Remember the embarrassing ten weeks of so of Henry Paulson failing about to try to get his “get the bad assets out of the structured investment vehicles” effort, the MLEC, also fondly known as The Entity, off the ground?
It quietly faded from the headlines.. Why? It was supposed to be a private sector solution, but guess what? Investors had no desire to buy assets at phony prices, and banks didn’t want to unload them at market. Various efforts to finesse the basic problem predictably got nowhere.
Then we had MLEC version 2.0, aka TARP version 1.0. Remember, the original concept of the TARP was that it would buy bad assets, “cleansing” banks so they could go forth and
make the same mistakes all over again lend. But that died stillborn because Paulson has mistakenly sold the bad bank plan by saying that taxpayers wouldn’t lose money and might even show a profit. But the only way for the program to make any sense for the banks was as a back-door recapitalization, permitting them to sell assets at above the value at which they were carried on their books (and they’d particularly have an incentive to unload those assets where the carrying prices were most above market). So that notion got scuttled quickly.
But the bad bank concept refuses to die (although its advocates seem to forget that previous US version, the Resolution Trust Corporation, and its ballyhooed Swedish counterpart, got their bad assets from banks that had already been seized by the state). Now the Wall Street Journal and New York Times report that the bank rescue plan, to be announced by Geithner on Tuesday, includes a new version of the MLEC concept. From the Times:
Administration officials said the plan, to be announced Tuesday, was likely to depend in part on the willingness of private investors other than banks — like hedge funds, private equity funds and perhaps even insurance companies — to buy the contaminating assets that wiped out the capital of many banks.
The officials say they are counting on the profit motive to create a market for those assets. The government would guarantee a floor value, officials say, as a way to overcome investors’ reluctance to buy them.
Details of the new plan, which were still being worked out during the weekend, are sketchy. And they are likely to remain so even after Treasury Secretary Timothy F. Geithner announces the plan on Tuesday. But the aim is to reduce the need for immediate federal financing and relieve fears that taxpayers will pay excessive prices if the government takes over risky securities. The banks created those securities when credit and home prices were booming a few years ago.
And the Journal:
The administration’s plans have evolved over the past several weeks as it has considered and discarded a host of ideas, with financial markets anxiously awaiting details. Mr. Geithner had planned an announcement Monday but delayed it a day to allow the focus to remain on the stimulus bill in Congress.
The aggregator bank, which some refer to as a “bad bank,” would be designed to solve a fundamental challenge: How can banks purge themselves of their bad bets without worsening their weakened condition?
The entity would be seeded with funds from the $700 billion financial-sector bailout fund, but the idea is that most financing would come from the private sector. Some critical elements remained unclear, including exactly how the government would entice investors to participate in the private bank, given that they can already buy soured assets on the open market if they want to. The government will likely offer some type of incentive, such as limiting the risk associated with buying the assets.
The administration hasn’t settled on exactly how it will work and intends to hash out the structure with the private sector over the next few weeks, the people familiar with the matter said. Investors would likely buy a stake in the entity, which would then buy mortgage-backed securities and other troubled assets.
The government would also be an investor, but the terms aren’t yet decided. The entity might also raise funds by selling government-backed debt or through financing from the Fed, the people familiar with the matter said.
This is so far from being a plan I cannot believe the Obama administration is putting it forward. This is well short of the sort of term sheet or agreement in principle that then gets hashed out in deal land to close a transaction. The basic structure of the New Entity is up in the air, subject to negotiation with a variety of investors who likely have differing perceptions of risk and investment time horizons (how does this work for a hedge fund that has to report its net asset value to investors monthly, for instance? That is one of a host of considerations on the investor side). Expect a rerun of the Paulson MLEC saga, weeks of floundering as the Treasury tries to herd cats.
And the issue that the MLEC version 1.0 and 2.0, how to value the assets, remains unresolved. If you believe these reports, the government hopes to finesse that somehow by having investors own part of the bank. But these investors can’t be active; it’s impractical and unwieldy. Someone will have to act as an asset manager with parameters as to how to buy assets. And look how long that took to get sorted out for the aborted MLEC: they had to have a beauty contest, negotiate fees, select a manager (Blackrock). And how happy will investors to pay fees to a manager, particularly one that in many cases in a competitor?
And how do you set the level of the government guarantee? Some types of assets, like CDOs, are completely heterogeneous. Each deal has a unique set of underlying assets AND a unique structure. Some are so hairy that it takes an experienced analyst a full weekend to value them. And they don’t decay in value in a simple fashion. The falloff in value depends very much on .
when and how the assets perform, and the falloff is NOT linear.
An asset-by-asset guarantee (say at some % of expected loss) that is then aggregated across the pool is unworkable, but anything else would seem to increase the odds of adverse selection (particularly, as noted above, the likely heterogeneity of the assets). Indeed, banks that think their assets might not be so bad don’t want to play ball. From the Journal:
Executives at J.P. Morgan Chase & Co. have been cool to the idea of selling assets into a “bad bank” structure. They believe it may be wiser to hold on to sour assets that have already been written down, in the hope the bank can recoup losses when markets revive.
And JP Morgan’s lack of enthusiasm raises another complication: will selling assets to the program be seen as an indicator of weakness? After all, it’s an admission that you have really bad assets and presumably had deficient enough procedures to be over their head with them (although I am told there are banks that are well run, like Fifth Third, that are in simply lousy geographies, in this case Ohio and Michigan).
To put it more simply, this deal works only if the government is the bagholder, big time. This elaborate structure is merely designed to put lipstick on a pig by dignifying the fiction that there might be some upside to the taxpayer and using guarantees to disguise what the ultimate cost might be.
The one bit of hope here is that so few of the obvious problems have been resolved that MLEC version 3.0 may, like its earlier iterations. never get off the ground.