Dear Reader: Please give me 8 minutes to explain the $1.1 trillion federal government Public-Private Investment Program (PPIP).
Start here with this simple example. It’s a coin toss. Heads you win $100; tails you get nothing. How much would you pay to play? You can play as many times as you wish. Answer: not more that $50. For less than $50 you would play as often as you can. $50 is your breakeven; only a fool would pay more.
Now add Tim Geithner as your partner. He matches what you invest but you, and only you, get to set the price to play. Answer: you put up no more than $25 as the investor and that means he matches your number. At under $25 you play as much as you can. $25 is your breakeven as the investor; $50 is still the breakeven for the coin flip.
Now let’s add some of the leverage from the FDIC.
Suppose that the FDIC will loan you $40 as a non-recourse loan. You and Geithner each put up $5 for a total of $10 and, adding in the loan money, you pay $50 to play, just as before. If you get heads, you pay off the loan of $40, and you and Geithner split the rest. That means you get $30 for your $5 and so does he. Remember, you set the price to play. If you get tails you get nothing and lose $5, Geithner loses $5, and the FDIC loses $40.
Now suppose we have an auction to decide who will play.
The highest bidder wins the right to play as many times as he wishes. With this example, the breakeven price rises from $50 to $70. At $70 you put up $15; Geithner puts up $15 and the FDIC still loans $40. Half the time you will win $100 and use $40 to pay off the FDIC, leaving $60 for you to split with Geithner. You will get $30 back for each $15 you play, when you win. The other half of the time, you will get zero, since it’s still a coin flip risk.
Notice that the price to play went from a $50 breakeven to a $70 breakeven. This happened while the odds remained a 50-50 coin flip.
Also, notice that the leverage ratio was low when you put up $15, Geithner put up $15, and the FDIC put up $40. Under the Treasury PPIP plan, the leverage ratio can go as high as 6 to 1. Using the full 6:1 leverage ratio, a coin-flip breakeven point would be about $6.25 for the investor.
Here is how I get that number. You put up $6.25; Geithner puts up $6.25; the total investor’s equity is $12.50. The FDIC loans 6 times or $75.00. Total price to play is $87.50. Each time you play you either collect $12.50 or zero.
Notice that the breakeven auction price is now $87.50 each time because you, as the private investor, are the one who sets the auction price. You are the only one who controls the bidding. Geithner is matching you and the FDIC is loaning 6 times the equity.
The leverage and the risk transfer have raised the investor’s breakeven from a $50 auction price, if you did this all by yourself and without any leverage, to a $87.50 auction price when leverage is fully deployed. The risk of winning or losing is still a coin flip.
Let’s substitute a toxic asset on a bank’s balance sheet for the coin.
Instead of a 50-50 coin flip, with PPIP we have a toxic piece of a mortgage-backed debt instrument that has an uncertain value. If we use PPIP, aren’t we really inflating the price artificially? It seems to me the answer is yes.
How can we adjust for this risk transfer that allows the auction breakeven price to rise? That answer lies in how much the FDIC will charge to make the non-recourse loan. If the FDIC charges enough, it will bring the auction price back to $50 and restore the deal to neutrality. If the FDIC charges more, it will bring the price below what it would be without the leverage.
But if the FDIC underpriced the loan cost, it would then have subsidized the deal and allowed the auction price to rise. That means the seller of the toxic debt instrument got more than it was worth and the investor made a profit because of the FDIC.
Some of the risk of payment on that instrument transferred to the FDIC. That means it transferred to the FDIC insurance fund, which means it transferred to every insured deposit in every bank that pays an insurance premium into the fund. That means the depositor may be getting a lower interest rate on that deposit than he otherwise would get.
That is PPIP.
Some Questions. Will this process set a true “market price” for these toxic assets or are we using a gambler’s pricing mechanism? Has Geithner been transparent about this risk transfer to the FDIC? What will the FDIC charge investors when it assumes the 6:1 leverage risk? Will it price risk fairly or will it grant massive subsidy to banks?
