Thursday, February 12, 2009

How to buy $500 billion in "toxic" assets for$50 billion

Re:  The Treasury plan to use public/private money with up to 10x leverage to buy $500 billion of "toxic assets." The short answer --- you plan on losing the $50.  Unlike the other Treasury/Fed proposals, which were set up so for the taxpayer to "come out whole" -- the only way to do this little trick is to plan to blow the money.  

Since the entire process is politically toxic, time to consider the option of leveraging what they have by letting go of the constraint of getting paid back.  The public mostly doesn't believe it will happen anyway, or don't make the distinction between a loan and spending.

Right now, private investors want 15% to 20% with little risk and what banks have is assets that yield 5% to 10% with a lot of risk.   

Here is something that might work:

1.  Plan on losing the $50 billion.  Set up a choice of structures.  The Treasury would take a layer of risk.  Like the first 10%.  Or let the private investors take the first 10% and the Treasury take the next 20%.  Or let the private investors take the first 20% and let the Treasury take the next $30%.

2.  One might wonder how the Treasury could afford to take more then 10% "layers" of risk -- but the further up the structure, the lower both the frequency and severity of potential losses.  That is, if a private investor was willing to take the first 20%, it must seem viable enough that it has a 50% or better chance of not losing a penny, much less 50%.  

3.  A lot of the problem assets already have haircuts.  If they started out with some subordination and already had writedowns of 10%, 20%, etc. then the Treasury has a lot of losses between it and a payout.  

4.  This would exclude the worst stuff, like CDO^2, which were too cute by 1/2.  

5.  Anything resembling a whole loan -- like a bunch of them bundled together, should be a pretty good bet.  

6.  Loan losses have both a frequency and severity component.  That is, X% default, and those defaults produce Y% losses.  If X and Y are both 50%, then the total dollar loss is 25%.  0.5 x 0.6 = .25.  1-.25 is .75 or 75% good money.  A lot of loans had some subordination built into them, and then the stuff has been partially written down.  Yea, people made bad loans, but to get to a 50% dollar loss ratio, 70% would have to default with a 70% loss on each default.  Even some of the worst stuff can't be much worse then this.  You would have to really try hard to write a portfolio of loans this awful.  

Under the 20%/30%/50% option, the most senior 50% piece would be a decent enough credit.  The 30% guaranteed piece is as good as the Treasury.  This gives the investor 5x leverage, so they don't have to do the best deal in the world to make money.  

One might ask what is in it for the banks.  This is the big, big question -- since this would involve selling something for less then its apparent economic value.  The idea is simply this -- getting rid of "financial reporting risk" is worth enough to motivate the sellers.  That is, it doesn't matter what they think it might be worth.  The fact that they could be forced to take additional haircuts ever single quarter until things bottom may be enough to motivate them to do deals.

Even more so, any asset that has an economic value higher then its book value would be chomping at the bit to do a deal.  In this environment, any asset that would fetch MORE then book value would lead to a write up!  

People that think that there are no assets that meet this qualification need to consider the arbitrary nature of a lot of valuation and accounting processes.  Lets just assume that overall, the assets are 10% Overvalued today in the aggregate.  Given the variance in the valuation process, 20% of the assets could still be under valued.  Just assume a distribution with the mean at 90% and a standard deviation of 10%.  1/6 will be over 100%.  

 Any one want a real world example?  Here is one from the Hartford:
Book value is $11.1 billion and market value is $6.8 billion -- or about 60%. Their CMBS's have been written down 40%. It is a little complex, since they use book value for Insurance Capital Ratios and market value for GAAP Capital. Nevertheless, they don't have to sell them, they don't have to fund them, they are planning to hold to maturity, but they need positive GAAP capital to continue to exist in the real world. These things are still paying. They started out with 20% or so initial subordination. If they sold $5 billion at today's market value, that would represent par value loans of $10 billion. The investor would put up $1 billion. The Treasury would insure the next $1.5 billion, and the final $2.5 billion could be financed.  If the CMBS's pay out $6 billion, thats 100% profit.  

For various reasons, this isn't a doable deal -- but remember that the banks *thought* they were keeping the best stuff and selling off the worst stuff.

The unfortunate reality is that the sellers will be getting cherry picked and will sell their most undervalued assets based on current accounting values.  However, given the cost of additional capital -- which is essentially infinity since it isn't available at any price -- it is still an offer that couldn't be refused.

This is just a general approach that makes some sense.  It is based on the assumption that there are a decent chunk of assets that need to be booked at a liquidation value that is lower then their economic value.  After all, thats what a true toxic or troubled asset amounts to.  A busted loan is just a loss and easy to account for.  

I don't know if the real banking system has enough bona fide troubled assets to need a buyout program.  A portfolio of option arm whole loans is just a bad portfolio --  and there is no gap between accounting values which are liberal and economic values.  

The real point of this is that if the Treasury wants private involvement and wants 10 to 1 leverage, they have to take the worst parts of the deals.  And plan to lose the $50.  The big brains that created the structured crap that is at the heart of this are more then capable of coming up with innovative ways to leverage the Treasury's $50 billion.  But it would have to be spent/lost/blown.  No free lunch on this one.   

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