Now It’s Semi-Official: MLEC to Rise From the Dead

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.

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34 comments

  1. American Goy

    “Swedish counterpart, got their bad assets from banks that had already been seized by the state”

    Key point alert!

  2. bg

    Directly capitalizaing banks is unpopular for taxpayers if it means more riches for bankers, and is unpopular for bankers if it doesn’t.

    Buying the bad assets is popular for bankers if it means more riches for bankers by marking the assets to Paulson. Geithner is hoping this will be popular to taxpayers if it is proposed by a Democrat.

    Nationalizing the banks will be popular to the 12 people who regularly comment on NakedCapitalism, but will be unpopular to Americans who equate nationalism with Hugo Chavez, and will be unpopular with bankers who will need to open Quizno’s outlets to earn a salary.

    If theres a fourth idea, I am sure Paul Krugman will take credit for it.

  3. Anonymous

    the only good in this could be that treasury postpones it plan to announce trillions in shitpile guarantees tuesday.

    finally obama delivers hope?

    treasury seems like its failing since it announced the announcment friday… and sunday isn’t even over in cali yet.

    incompetence at treasury is our only hope!

  4. Independent Accountant

    YS:
    The issue of how to value the assets transferred into MLEC, super-SIV, TARP, whatever the current incarnation is, won’t go away. Either Uncle Sam overpays for this junk to bail the banks out, or he doesn’t. There was a recent WSJ piece by Paul Romer about this. My solution, borrowed from Mencius Moldbug, a reset. Let the existing banks die.

  5. alexblack

    Trial balloon!
    Ready, aim, fire.
    You’re welcome, Mr. President. Always happy to be of service to my government.

  6. EEngineer

    At this point appearances are everything. Perhaps they are proposing this option in such a fashion as to show it to be the joke that it is? That would clear the decks for plan ‘B’. At this point we’re in ‘theater mode’…

  7. Anonymous

    The greatest fleecing of an ignorant public for the benefit of the oligarchy continues uninterrupted.
    Let the beating continue.

  8. Anonymous

    Rating agencies just need to continue stamping everything AAA+ and the Fed will buy it, no worries.

  9. Anonymous

    I now Yves. I saw that earlier tonight, and was waiting for your comment.

    In my opinion, the Obama economic team has lost almost all credibility.

    I don’t think that anything truly substantive is going to come out of the political sphere until the fall…when they will have to act, simply because things will be so bad, they have no choice.

    See you in September ;)

  10. Anonymous

    Summers/Geithner/Bernanke will try to ram through a massive gift from taxpayers to bankers by terrorizing Congress. Listen to Representative Kanjorski. Paulson/Bernanke terrified him and others in Congress by saying that there was a 550 billion run in 1 or 2 hours on the banks by money market accounts and funds pulling money out of banks, and buying the banks garbage assets at the prices the banks want would cost $3 or 4 trillion. http://www.youtube.com/watch?v=-xKPcyvlfnc&feature=related

    Kanjorski is so clueless that he thinks the story about the 2 hour 550 billion drawdown is persuasive. It shows there is a problem, but doesn't in any way support a $3 or 4 trillion gift to creditors/executives of the big banks.

    We need Eugene Fama's proposal of putting banks in conservatorship, writing the assets down the vulture bids, and cramming down enough creditors by giving them stock for debt to leave the bank healthily capitalized. Fama's proposal costs the public and the taxpayers nothing.

    Here is a link to Fama's proposal:
    http://www.dimensional.com/famafrench/2009/01/government-equity-capital-for-financial-firms.html

  11. NS

    “Nationalizing the banks will be popular to the 12 people who regularly comment on NakedCapitalism”

    and to some of us who don’t regularly post here, but read it for intellectual and moral clarity.

  12. Frequent

    Some thoughts for discussion:

    1. Govt. allows debtors to sell / transfer their own credit contracts.

    Even without consent of the creditor, debtors should be able to move their "good credit". Worked the other way…

    > Price of "good credit" = easy = value of obligation.
    > Transfer = transfer of credit contract & underlying securities

    2. Govt. announces "Good Bank"

    For temporary period, existing credit contracts can be transferred to Good Bank. Good Bank also hands out new financing.

    Purchase of good credit and new obligations depend on accepted market measures (credit ratings, failure probability, securities posted etc.) = Good Bank only buys/issues good credit.

    > Govt. can define when a credit is "good".
    > Maybe announcement of Good Bank gets credit flowing again. After all – if a bank refuses refinancing or issueance of new credit, the Good Bank can now jump in as alternative.

    3. Good Bank refinancing

    Govt. issues "Good Bank Govt Bonds". Bonds with underlying securities should do well among other countries' toxic bonds.

    > New debt, but for good assets, temporary period and with sense and cause
    > Economy receives credit to get working again.

