Each of the three programs announced by the Secretary of the Treasury today has the same theme: the private investor has a limited downside and a huge upside – the American taxpayer bears almost all the downside and gets shafted on the upside.
Read my preliminary analysis of the three programs.
I. Legacy Loan Program
The idea of this program is to combine a small amount of private equity with a small amount of government equity – and a large amount of government guaranteed debt to buy some troubled loans from banks.
Here is an example of the mechanics.
Private investors bid for $100 million for pool of loans that are deemed eligible by the FDIC.
Private investors contribute: $7.1 million in equity
Government contributes: $7.1 million in equity
Government guarantees: debt of $85.8 million
Maximum possible loss: Private investor $7.1 million; Government $92.9 million
Profit: shared equally.
Example, suppose a pool of mortgage loans is purchased for $100 million. In one year, the value increases to $125 million and the portfolio is liquidated. Suppose the interest rate on the debt is 4.7%. Hence, the debt holders get 4.7% x $85.8 = $4 million plus their principal, $85.8 million. What’s left over is approximately $35.2 million. The private share is $17.6 million. The rate of return ($7.1 grows to $17.6 million) is 148%. Now it is true that the government gets the same rate of return on their equity investment – but this ignores a crucial difference. The private investor has unlimited upside and the most they can lose is their initial investment. The government has the same upside but they are guaranteeing the bonds. Hence, we suffer almost all of the downside.
Does this sound familiar? This is exactly how we got in this mess. Private investors taking risky levered bets knowing that the government would bail them out.
Here we go again.
If we are going to take all the downside, then it is only fair that we get all the upside. Why should we share half the profits with somebody putting up only 7% of the capital? The American taxpayer is putting up approximately 93% of the capital (counting guarantees) but only getting half the profits.
I reject the idea that this is the best way (or the least worst way) to handle this problem.
There are three simple alternatives.
- The RTC model. Relegate the insolvent banks to a Resolution Trust Corporation-like entity (modeled after the solution to the S&L crisis in the 1980s) and unwind their troubled assets over a period of 5-7 years. If there is any upside, the American taxpayer gets it all.
- LLP minus the private equity. Farm the management to professional firms and pay them a modest fee. This way the American taxpayer bears 100% of the downside and gets 100% of the upside (minus a fee). It is safe to assume that the fee would be less than 50% of all profits!
- Distressed fund with the government as an equity investor. This fund could be levered but without government guarantees. This is a model that I proposed in September 2008 before the TARP was introduced.
II. TALF for Legacy Securities
The details are still vague on this initiative. Essentially, the government will lend money to investors to buy legacy securities that were at some point AAA rated – but could have any rating today. It is an expansion of the TALF (Term Asset-Backed Securities Lending Program). The original TALF focused only on today’s AAA securities. The government would lend money for participants to buy these securities – thus providing much needed liquidity in important markets like credit cards and student loans. Critically, these were low risk loans that the Federal Reserve is making because they focus on securities that are rated AAA today.
The new program expands this to potentially very risky securities.
The details are vague: “Haircuts will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not yet been determined. These and other terms of the program will be informed by discussions with market participants.”
This simply means that the government has not determined how much leverage the private investors get to use.
In the end, this program might be worse than the first initiative. The private investor maximum downside is simply their investment. The government bears all the downside. Profits go 100% to the private investor.
In the Legacy Loan Program, profits were shared. Not in this one. The American taxpayer gets stuck with the downside and gets jack on the upside.
III. Legacy Securities in PPIF
Government farms out investment management to about five professional firms. Here is an example of the mechanics.
Invest $100 million in RMBS, CMBS, that were originally rated AAA (but could have any rating today)
Private investors contribute: $25 million in equity
Government contributes: $25 million in equity
Government contributes: $50 million in debt
Maximum possible loss: Private investors $25 million; Government $75 million
Profits: shared equally. Professional manager also collects management (and presumably a performance fee).
Sound familiar. All of these programs have similar themes. Let’s induce private investors to put a very modest amount of capital up. The inducements are: we will cover the downside and we will allow them to have potentially massive profits (essentially giving them an inordinate amount of the upside).
One of the reasons that the market for illiquid assets has remained so illiquid is that everyone expected the government to come in and do something out – to subsidize the private investors. Why buy today when you can get a much better deal from the government? We have expected this since the TARP was introduced last year. And now it comes to fruition.
Yes, the market is up. Why not? It is a good deal for private investors. Did you hear the laudatory comments from PIMCO, BlackRock, etc.? They stand to gain the most.
Yes, the programs will create new liquidity and drive prices of troubled assets upward. However, I believe that the stock and bond markets are putting undue weight on the short-term implications and not thinking through the long-term implications. These programs are not free. The size of the government debt will dramatically increase potentially crowding future debt. The Fed is printing money at will potentially at the cost of future inflation. Eventually, participants will ponder the long term costs of these actions. The hangover will not be worth the party.
Here is the link to the Treasury proposal.