Wednesday, May 27, 2009

The Banks Just Don't Get It

As if the banks hadn't already taken advantage of the government and taxpayers enough, the news broke today in the Wall Street Journal ( that the banks are lobbying in Washington to be allowed to take part in PPIP. For those of you unfamiliar with this particular alliterative acronym, the Public Private Investment Program is a taxpayer funded scheme to help banks get toxic assets off of their balance sheets so they can start lending again. Sounds innocuous enough, right? Well, that is until a diligent taxpayer (meaning someone who is not trying to be a member of Obama's cabinet) scrutinizes the details of the Legacy Loan PPIP. I should note that the announced terms of the Legacy Securities PPIP are slightly different but I am focusing on the Legacy Loan PPIP (consisting of whole loans such as residential and commercial mortgages) because it is the one the banks are apparently interested in taking part in.

Here is the basic structure: the Treasury and a "private investor" team up to provide equity for the purchase of assets that a bank is holding on its balance sheet. The example that the Fed uses is based on $100 worth of assets being auctioned off by the FDIC. Assuming that the winning bid was $84, the Treasury would put up $6, the private investor would put up $6, and the FDIC would provide a non-recourse loan for $72, effectively a 6:1 leverage ratio. From there the private investor would supposedly hold the assets with the hope that they increase in value as the economy recovers and the market for these assets becomes more liquid. In the event the assets were sold at more than $84 at some point, the Treasury and the private investors would share in any profits. If, however, the price of the assets declined further the private investor would have the option to walk away only losing the initial $6 and sticking the taxpayer with any losses beyond that.

Now, aside from my original concerns about whether this program is fair to taxpayers or will even work, I see two new potential deal structures that bring about a whole slew of conflicts of interest. First off, is the banks buying the assets of other banks. Let's say you are Citigroup (C) and you have $100M in loans that you would love to get off your balance sheet. What you do is call your buddy at JP Morgan (JPM) and invite him to lunch (making sure not to discuss any of your plans on the phone or over email) and propose a transaction. Here is how it would work: I will tip you off about the $100M in loans I am about to put on the auction block. These are not my absolute worst loans that are likely to be worth pennies on the dollar because I don't really want to fleece you. But these are loans that have very skewed outcomes, meaning that in the unlikely scenario in which the economy recovers to the extent that these loans actually perform, they would be worth a lot. Under a more realistic scenario these loans retain most of their depressed values and eventually the sale is a wash. But even if the economy got much worse and these poorly underwritten loans turned out to be worth much less than they were marked and sold at, all the purchaser could lose is the miniscule equity investment.

Let's look at what Citi gets out of this. To make the example simple I am assuming that JP pays $84M for the assets: $6M of its money, $6M of the Treasury's money, and $72M from the FDIC's loan. If Citi had the assets marked at $75M, for example, it would book a $9M gain and get them off its balance sheet and be able to either delever or use the money to make new loans at very attractive spreads.

Wait a second though, why would JP agree to be involved with this? The first reason is that I am assuming that JP would not be buying these assets to put them on its balance sheet. It would create some off balance sheet special vehicle and fund it with the $6M to complete the transaction. I am aware the FAS 140 is coming and banks may be forced to take certain off balance sheet vehicles onto their balance sheet if they have not been deemed to have given up control of the assets. So that could complicate things a little. But not enough to derail the scheme because this is only part of the transaction. In return, I envision Citi doing the same thing for JP: overbidding so JP could get some relatively toxic assets of its balance sheet, book a gain, and be free to lend that new money out. It could all be done with a wink and a nod. To make it even less obvious 10 banks could secretly get together and agree that Citi will buy JP's assets, Goldman will buy Citi's and so on. The FDIC's guarantee puts a floor under the value of the assets regardless of any turmoil in the economy or regarding the consumers and businesses who took on these loans. If the banks were allowed to do this it would be like a game of musical chairs where even when the music stops the only one without a chair is the FDIC and the taxpayer. The banks just keep on playing.

