The Geithner Put – PPIP Plan
I have been thinking about this for a while on how best to simplify and John Hussman did an excellent write-up to explain his thoughts, similar to mine, about this whole PPIF program. So without any modifications, let me share what what he thinks-
Last week saw a continuation of the impenetrably misguided policy response to this financial crisis, which seeks to address the downturn by encouraging more of what got us into this mess in the first place. The U.S. Treasury’s toxic assets plan, for instance, looks to “leverage” public funds (with the FDIC providing the “6-to-1 leverage”) in order to defend the bondholders of mismanaged financials who took excessive leverage. At the same time, the Treasury plans to limit the “competitive bidding” to a few hand-picked “managers” who will be encouraged to overpay thanks to put options granted at public expense. This is a recipe for the insolvency of the FDIC and an attempt to bail out bank bondholders using funds that have not even been allocated by Congress. The whole plan is a bureaucratic abuse of the FDIC’s balance sheet, which exists to protect ordinary depositors, not bank bondholders.
If you have not yet read the plan, I think you should. This is a plan that is being used as “panacea” that is probably going to solve all the issues(Download it here)
So what is the plan- 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
The internet is filled with comments from all the over the world. Famous economists have already expressed their opinions. I shall share my simple thoughts (rather questions). I hope this plan works, and works well to take us out from the crisis. Hence, I would love to be wrong.
The PPIF plan allows investors who want to bid on distressed assets to use Treasury matching funds plus FDIC “non-recourse loans” to lever up their investments. The combined leverage is about 12:1, so a hedge fund that wants to buy $100 worth of toxic assets would end up investing about $7 of its own money. What’s more, since the FDIC loan is non-recourse, it means that if the investment goes bad the hedge fund doesn’t have to pay back the loan. It only loses its original $7. What a beautiful deal; For investors, this is a great deal. If the investment does well, they make lots of money. If it tanks, they can only lose $7. I’ll take it.
However, thinking from the other side-
- If you are a true business man, first will you offer any non-recourse loan for a “toxic” asset? Will you offer 85% of the loan without participating into any upsides? And without compensating yourself for any downward protection? Who loses the money in case the asset value goes down? You bet it is FDIC. And in fact they are selling this naked put for, guess what, free. Let’s have an example- In the options business, if I sell a Jan 11 BAC 7.5 slightly OTM put, I receive US$4.00 premium, over 50% downside protection (Friday close @7.60). FDIC sells the Geithner put for Free.
- I haven’t heard of any venture capital offering an 85% funding without assessing feasibility of the business model and future cash flow streams. Fine, so it appears that FDIC has better expertise to value these “toxic” assets than the ones who sold those and are now unable to value it, and brought this crisis. Do you agree?
- Does anything stop a bank that holds toxic assets from using a proxy to bid for them – moving the assets from one pocket to another, but getting the FDIC to guarantee (part of) them?
- Does anything stop a bank to bid for toxic assets of another bank? They can put up a few percent of their own money, and swap each other’s toxic assets financed by public suddenly bearing more than 90% of the downside risk. The “investors” keep half the upside while ordinary Americans take the downside. Here is what financial times reports– US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn plan to revive the financial system.” How can they even value the assets of others to come to a bidding price when they can’t value their own? Hello?
- Let me paint a few more scenarios-I don’t know if Banks have been given a choice to sell “All or None”- a) What if the Banks sells only the toxic assets but not the quality one? b) However, what if the Bank sells only the good assets; use the value from the proceeds of good assets to boost value of toxic asset on their books?
- And by the way to have an excellent bidding process, there should be good number of bidders. I am not sure how many competitive bidders will be left after eligibility criteria is finalized?
- Oh btw, where is the little “home owner” in this whole process? How is his/her pain being alleviated? His debt is not being restructured so who is going to stop his home from foreclosure?
I have more questions than I have answers for. There is some good discussion by Rotorybomb including mathematical modeling. There are good Q&A as well. You may want to read it to acquaint yourself with what’s going on with the plan that is expected to solve the issue. He has done an excellent job to provide a crux.
I understand, the government is different from a business person and probably need to take steps which are contrary to pure business sense. The plans needs to be attractive enough to have private investors come on board. But at the end, risk is a risk. And risk should be compensated with appropriate rewards or vice versa. Lastly private sectors leveraging brought this crisis, now the de-leveraging is taking place. Now it is the government that is leveraging up. What will happen when the government de-leveraging starts? When and How?
I don’t know if this is beginning of a new trouble or an end to the trouble we are going through. Only time will tell. In the meanwhile, enjoy the rallies. Trade carefully and go long selectively and in incremental steps should you choose to go long.
Profitable trading, OP