    4. Good Bank interest

    To be truly temporary, interests received on assets are below market rates. Interests paid on obligations are above market rates.

    > Debtors always have incentive to find cheaper alternative.
    > Govt. can set market interest rate through own rate = a little means of control.

    5. Banks

    Banks keep toxic assets. Receive new cash through the Govt. refinancing good assets.

    6. Silent Burden
    Govt. announces "silent burden clause" for banks. Toxic papers can be written off once. Value of write-off must be declared. Write-Off = Silent Burden, which can be taken out of balance sheet. All future profits must be used to clearing Silent Burden. Dividends can be paid again after clearing.

    > Banks have cash in hand, a clean balance sheet and a new mission.

    7. Concluding

    > Credit for economy is flowing again.
    > Govt. can control credit flow and interest rate levels.
    > No need for Govt. to print money
    > Govt. bond market is not "intoxicated", less risk of Govt. failure
    > Banks keep toxic paper. Have chance for fresh start and can clean up the mess.

    I like it.

  13. Anonymous

    Though no expert I have been reading this blog carefully and now humbly offer my layman interpretation of the Mr Summers-Geithner plan.

    First the background. The out of control MBS market seized up (because it was, uh, out of control). This caused a severe recession AND caused a big fire on bank balance sheets.

    Naturally, and in view of the above inconveniences, the market for MBSs is dead. No tears please. The brave MBSs burned brightly and had a wild ride while speeding through the universe even faster than their masters could calculate. We shant look upon their kind again.

    Or so I thought. Now there is hope for our fallen MBS comrades. For word is coming down from our wise and fearless leaders who have been toiling along the shore of the great Atlantic. The word is that the resurrection is coming. The determined sorcerers inhabiting the Treasury and economic counsels and economic advisory committees and other economically named contrivances will speak magic incantations to the evil recession; they will wave sparkling new taxpayer backed guarantees at the valiant hedge men; suddenly the MBS market will arise and heave to; and the wheels of banking will churn once again.

    In the meantime, and though rather cumbersome to perform, our heroic all powerful government will have swallowed the evilness that plagued the MBS market. Yes this may very well cause the final destruction of the government balance sheet; but surely you will all agree such sacrifice is wise and admirable. Because the fruit of this heroic selfless act of government will be the veritable creation of an artificial, concocted psuedo-MBS market.

    And the Zombieconomy will survive to walk the earth for another cycle.

    So I hope my understanding of this happy ending is correct.

    (Side note: I stand in awe at my new found knowledge that a miracle will soon occur and thanks is due to Mr Summers-Geithner for his relentless commitment to truth and capitalism)

    –Economissed_It

  14. Anonymous

    At least Paulson announced his plans. Not that he ever did anything he announced, but that’s a small technicality. These guys can’t even make an announcement. Obama’s in a real tough spot, caught between Nancy Pelosi and Debt Deflation.

  15. ruetheday

    I have an idea. Let’s structure the MLEC as a CDO, give the government the equity tranche, and sell off the AAA+ tranche on the market.

    Seriously though, the entire idea is absurd. If private investors wanted to invest in failing banks now, they already would have. This plan will not fly in the absence of government backstopping of losses on assets and likely government financing at below market rates. We’re right back to square one, and time is running out.

  16. fresno dan

    “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”

    I keep telling ya – that Amazon I bought at 400$ a share could still show a profit! Just waiting for the market to come back…wait for it…in the year 2525

  17. Donlast

    Behind all this bailout talk there seems to be an assumption that if a solution can be found banks can lend again. This is just another stimulus fallacy. Banks respond to a demand for loans. There is not some Say’s Law which says bank supply of loans generates its own demand. Currently, there is no net demand for debt – period. People want to get rid of it. Whatever is done the banks are supine and Depression continues because the economy is having to be reset to a lower level of sustainable output consonant with long-term real productivity and real income growth with debt/GDP ratios back to historical norms. I mean real productive activity to meet the average households wants – not ersatz activity as envisaged by the Democrats condom stimulus.

  18. Anonymous

    Lets offer the Big Bank CEO’s a Billion Dollar bonus if they can revive our economy in 6 months.That ought a do it.

  19. David

    They will do something so complicated that the public won’t understand it (that is not hard) but which will benefit the banks. They will make it look like they are being tough and all the chief bankers will complain in public. For example, they might take a 30% equity stake (gasp!) and put curbs on executive pay (in an easy to get around way). Then they will tack on all kinds of meaningless but showy things to appease the public.

  20. TallIndian

    The idea of ‘private participation’ is akin to what happens in most con games.

    To induce the ‘mark’ to invest in some scheme, the con artist claims to have his own money on the line also.

    No one ever went broke underestimating the intelligence of the American news media.

  21. nanute

    Changing the rules in the middle of the game will have unintended consequences. (Remember the S&L crisis)? The "market" created this mess, and only the "market" can correct it.

