The $2 Trillion Question: Will Investors Buy the Government's Toxic Asset Plan?Published: April 01, 2009 in Knowledge@Wharton
The Obama administration has announced a vast effort to get up to $2 trillion in toxic assets off financial institutions' books by offering taxpayer-backed loans to hedge funds and other investors that might buy them, trying to improve on earlier strategies that have failed to rekindle trading in securities backed by mortgages and other debt. The goal is to thaw the credit markets -- to get banks to lend money the economy needs to grow.
Will it work? Experts have mixed views.
"I think they are headed in the right direction," says Wharton finance professor Jeremy J. Siegel, arguing that the government's non-recourse loans will encourage hedge funds and other potential buyers to offer attractive prices for banks' toxic assets. (Non-recourse loans are those where, if a borrower defaults, the lender cannot go after any asset other than the security pledged as collateral.) The government will put up about $6 for every $1 spent by investors.
Are 'Mark-to-market' Accounting Rules on the Mark?
"If they provide good lending terms and lend a substantial amount, you could get prices that are substantially higher than what the market is paying today," Siegel notes, adding: "They are going to reignite a market." But others are not as certain. "The policy makers have to be given credit for systematically attacking the integrated components of these problems," says Wharton real estate professor Susan M. Wachter. As for whether this strategy will succeed, "I think it will be three to six months before we know whether it's working."
Initially, the financial markets were enthusiastic, and stocks soared around the world after the March 23 announcement. But most experts say big questions hang over the program. "Will these [investors] pay sufficiently more than what are now called fire sale prices to induce the banks to sell?" asks Wharton finance professor Marshall E. Blume. "That's the big question."
Banks are unwilling to sell at rock-bottom prices because that means booking losses that could be avoided if prices recover later. Among the problems: The value of a toxic asset largely hinges on the default rates of the underlying loans, a figure that cannot be predicted. Some of these assets are safer than others, but not many people are equipped to tell the difference. "It is almost impossible to figure out the prices of these things," Blume says.
Ultimately, the health of the housing market is the key to default rates, according to Wachter, and it is too soon to know when home prices will stop falling. "It is the purchase price of homes that will determine the value of the toxic assets -- the mortgage-backed securities."
If the new purchase programs lead to market prices too low to induce banks to sell, they will prolong the uncertainty about bank liabilities that has choked lending. On the other hand, the public loans dramatically reduce buyers' risks, which could lead to prices that are too high, putting taxpayers at grave risk if the assets turn out to be worth less than the investors borrow from the government.
Finally, no one knows for sure whether bank lending will resume even if toxic assets are removed from their books.
Las Vegas vs. Philadelphia
The bulk of these assets are fashioned by bundling mortgages together and creating bond-like securities that give investors shares in homeowners' monthly mortgage payments. "A lot of them are mortgage [backed securities], but there are probably automobile loans out there, credit card debt, all sorts of things like that," says Blume.
But the broad term "mortgage-backed securities" doesn't give an indication of their great variety. A security based on mortgages from Las Vegas -- some are packaged on a regional basis, though most are a broad mix -- is far riskier than one with mortgages from Philadelphia, because the plunging housing market in Nevada has caused many more homeowners to fall behind in payments there. When homeowners default, securities based on their expected payments lose value.
In addition to geographical variations, some toxic assets contain loans to borrowers with poor credit, while others do not. Some of these securities put their investors first in line to receive homeowners' payments, while others don't pay off until the higher-ranked investors have been paid.
Because these variations make the assets so hard to price, no one knows how hazardous they are to the banks that own them, especially as a bank may own a wide assortment of such assets. In this climate, banks are wary of lending to one another for fear they might not be paid back. That has choked lending to businesses and individuals. The freeze-up also has made it extremely difficult for banks to bundle new loans into securities. They need to create these securities and sell them to investors to raise cash for new loans.
Last fall the U.S. Treasury and Federal Reserve proposed dealing with these problems by purchasing the toxic assets with government funds, in hopes of reselling them to investors later. But as soon as the $700 billion Troubled Assets Relief Program was approved, the agencies dropped the plan and started pumping the money directly into the banks, arguing the crisis had become so severe it needed quicker action.
With the crisis dragging on, the Obama administration returned to the idea of buying up troubled assets. The first outlines of its plan were announced in February and were widely criticized as too vague. But the March 23 announcement of the Public-Private Investment Program provided details of three interconnected moves to buy up to $2 trillion in toxic assets.
Under one part of the plan, the Federal Deposit Insurance Corp. will oversee the auction of bank-owned bundles of mortgages to investors such as hedge funds, private equity funds and pensions. The government will lend investors up to 85% of the money they need for the purchases, and it will use taxpayer money to match investors' spending for the remaining 15%.