Dear reader: you decide if this is a good thing or a bad thing. You decide if this is how it was presented to you. You decide if this is a sound policy solution for the US banking system or if you believe that, our government has taken “moral hazard” to a new level with pee-pip?
For more details on PPIP see this weekend’s issue (March 30) of Barron’s and the columns on PPIP by Jonathan Laing and Andrew Bary. They start on page 25 and offer an investor’s view. As a money manager for our clients, the Cumberland firm will look at PPIP and may use it on behalf of clients after we have reviewed an official form of an offering document. As a private citizen concerned about my country and its policy direction, I think this reeks and stinks.
Heads or Tails? - Part II
We thank readers for their responses to our “Heads or Tails” commentary, dated March 29, 2009. Many issues were raised. We will use this Part 2 to address some of the items and correct technical errors or lack of clarity in our first missive.
First, let’s offer a recap and explanation. In Part 1 we used the metaphor of a coin toss to depict how leverage works to raise the auction price of assets. Six to one leverage is the maximum under PPIP. We used it to dramatize the volatile effect on the auction price. Some components of the PPIP are likely to have much lower leverage ratios. We also argued that the transfer of risk to the federal government is the mechanism of the PPIP. We pondered whether this process actually will result in an artificially inflated transaction price. The financial market reaction to the announcement of PPIP suggests that it will. Lastly we questioned whether this is a sound policy prescription for the United
Technical and clarifying points follow:
1. PPIP is divided into two categories. The first deals with loans on the books of banks. The second deals with securities held by banks, insurance companies, and others. Treasury calls both “legacy assets,” but it is important to note that the programs dealing with each of these two categories differ in construction and leverage.
2. The FDIC is involved in the loan program. It doesn’t lend directly; it acts as a guarantor and receives a fee. The pricing of this fee is critical, as we outlined in the first commentary. At this writing we do not know what the pricing mechanism will be. The FDIC is asking for comments, as readers can find for themselves at http://www.fdic.gov/llp/index.html . A full description of “legacy loans” is available.
3. The Federal Reserve and the Treasury are the financing sources of the securities category. A more detailed description is available on the Treasury website at http://www.ustreas.gov/press/releases/tg65.htm. This is the March 23, 2009 press release. Several links at the bottom direct interested readers to the details.
Some thoughtful responses to Part 1 are reproduced below. We are withholding names of all writers, since some have asked for anonymity.
From a seasoned and skilled broker who has special expertise in bank stocks:
“Those institutions that have marked both loans and investments properly will have capital added to their balance sheets as they sell: let us hope and pray that is the majority of them. By the way, one might conclude that it is a good time to buy those stocks aggressively, as they benefit handsomely from this plan. They may even be able to mark up their remaining assets as market pricing improves. Could you imagine book values growing from this? Stranger things have happened.”
“Those institutions who have not priced their assets ‘to market’, but are still in the ‘ballpark’ (forgive me, baseball is upon us) will get bailed out as leverage encourages higher prices, and that may not be all bad as their balance sheets are cleansed. One can speculate that fear may have driven down some of these prices to levels that are penurious at best. This assist may let assets clear the markets at more realistic levels, whatever that means. “
“What are the prices going to be? Will the banks really sell assets or will they be too afraid to test the waters? In many cases their investment securities are marked to market, but how about their loans? Price realization in that area has me concerned, but I am hoping that once this logjam gets moving it will adjust quickly, as participants don’t want to miss this one. So many questions!”
“Understand I am just speculating here, as I have never seen anything like this — but I sense a real opportunity here.”
