Three Card Monte

Three card monte comes to mind when considering the Geithner plan.  Everybody knows that it is a few years too late to believe in financial alchemy, that there is a subsidy, that there is a valuable, implicit put to grease the deal.  Or even more ways the system is/can/will be gamed.   However, I'm not buying complexity here -- the subsidy is big and it's right in your face.

I suggest people read the Treasury Plan documents themselves instead of relying on secondary sources which seem lax regarding details.  From the "legacy" loan term sheet:

Leverage will be determined on a pool-by-pool basis at the FDIC’s sole discretion, with input from the Third Party Valuation Firm. It is anticipated that the debt to equity ratio will not exceed 6 to 1 for each PPIF. [note: max leverage 4 to 1 for legacy securities]

FDIC will provide credit support for PPIF financing through guarantees of debt issued by the PPIF.

Right now, FDIC backed notes are yielding 22 bps over Treasuries, or about 2 .125% on a 2 year.  Thats exactly what Wells got on a recent issue.

Let's work through a simple example, substituting a 2 year loan for roughly equivalent pool of cash flows.  Consider this a loan of 100 originated @ 5%, with a payment of 55 at the end of year 1 and 52.5 at the end of year 2.

The pools have deteriorated and 10% will default with no recovery prior to the first payment.  The new expected payments are 49.5 and 47.25.  The bank has a loan loss reserve of $10.  This assumes that the 5% interest rate imbedded in the original loan is still reasonable.

However, vulture investors today are looking to get 20% returns on their now very valuable capital.  Without financing, they would have to buy the asset for 74 to get a 20% return.

With 2.125% financing and 6x leverage, they would need about 4.7% to get 20% on their capital.  That would put the price of the loan at 90 and change.  Not much of a surprise, since the critical valuation assumption is the correct interest rate -- not the default rate.  And not much of a surprise since 4.7% is very close to 5%.  

This is something that most people aren't getting when comparing so called market prices to modeled estimates.  The risk adjusted interest rates have blown out which drive the gap more than the cash flow assumptions.  

In the example above, the gap gets bigger with a 3 year duration.  So, yes -- there is a big subsidy in the plan.  And no, it won't all go to the banks.  But the subsidy allows the new, subsidized vultures to turbo charge their bids with very cheap financing.  

Maybe this is why the New York Post reported that C and BAC are aggressively buying former AAA mortgage securities that were selling for 30% of par:

But the banks' purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders...

One Wall Street trader told The Post that what's been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

If the 30 cent bid is based on 20% returns and 3 year durations, the securities could easily sell north of 50 cents @ 10%, leaving a nice profit for everyone but the seller. 

People are assuming that the banks models are heavily biased regarding default and recovery assumptions. But if the securities were originally priced @ 5% and the market price is now based on 20% returns, that would account for major differences.

So to the extent that the problem is the market based price of risk capital, this sort of subsidy will work without an explicit cost to anyone. Financial alchemy. The catch is that the US can borrow a lot and at surprisingly low rates. Right now. Everything the government is doing is based on the idea that they can essentially become the hedge fund of last resort, and borrow low to fund illiquid asset purchases. It works until it doesn't.  Let's hope it works.