have been at the heart of many banks' troubles.

"When the program was first announced, we were originally interested" because the leverage the government was promising made the assets cheaper. "However, as things now stand, very little leverage is actually being offered via the 'Legacy Securities Program,' " Dalio wrote, pointing out that the leverage offered is just 1-to-1.

He also blasted the program for its initial design, saying it is ripe for conflicts, pointing to the plan to hire five asset managers to run everything on behalf of themselves, the government and the other investors.

"The managers are clearly in a conflict-of-interest position because they have both the government and the investors to please and because they will get their fees regardless of how these investments turn out," Dalio wrote.

Bridgewater's investors include pension funds, endowments and foreign governments.

He also questioned the political risks that the program's design could create, saying the limited number of managers "raises possibilities (or at least perceived possibilities) of them colluding because they all know each other."

And so regardless of whether the investments make or lose money, "there will be reasons for politicians to complain and to focus on the five winners to see how they 'abused' the system," he wrote.

Dalio's criticism of the program is sure to raise eyebrows, as his firm is one of just a handful that would have likely met Treasury's requirements for participation. What's more, Dalio is widely regarded as an influential expert, and recently was named by Alpha Magazine as the fifth-best money maker in the hedge-fund world, behind George Soros.

To be sure, Dalio doesn't slam everything about PIPP. Indeed, he doesn't slam the legacy-loan program, in which investors buy loans instead of securities and offers leverage of between 6-to-1 and 12-to-1.

But, "we aren't interested in illiquid loans," he said in his note.

Dalio didn't respond to a request for comment."

Unless the Legacy Loan Program winds up buying assets at $90 or more, banks won't sell.

TO BE NOTED: From Accrued Interest:

"PPIP: Maybe you'd like it back in your cell?

The big question surrounding the toxic asset plan is will banks sell? I've put a little pencil to paper here and come up with some actual numbers.

First of all, I expect the Legacy Securities Program will work wonderfully. Sellers will flock to it like Jawas to a stray astromech droid. This program is aimed at securities which have been severely impaired from both a credit and liquidity perspective. CLOs, RMBS, ABS, CMBS, etc. The program should succeed in turning these programs into just liquidity impaired. In effect, it will separate the red ones with the bad motivators from the blue ones in prime condition. That will be key to an eventual economic recovery. It should foster a healthy new issue market for RMBS, ABS and CMBS (don't know that CLOs can come back), which will help get the velocity of money back to a more normal level.

Obviously having ready buyers able to earn impressive ROEs should improve the value of the underlying assets. Financial institutions have already marked these securities to market, an improvement in the actual value of the instruments ought to result in an improvement of balance sheets. This will particularly benefit financials who invested primarily at the top of the asset-backed capital structure. It will also benefit those that hold more risk in securities (such as brokerages Goldman Sachs and Morgan Stanley and possibly some P&C insurers) and less those that hold risk in loans (such as almost all banks). Even there, much of Goldman and Morgan's risks are tied to the equity markets, not to debt markets. Same goes for life insurance, generally speaking.

That brings us to the with the Treasury's Legacy Loan Program. I expect this to go over like the exotic twi'lek dancer's routine in Jabba's palace. The plan will indeed increase the theoretical price at which banks could sell loans. That's fine, but its short help. Loans haven't been marked to market. Instead, they are held at book value less an allowance for expected loss.

I've done some deep dives on bank residential loan portfolios. Getting detailed data is a challenge, but basically I tried to figure out what percentage of the bank's current portfolio is "challenged." High CLTV, bad geographics, low FICO, etc. You can make a relatively safe assumption that most of the loss reserve is pledged to those kinds of loans. Anyway, I can't find any big banks that are holding, say home equity loans at less than 90% of face. Unless the Legacy Loan Program winds up buying assets at $90 or more, banks won't sell.

So will the PPIF's pay $90? I doubt it. Take home equity loans as an example. Start with the following assumptions:

• PPIFs get loans at 1mo-LIBOR +50bps. Its hard to say exactly what the cost of funds might be, but worth noting that FDIC paper trades around L+20.
• 6-1 leverage, which is the max allowed under the program. I think its reasonable that non-delinquent, prime loans would get the max leverage.
• Assume the loans float at Prime-flat.
• Assume the loans are 1-2 years old, and will repay over the course of 6 years. To make it easy I'm going to assume equal payments per month.
• The pool of loans will suffer 10% cumulative losses, all of which occur in the first two years. I won't write down the losses as they occur, simply take away the interest. That's consistent with a hold-to-maturity IRR calculation.
• Finally, and perhaps most importantly, I'm assuming that the PPIF equity investors are targeting an IRR of 20%.

The result? $82.5.

That price will render it impossible for most banks to sell. For example, based on Bank of America's recent earnings presentation, it has something like $250 billion of prime, non-delinquent home equity loans with 90%+ LTV. I'd call this the kind of stuff that isn't exactly toxic, but selling could improve BAC's risk exposure significantly. Say they effectively have a $90 mark on these. If they sell at $82, they'd suffer an 8% loss versus their capital, or $20 billion. BAC has core equity capital of $48 billion. You do the math.

I don't expect commercial loans to be much better. Now a lot of commercial stuff has large loan loss reserves, and therefore sales would more easily be accretive to capital. But commercial loans are also present an information asymmetry problem. You can put a zillion residential loans into a pool and get some semblance of diversification. You can then look at average stats and get some idea of the make-up of the loans: geo diversification, average FICO, etc. A bank that is selling a commercial loan is telling you they don't want that commercial loan anymore.

This isn't to say the toxic asset plan will have no positive impact, but it is likely to be more indirect than investors are currently hoping. The best chance banks have for decreasing their residential loan portfolios is a revived securitization market, which is the primary aim of the TALF. Banks may be more willing to sell a portion of their home equity loans as a senior security, with the bank retaining a subordinate position. In that case, the bank might retain the upside while still freeing up some capital. In addition, a revived securitization market would give the market confidence that banks have enough liquidity to hold their loan portfolios to maturity.

It will also help banks who have made larger writedowns, especially those that made acquisitions. At the time of acquisition, the bank has to write down the loan to fair market value. In the case of J.P. Morgan's acquisition of WaMu, or Wells Fargo's acquisition of Wachovia, there would be no motivation to under-estimate the FMV decline. Those banks could therefore enjoy improved capital positions from certain sales. "