The New Toxic Asset Plan
Tuesday, March 24, 2009
Yesterday, we finally got some clarity on the Treasury’s toxic asset plan and the market appeared to like it – but the devil is in the details. I am going to attempt to simplify it – for my readers as well as for myself!!
So, let’s start with an overview of what has been clogging the credit markets: the biggest problem has been the legacy (toxic) assets which are complicated parts of home mortgages - many of which have gone bad, and many more of which are likely to go bad in the near future. For simplicty, suppose a bank has $100 million (face value) of these assets on its books. But due to the increased bad debts associated with these assets and mark to market accounting, the banks have had to mark the assets down to $80 million, and in the process have had to take huge losses (in this case $20 million). Most of the banks would like to get these assets off its books, but claim there is no market for them or in other words that there is a liquidity issue.
In reality it might not be a liquidity issue since there are people out there who might be willing to buy those assets for say $10 million. That, however, would require the bank to write-off an additional $70 million and if it did so, it would be bankrupt. However, let’s just say this bank is in the class that has been deemed “too big to fail.” So in comes the NEW PLAN.
Under the new Toxic Asset Plan, the government will hire five investment managers to raise capital with a “dollar for dollar public match.” These managers will then be able to access debt from the Treasury equal to “50% of the combined capital to purchase these toxic assets from the banks.” Under this plan, if a money manager is willing to buy these toxic assets for $70 million, it would put up $5 million in equity and the government would also put up $5 million in equity capital for $10 million in total equity capital supporting $100 million in face value assets, and $70 million of market value.
The government will then lend this partnership (itself being a 50% partner) $60 million on a non-recourse basis. In this scenario, the bank will have to take another $10 million write-down (remember it’s at $80 on its books now) - which will hurt, but it sure beats marking it down by $70 million to $10 million – which the market is now willing to pay.
So what hapends after the assets are purchased by the private public partnership?
Let’s say that over time, the price of the assets go up to $90 million. When the assets mature or are sold, the partnership will make a $20 million profit and will repay the $60 million loan. The profits are split between the investor and the government, each of which will have turned a $10 million profit on a $5 million investment. The private investor gets a 200% return. The government also makes a 200% return on its $5 million equity stake, but in reality, it put up $65 million not $5 million, - the loan plus the equity stake. So the government’s real return is a lot lower - 15%.
Now, let’s say the price of the assets go down and are worth only $50 million and the loss is $20 million. The private investor loses his $5 million investment, but that is all he loses – his losses are capped. The government owns all the assets, and is now out $15 million.
Given the size of this program, starting at $500 billion of assets - the holders of these toxic assets will not be able to claim that the only reason people are willing to bid $10 million for the $100 face value of assets is that they don’t have the cash to bid more – because there will now be plenty of cash to do so.
If with all this cash in the hands of several of these public private partnerships they start to bid up the price of these assets to $80 million, well then, problem solved. The bank that currently owns them will not have to take any more write-downs.
There have to be both buyers and sellers for there to be a market. The assumption on the part of the government plan is the reason that there is not much activity in this market is that there have been no buyers. But is that assumption true? There are buyers out there, but they are only bidding $10 million right now. Banks could sell vast amounts of its toxic sludge at $0.10 on the dollar tomorrow if it so chose to. The result of course, though, would be that the bank would be even more broke than it is now; it would have to take that additional $70 million hit on top of the $20 million hit it has already taken has done to it.
So, do the banks have a liquidity issue as they claim or a solvency issue? If they have a solvency issue – what are the effects of this plan on taxpayer money?
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Posted by mmnn on 09/20 at 06:01 AM