  22. Stuart

    essence of the situation is the losses are so large, nobody wants to take them. And the tumor continues to grow. Inflating them away seems to become more and more likely each day.

  23. DoctoRx

    The deeper point than what to do w insolvent financial institutions is that we need less credit and more equity in the system. Shakespeare had it correct even though he had Hamlet call Polonius a prating old fool: neither a borrower or a lender be.

    The rot goes beyond our banks. In my blog I detail the massive negative tangible net worth of Procter & Gamble and AT&T. Our economy has been "financialized" in innumerable ways.

    And notice Yves' earlier post wherein the CEO of Saks states that Saks would/could have gone under absent price slashing. One bad season and Saks could have failed? How many other companies are one or two down quarters from bankruptcy?

  24. Anonymous

    I think this plan is much better than most of the previous plans.

    You seem to think it is hard to set the guarantees. Why? Why not just set the guarantee at 30% less than the private purchase price?

    The private purchaser cannot make money by losing 30% on every transaction, so they have a strong incentive to bid wisely. However, offering insurance that the private purchase won’t lose more than 30% should draw more private capital out to purchase (and value) the assets. You should get competitive bidding for the assets.

    This prevents the gov’t from having to value the assets. It doesn’t have the expertise to value them anyway. The private sector values the assets. The gov’t provides them an incentive to do so now by limiting their downside risk.

  25. Anonymous

    If Steve Keen’s point that credit precedes the creation of money is correct then the Obama team is doomed no matter what they do. Trust is gone, ergo credit is gone. The tattered balloon is blown and lies flapping all about in rubbery shards. The wind is howling and the doors are creaking on rusty hinges. The party is over but we have yet to discover that the binge we just paid for with tomorrow’s earnings that let us play in the holodeck for a few hours using that “City of Tomorrow” theme has drained our batteries and we now find ourselves in a financial dust bowl. Yes, Dorothy, we’re back. Sadder but no wiser.

  26. Anonymous

    Donald Trump for president! Let’s get going, gang. I think he has a good shot at it. Who else has dealt with so many financial failures and still remains standing?

  27. Eric L. Prentis

    The US is way over-banked with approximately 8,000 institutions, we would not miss 25 percent of them during this downturn, consequently, let failed banks go bankrupt. The Fed/Bernanke is trying to save all the politically connected banks and equating that with saving the financial system, which it isn’t. Also, the Fed/Congress is not investigating what went wrong during this financial crisis and how to fix it, e.g., what do we do with CDS (answer: they should be illegal in their present form because they are “bucket shop” contracts), lax regulations (they should be beefed up but which ones and how should they be better enforced) and phony accounting rules (how was Lehman ever a sound business with a $100 billion dollar hole in their balance sheet). Doing more of the same and expecting a different outcome is the height of irresponsibility, but obviously the slimy-on-the-take politicians, i.e., Geithner/Summers/Bernanke/Schumer/Dodd/Frank, subscribe to the Bernie Madoff swindling school of investing and believe the American people can be conned.

  28. Anonymous

    There’s no need for a Bad Bank — we alrady have one. It’s called Citibank.

    Vinny GOLDberg

  29. Anonymous

    You know, I kind of knew these big banks were on their way out some 4 or 5 years ago, when Bank One (big Chicago bank now part of JP Morgan Chase) decided to remove all chairs from their lobbies, and instead plant a standing-room-only counter, like the ticketing counters in airports. The idea was that if customers stand, they won’t waste too much of their clerks’ valuable time with small talk, as the pain in their legs becomes unbearable. Well, I for one have always loved to chit-chat for hours with bank clerks, so I immediately moved my trillions in savings to my friendly neighborhood community bank. Now I chit-chat all I want, and let me tell you, they have a heluva bunch of comfy recliners.

    And, last I looked, my little community bank was still rock solid financially.

    Vinny GOLDberg

  30. ciccocicco

    Government buys the toxic assets from the banks at prices a bit higher than market.
    What is the government buying? Mostly debt owed by little guys to the banks.
    Government is all of the little guys.
    Little guys are buying back their debt at fraction of the nominal (score 1 for the little guy).
    Government pays for the toxic assets by printing a lot of money, resulting in high inflation, price of assets under the toxic assets shoot up.
    Value of the toxic assets owned by the government shoots up (score 2 for the little guy).
    Value of the money given to bank to pay assets goes down.

    At the end of the story the rich guys (owners of the bank) have mostly been expropriated of all their possession. The little guys have been given by them the gift of their large houses (gains from the toxic assets will be used to help people pay down mortgages).

    Day dreaming ……. sometime is fun just to dream …..

  31. Let them eat cake

    Buy and aggregate the GOOD assets into a new bank and leave the BAD with the banks to try and manage, fixes all the problems and doesn’t bail out the shareholders, bond holders and failed managers.

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