It doesn’t matter if the plan Timothy Geithner finally, finally released yesterday to clean up the banking sector is perfect. The only thing that matters is whether most people think that the Administration finally has a workable plan in place. Market psychology trumps the details, and the market wants action, not dithering.
That said, I can’t help but raise one question about the “legacy assets” aspect of the plan, which addresses how to shed the toxic mortgage securities poisoning bank portfolios. Under the Treasury Public-Private Investor Program investors will get cheap financing plus equity funding from Treasury. Further, Treasury may allow leverage for some private partners to enhance returns.
But, and this is very important, banks do not have to accept bids they deem to be too low in price. This is a big flaw, writes Roger Ehrenberg, a former trader and now an entrepreneur.
Forgetting the appetite of the supply side. The Program, with all the benefits provided to approved buyers – equity matching funds, cheap leverage, etc. – lists only a single line when addressing a key weakness: Participant Banks don’t actually have to participate. Participant Banks can submit portfolios for auction, Approved buyers can line up, valuation firms can estimate the worth of portfolios submitted for auction, buyers can submit their bids and Participant Banks can say: no. I fail to see how the Program is a material departure from the current landscape, except for the fact that the Government is providing cheap financing. The buyers are still running equity risk regardless of the 1-1 Government match (as they should), and will only submit bids that reflect their assessment of risk and return. This may result in prices that are still far out-of-line with current bank carrying values, causing banks to reject the highest bids in a move to avoid further asset write-downs. So even a protracted auction process could result in a whole lot of nothing. What does Larry Summers think a failed auction will do to stock prices? I shudder to think.
If banks simply refuse to accept market judgments on value this could be disastrous — mainly because it would show that the banks involved are insolvent and Treasury wasn’t adequately aggressive in cleaning them up. I see one saving grace. Only an elite group of up to five investment firms can make bids on the so-called legacy assets. And those firms must already own $10 billion in legacy assets. That means the investors like Pimco and BlackRock would not be inclined to underbid for assets they already hold — or they themselves would need to mark down their own portfolios. Stay tuned.