The other potential (and even more egregious) conflict of interest would come about if somehow the banks were allowed to bid on their own assets. Maybe I give the government way too much credit, but I assume that this is very unlikely to be permitted. The idea that the banks could set up an off balance sheet vehicle, bid on their own assets with taxpayer funded capital, and get them off their balance sheets with an underlying put option is absolutely ludicrous to me. One of the major problems that caused this financial crisis was banks' use of off balance sheet vehicles and the lack of transparency that was inevitably created. As a result, I don't see how promoting less transparency and allowing the banks to bid against themselves in a transaction that obviously is not arm's length helps solve anything. Let us all hope and pray that the powers that be see this conflict of interest and tell the banks they cannot participate in PPIP with a resounding "No!"

I also think it is informative (and somewhat humorous) to take a look at what people initially thought of the proposal to let banks take part in PPIP.

From the WSJ article:

1."Banks may be more willing to accept a lower initial price if they and their shareholders have a meaningful opportunity to share in the upside," Norman R. Nelson, general counsel of the Clearing House Association LLC, wrote in a letter to the FDIC last month.

I guess the theory here is that the banks would be willing to sell their own toxic waste at a lower price if they also had the opportunity to buy someone else's radioactive sludge at a commensurately low price with the hope of making a multiple on their investment. What this ignores is that due to the leverage provided by the FDIC and the clubby (slash collusive) nature of the banks there is actually an incentive to overpay and stick the taxpayer with any losses.

2. "To allow the government to finance an off-balance-sheet maneuver that claims to shift risk off the parent firm's books but really doesn't offload it is highly problematic," said Arthur Levitt, a former Securities and Exchange Commission chairman who is an adviser to private-equity firm Carlyle Group LLC.

You can always count on Arthur Levitt to provide some reason within a completely irrational environment. As an aside, I happen to believe that if he had been the head of the SEC instead of the infamous Chris Cox things would be very different right now.

3. "The notion of banks doing this is incongruent with the original purpose of the PPIP and wrought with major conflicts," said Thomas Priore, president of ICP Capital, a New York fixed-income investment firm overseeing about $16 billion in assets.

No, really? Thanks Thomas. I just hope the feds see this as clearly as you and I do.

4. "Sensible restrictions should be placed on banks, especially those that have received government capital, from investing their own balance sheets in a backdoor effort to reacquire what could be their own assets with an enormous amount of federally guaranteed leverage," said Daniel Alpert, managing director at Westwood Capital LLC, an investment bank.

Mr. Alpert reminds us that many banks took government capital in the form of TARP money and continue to issue debt backed by the FDIC so that they can boost their capital reserves and reduce leverage. Somehow adding more dodgy assets on a levered basis seems to defeat the purpose of shoring up our financial system.

5. "A bank bidding on its own assets really has the potential to look awful in the public's mind," said Mark J. Tenhundfeld, an American Bankers Association lobbyist.

Even the banks' lobby understands how the public might see this self-dealing as slightly problematic. But it never hurts to ask!

(And finally, my favorite quote)

6. The California Bankers Association said in a letter that the FDIC's supervision of the asset-pricing process "should alleviate concerns about the inability to effect arm's length transactions between a bank and its affiliate that purchases through a public-private investment fund."

FDIC supervision? You mean that we should trust the regulators to be able to protect the taxpayers? I think the recent track record of the Fed, the SEC, and the OTS make it very clear that these entities are incapable of regulating the banks properly and monitoring systemic risk.

In conclusion, I think it is painfully obvious that the banks' involvement in the PPIP in any form brings up a number of conflicts of interest and presents a very real possibility of collusion. I don't see any way in which the taxpayer benefits from the banks getting more free lunch. While the banks proposal to be included is somewhat nebulous (since I am just relying on the WSJ article as source material), it seems to me that any manifestation would only serve to make the current financial crisis even worse. But what frightens me even more is that after everything that we have been through, from Bear Stearns to AIG to TARP, the banks would have the audacity to ask for more handouts. My hope is that one day public sentiment becomes so negative that the leaders of these institutions no longer are able to play the government and the taxpayers for fools.

(Update: According to the Wall Street Journal, FDIC head Sheila Bair has already said banks will not be able to bid on their own assets. That's a relief. But don't rule out them asking to bid on the assets of other banks.)