From a former Federal Reserve official, about the theoretical breakeven point:
“The FDIC isn’t lending the money, but rather the buyer has to issue debt. The cost of the debt and the cost of the guarantee will make its price critical. This should trade like Treasury debt, I believe; and if it does, then the fee and interest costs will have to also be shared between the investor and Treasury, which will lower the breakeven point. They haven’t decided on whether this debt is tradable or not. If it isn’t, then it will bear a higher interest rate than treasuries for liquidity reasons. Also, it will compete with Freddie and Fannie debt and also with the flood of Treasury debt that will come on the market. In the end, won’t there be moral hazard as the investors who have to be sellers of the debt to finance the program bid up the interest rate they are willing to pay to get a share of the market, which will exacerbate the price discovery mechanism and lead to overpayment for the assets in auction?”
From a prominent law school professor:
“Your concept did come through, and it was a very good way of explaining it. It’s just that the loan/securities distinction means little to most casual observers, but is really big. It also shows how the government has spun this. The loan program is open to anybody and has 85% financing. The securities program will be handled by 5 managers and they must each have 10bb of MBS under management. And, most of what are called “toxic assets” on balance sheets are securities not loans, so the latter program will by necessity be bigger and the discounts larger. So the best opportunities in this deal may well be only for the very institutions that are so often blamed for how we got here. But by making it seem that the loan program is equal, and emphasizing it, the administration is able to make the whole thing seem much more egalitarian than I suspect it is. Pardon if my cynicism is showing, but I am not a big fan — as a citizen — of the program. As a businessperson, if we can figure out how to play in the sandbox, we will try to have a lot of shovels and a sturdy bucket.”
From an insurance executive:
“A traditionalist would hang on dearly to the ‘good’ in the financial world, wanting to believe that the world as we know it is not “The Matrix” or the Mother of All Ponzi Schemes (MOAPS, to stay in tune w/ the government’s acronyms). A New World theorist would comment that this is all part of the plan to dismantle the US and level the playing field. The theorist believes that the Obamas and the Geithners of the world aren’t who we think they are, but have been ‘bought’ to play their part in the plan. Unless you ask me to cease and desist, as a patriotic American (which I imagine we both are), I will continue to stay in touch as we observe the gradual erosion of the America we once knew when we were younger.”
From a seasoned investor with skills in the mortgage arena:
“The current idea floated by financial institutions, and the media in partner with them, is that these derivatives may actually come back in value. That cannot and will not happen for very concrete mathematical reasons. “
“A CDO built in 2005 is almost certain to contain mortgages written with 105% financing with 50% DTI. Those loans are blowing up at enormous rates. Hence, since the CDO’s return is predicated on nothing more than a positive flow from the underlying securities, every tranche containing blown mortgages exceeding the modeled margin of default is a 1000!o loss. “
“Underwriting guidelines have almost returned to sane levels. The banks are lending, but the new guidelines limit those that are lent to. That has eliminated more than 50% of the possible buyers which existed 3 years ago.”
“The only way for any of the CDO’s, CMO’s or CLO’s to retain any value is if housing values go back to where they were in Jan 2006, and soon, before any more mortgages in the underlying MBS go into foreclosure. “
“My point is this: even the conduits are a time bomb, which will realize near 100% losses, unless housing values dramatically rise, right now, so no more houses (mortgages) in the MBS go bad, and give the current mortgagees a way out through sale for profit or true refinance. “
“Every credit derivative based on obscene underwriting guidelines will eventually be a near 100% loss. For that to be different, we need to let as many people back into the buying market as were present then, to put upward pressure on housing values. “
“The only way to do that is to adopt, again, obscene underwriting guidelines. Because that will not happen, any and all monies given banks to cover losses with credit derivatives will be a total loss. I believe it is better the banks assume the loss. There are several hundred middle-tier banks with no credit derivative exposure, and little residential or commercial RE exposure. They can and will fill the void should some “big brothers” go by the wayside. “
“The PPIP is nothing but a shell game, and will drag this country somewhere no one wants to go.”
From a stranger known only as JPM:
“Your explanation assumes that the buyer and seller are unrelated and have no association. If they have related interests, then it gets much much worse.