In the second element, the Treasury will lend money for a joint public-private purchase of mortgage-backed securities and pools of mortgages. Together, the first two programs could buy up to $1 trillion in assets. The third program will buy about $1 trillion in toxic assets through the Term Asset-Backed Securities Loan Facility, or TALF.
To attract investors, all three programs will offer non-recourse loans secured only by the underlying assets. This means an investor such as a hedge fund can lose only the money it puts up itself for the asset purchase. While borrowing at a six-to-one ratio will increase potential profits, potential losses will be limited because the investor will not be liable if the assets bought with borrowed money turn out to worth less than was paid. In that event, taxpayers would lose money when that portion of the loan is not paid back. Taxpayers could make money if the investments end up being worth more than was paid, and they will earn interest on the loans.
Tapping the Private Sector
A critical feature of the new plan is its attempt to harness private money, which was not part of TARP when it was approved by Congress and President Bush last fall. The government wants private sector involvement, according to Wharton finance professor Richard Marston, "because of the obvious reason that this stretches TARP funds [and] it gets the private investors to value the assets."
Under current conditions, market prices for many of these assets are extremely low, but many are sure to be worth much more if held until they mature -- when all the homeowner payments have been made. Encouraging private investors to buy should help set prices somewhere between these two extremes, Marston says. "By getting the private sector involved in pricing and by subsidizing the private sector and perhaps taking on the downside risk, you get prices that help the banks while jumpstarting the markets." Still, he worries that in the wake of the AIG bonus controversy, financial players will be reluctant to get involved in the asset-purchase program for fear of government conditions such as restrictions on executive pay.
While taxpayers will have hundreds of billions of dollars at risk, they will lose money only if investors badly misjudge the assets' values, according to Siegel. "The government doesn't have to put out any money unless these assets get purchased at prices which are substantially higher than what they are worth," Siegel says, adding, "I don't think taxpayers are going to take a bath on it."
Though the market for toxic assets is sluggish, it does exist, providing a starting point for establishing values. "For many of these toxic assets, there are markets and there are market prices," Blume notes. But "those are fire sale prices [and they are] lower than what the banks want to sell the assets for. That is the basic issue. Now the government is giving a valuable subsidy to buyers of these assets."
In many cases, accounting rules allow the banks to use their own mathematical models to value these assets when they account for them in their financial statements, and these "mark-to-model" prices can be substantially higher than current market prices. Selling for less -- at "mark-to-market" prices -- forces an accounting of the sale at the lower price, weakening the bank's financial performance and perhaps causing it to fall short of capital-reserve requirements.
By offering low interest rates, allowing loans to be carried for long terms and insulating borrowers from big losses, the government may induce investors to bid up asset prices, Blume estimates. In addition, he suspects the government, which regulates the banks, may be making "suggestions with a hidden threat" to encourage the banks to sell assets for less than they would like.
Still, there is plenty to worry about, including the long-term damage to the economy if the new toxic asset programs end up adding to the country's ballooning debt.
"If you look at the kinds of deficits they are predicting, these are enormous amounts of money," says Wharton finance professor Franklin Allen, who warns of higher inflation and interest rates as a result. "I think what they are doing is extremely risky. Because there are so few precedents, I don't think people fully understand how risky it is."
The new programs have a reasonable chance of rekindling the market for toxic assets, he says, adding that he would nonetheless not be surprised if they fail, leaving taxpayers holding the bag. "When they first suggested [buying toxic assets] last fall, I thought the government would make money. But now the economic situation is so bad it may not be clear. I wouldn't be surprised if they lost substantial amounts of money out there." Temporary nationalization might be the best approach to the banking problem, he suggests, arguing that while bank stocks would become worthless, the bad assets could be removed from their books and the banks could then be turned in to healthy public companies again.
The administration's theory is that removing toxic assets from banks' books will ease worries about bank solvency, spurring a flow of new capital to the banks so they can lend. But it's not certain they will lend even if they have the cash. "They're not making loans because on one hand, Congress is saying lend, lend, lend, and on the other hand, regulators are saying build capital, build capital, build capital," Wachter notes.
Getting lending started may be a chicken-or-egg dilemma, adds Wharton finance professor Itay Goldstein. The problem: Even if it has plenty of money, a bank may be reluctant to lend for fear that other banks will not join in. He describes a case of a bank considering a loan to a company that does business with another company that also needs a loan. If the second company cannot borrow, it may not pay money it owes the first company, causing that firm to default on its loan. Worried about this, the bank may be reluctant to lend even if thinks its borrower is healthy. "It's kind of a self-fulfilling belief," he says.