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PPFI: Going to be a disaster

The Toxic Asset Plan detail trial balloons are starting to be floated. This piece in the NYT has some preliminary details.

Basically, FDIC will provide leverage of 85% at something like 1% interest. Then FDIC will also chip in 12% of equity, and the private investor will put in 3% equity.

This is supposed to encourage the private investor to buy assets which are worth 30 cents on the dollar for the 60 cents that it’s marked on the bank’s book.

Devil in the details.

Basically I see only two ways this can play out, either A) It’s not going to work or B)It’s going to work, but produce massive profits for investors and massive losses for taxpayers… at the same time.

A) It’s not going to work

Because the investor still bears the first loss piece. So he is highly incentivized to pick and choose among the assets on offer and price them correctly. What happens when they hold the first auction and all the bids come in below the bank marks? Do you force the banks to sell? Or do you allow the banks to keep them on the book?

B) It’s going to work, but with massive losses for the taxpayer, and massive profits for private investors

This goes back to my earlier ringfencing post. Someone is going to figure out a structure so that assets can be segregated. Investors are going to punt, and they’re going to take the massive profits when they win, and leave everyone else saddled with losses when they lose.

Other considerations:

Special treatment: What happens if Treasure chooses say 5 firms, Blackrock, PIMCO, Western Asset Mgmt, Oaktree and Goldman. Won’t all the other firms scream bloody murder? Varde in Minnesota, Citadel in Chicago, Berkshire in Omaha? Each with it’s own congressional delegation making the appropriate noises? How are they not going to play favorites?

Spreading the wealth: Say due to the last point, anyone with say 50 mil under management gets to play. First it’s going to be an administrative nightmare, they’re going to be thousands of firms. Second, if the SEC didn’t know what Madoff was doing for 20 years, how are they going to keep track of this? What’s to prevent investors from playing games and money laundering and using derivatives to milk the taxpayer?

Is the money really out there? : Treasury seems to think that there’s 30 bill or more waiting to jump into this stuff. I doubt it. Firstly most of the private equity funds have far less money than the stated fund size. Secondly even if they could access it, they probably couldn’t draw all of it down in 1 go. It’s a practical matter because their investors are institutions like Harvard Management Company which simply don’t have liquid assets to fund PE commitments.

So where might the money come from? Foreign investors. That’s right. The guys holding the Treasuries who can put them into this. But it’ll have to be washed, so they’d pump money in through Blackstone or the other group.

Foreign governments are effectively going to assetize their US government debt, and end up owning large portions of the US economy.

March 21, 2009 Posted by | Credit Crisis | , , , , , , , , , , | Leave a comment

How would I play the Treasury’s Public Private Partnership to buy assets?

Let me count the ways…

To recap, Geither proposes that the Treasury will contribute, say 70%-90%  of the funding required such toxic bank assets as long as unnamed hedge funds and private equity funds put in the remainder. Any loss that occurs would come out of the fund’s equity portion, before affecting the Treasury contribution.

Face value

This structure is essentially equivalent to having private investors contribute equity capital in a bank and having the government provide the deposits and unsecured debt. This would form the liability side of the balance sheet, and then the new shareholders would be incentivized to go out and buy bank assets. The key problem that this structure is supposed to resolve is that of price discovery: the private investors would have the incentive to price assets correctly in order not to lose their shirts.

As Mr. Geithner already knows from the AIG bailout, the devil is in the details, so here is an early preview of what could go wrong. Private investors will make a simple evaluation: Can I buy this toxic asset from a distressed bank, such that after whatever defaults may occur in the future, I will make a profit?

Cherry-Picking

The first thing I would do it cherry pick. I would go over a bank’s book, and wherever they have undervalued assets i.e. assets they have marked down already, but I think has a greater chance of recovery than they do, I would buy. This would load up the PPP bank with the higher quality assets, and leave the banks with lower quality assets. In return, the distressed banks will realize a profit because they sold the asset for a higher price than the mark.

Ring Fencing

The next thing I would do is ring fence, or play the odds. This is actually a typical private equity trick. Let’s say I have a 100 million dollars. I split that into ten vehicles, and have the Treasure give me 10:1 leverage on each vehicle. I have a billion dollars of firepower in 10 vehicles. I then make absolute punts with each vehicle, going for broke, buying stuff that no one else will buy. If each vehicle buys an asset at 30 cents on the dollar,  and just one of the vehicles manages full recovery and all the others go bust,  then for that one vehicle:

10mm equity+90mm debt = 100mm assets

after recovery

333mm assets = 90mm debt + 10mm interest + 233mm equity

My return on 10mm would be 2330% and on 100mm would 233%.

Most real banks are prevented from doing this because the Fed and FDIC has restrictions about how much risk they can take on the book, but the PPP vehicles will not.

My ring fence strategy would probably lose the Treasury a butt load of money, because they will lose money on all the other nine vehicles and won’t have recourse to my profitable tenth.

More coming soon…

March 20, 2009 Posted by | Credit Crisis | , , , | 1 Comment