“There is nothing substantive in the Treasury Dept language that prevents the seller of (say) MBS from creating an “unrelated” third party, who can then compensate the buyer for bidding face value of the assets. The PPIP is so easy to game it ought to be DOA.”
From a regular Cumberland reader who gives a jet-lagged writer some comfort and strength to continue:
“This analysis couples with John Hussman’s article regarding the potential abuses of the PPIP — namely that sellers of the ‘legacy assets’ are actually allowed to bid on their paper or the paper of other sellers, opening the door for all sorts of conflicts. Where are the checks and balances of this auction process? Once again, the US taxpayer is going to get left holding the bag as the banks that created this mess get a ‘Get Out of Jail’ card for free. This is going to end in a disaster, as a massive transfer of wealth is happening right before our eyes. I for one am writing to all the Congressmen/women who have the wisdom to see the folly of this plan. “
“For your part, you nail the conundrum squarely — as an investor you see a tremendous opportunity to make money with the risk/reward balance tilted severely in your favor. As a citizen of the US, you see a tremendous burden being placed on the taxpayer and future generations of Americans. Time will tell which path is taken.”
We offer this from a hawkeyed reader who embellished the math:
“When comparing this auction price to the hypothesized fair value of the unleveraged bet of $50, there is a $37.50 premium induced by the leverage. Alternatively, the owner of the asset with a $100 nominal value takes only a $12.50 haircut in the auction.”
“A perhaps more realistic example, however, would be to suggest that the asset might have a value of $100 or $80 with a 50% probability of either result. In this case, the fully leveraged breakeven point is $6.43 for the private investor, $6.43 for the Treasury, and a FDIC loan of $77.16. In this case the payoffs would be $22.84 if the asset was worth $100 and $2.84 if the asset was only worth $80. The fair value of this coin flip bet is $12.84 (within rounding of the equity portion of the purchase price) and the auction price would be $90.02. This auction price is almost exactly the fair value of the original bet $90.00 and the owner of the asset takes a haircut equal to the full difference. I think this example shows that in the case where the nominal and worst case values of the asset are closer together, the leveraged auction will produce a reasonably equitable result.”
“The difference in outcome between these examples lies with whether the FDIC takes a loss on its loan. This occurs when the worst case value falls below $75 in this coin flip world. As long as the equity partners are not exposed to a loss in the worst case, the breakeven private investment amount will remain $6.25 and there will be a premium paid above the fair value of the asset.”
And this is from an expert in a ratings agency:
“I work in a small group in (name withheld) that focuses on the capital markets, and I have followed your firm for--well, about 100 years. Some of you (the older ones) might recognize my surname and know why.”
“I agree with Mr. Kotok's assessment of the PPIP. Actually, if you look at the Treasury's statement, there are a few interesting things to be gleaned from it--at least in my opinion. First, on "legacy securities", it looks like they finally got Pimco's and BlackRock's agreement on the terms they would accept and will now allow 3 more firms to bid as long as they can get their applications in by April 10th. Given the "eligible securities" (originally rated AAA, collateral has to be connected to securitization), I can't imagine that much will actually trade hands because it looks like the asset managers were looking for the "lay-ups"--the RMBS that are performing quite well, thank you very much. Prices may not be great, but cash flows are still coming through. What bank wants to sell those? I would buy them without leverage from the Treasury. CMBS prices are terrible, but underlying asset prices are soon to follow, so prices reflect collateral, not liquidity discount.”
“But on "legacy loans", different story entirely. First, check out the different type face. What? Is the Treasury talking with two voices? This was not limited to 5 managers, and, reading between the lines, they were going to be willing to be a lot more flexible on terms. They are desperate on whole loans. They see the problem (I go to the FDIC failed bank list every Friday), and they see the problems coming.”
“On all of this, yes, I think the government is taking, has taken the wrong approach. My biggest beef was paying face on the CDS contracts from AIGFP, but that was not the issue here. I think there is enough revulsion from many quarters, financial and even non financial, that we are close to the end of this. I certainly hope so.”