Toxic Asset Plan for Investors and Banks

Cited: TheStreet.com

Additional details regarding the Obama administration’s plan to kick-start the market for toxic was given to banks who wish to get rid of bad assets and investors who were interested in buying them. A summit was held to discuss aspects and potential impacts of the government’s Public-Private Investment Program (PREA) that was hosted by the Securities Industry and Financial Markets Association (SIFMA) and the Pension Real Estate Association. The PREA is set to begin operation this month. Featured speakers from the Federal Reserve, Treasury Department and Federal Deposit Insurance Corporation will likely discuss pricing and public scrutiny that so far have caused problems for the endeavor so far.

The PPIP has gained little traction since it was announced with great fanfare over two months ago, calling into question how much success it will ultimately have. One pitfall pertains to a lack of confidence that the government will not spontaneously change the rules of the game to mollify populist rage.

Potential investors have witnessed punishment levied against firms receiving government support in the form of compensation limits, strict oversight and fiery questioning at congressional hearings, with American International Group (AIG:NYSE) being the most prominent example. Banks have also faced a slew of restrictions that were added after accepting funds from the Troubled Asset Relief Program, money that some firms claim they did not need in the first place.

The retroactive provisions and public scrutiny has made banks eager to repay those dollars as soon as possible. JPMorgan Chase (JPM:NYSE), Goldman Sachs (GS:NYSE), American Express (AXP:NYSE), BB&T (BBT:NYSE) and Northern Trust (NTRS:NYSE) have already applied to do so, and Morgan Stanley (MS:NYSE), Wells Fargo (WFC:NYSE), Bank of America (BAC:NYSE), and others have expressed interest in doing so as well.

“One of the things that has been the most challenging aspects of the federal government’s efforts to put in place programs is the populist backlash against lots of different issues — executive compensation being the classic example,” says Kevin Petrasic, former special counsel at the Office of Thrift Supervision.

Potential PPIP investors were mostly hedge funds and private-equity firms that tend to recoil from regulatory oversight in ordinary times. As a result, few have been eager to participate in the PPIP without explicit guarantees that the same restrictions and public flogging will not befall them.

There is also the initial issue that PPIP hoped to address, but which it may not be able to solve the wide gap that exists between bid prices and ask prices on distressed assets weighing down bank balance sheets. Banks are not selling these “toxic” holdings because managers believe prices offered are far below the intrinsic value. Investors are not offering higher prices because they do not know where the bottom lies, or simply because they do not have to yet.

The government has an unenviable position in this financial crisis. Regulators must use taxpayer dollars to strengthen the banking system by fostering healthier, more profitable lenders. But they must also market their programs as ones that will not allow banks or investors to profit excessively on the taxpayer dime. What “excessively” means is anyone’s guess.

As a result of those contradictory goals, says Petrasic, “you sort of have a half-implemented program that’s not particularly effective because of hesitancy or distrust from private investors who don’t know what could possibly happen. Will the government come in late in the game and change the rules, adversely affecting those investors?”

There are two components to the program, the major one to tackle asset-backed securities that the Treasury Department will oversee, and a smaller one regarding whole loans that the Federal Deposit Insurance Corp. will oversee. While the Treasury portion is still set to launch this month, the FDIC on Wednesday said it would postpone a pilot sale of assets through its Legacy Loan Program until the summer.

“Banks have been able to raise capital without having to sell bad assets through the [Legacy Loan Program], which reflects renewed investor confidence in our banking system,” FDIC Chairwoman Sheila Bair said Wednesday. “As a consequence, banks and their supervisors will take additional time to assess the magnitude and timing of troubled assets sales as part of our larger efforts to strengthen the banking sector.”

Hundreds of billions of dollars’ worth of troubled assets are weighing down the balance sheets of the country’s biggest banks, from behemoths like BofA and Citigroup (C:NYSE), to major regional players like Fifth Third (FITB:NYSE), KeyCorp (KEY:NYSE), PNC Financial Services (PNC:NYSE), US Bancorp (USB:NYSE) and Capital One (COF:NYSE).

Conditions stand to worsen if a resolution is not reached soon, especially for firms that have not written down assets to rock-bottom levels. Those heavily exposed to assets whose performance is still deteriorating, like commercial real estate and credit card debt, or areas of the country whose economies have not yet stabilized, stand to get hit the worst.

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On the ther hand, a return to profitability for the banking industry last quarter, and signs of life in the housing market and broader economy has given investors faith that a rebound is at hand. The surge in investor confidence has been evidenced by the tens of billions of dollars banks have raised in the market to fill in capital shortfalls identified by the government’s stress tests.

Petrasic, who now counsels financial firms on participating in the PPIP at the law firm Paul Hastings, says that by installing adequate oversight, being transparent and emphasizing that the PPIP seeks to benefit all participants — including taxpayers — the Treasury Department could successfully launch its pilot program this month with minimal pushback from public advocates.

“You want a program that works,” says Petrasic. “There’s got to be a certain give and take…but I think the key thing is to separate what happened in the past from what happens going forward.”

Chip MacDonald, a Jones Day lawyer who advises banks, asset managers and other financial firms on the PPIP, says a solution can come in the form of a collaborative “bad bank” in which buyers, sellers and taxpayers all share in upside or losses that stem from deals.

Under such a plan, a portion of the financing would come from the FDIC and all three parties would retain an interest in the assets while working to restructure loans for troubled borrowers. It would bring banks closer to offered prices, since they would retain a stake in the potential upside they predict; and bring sellers closer to banks’ demanded prices, since part of the financing comes from the government, limiting downside risk.

Regulators could also install terms that provide significant upside potential in exchange for government funds. In working out troubled loans, regulators can oversee the program to ensure that struggling borrowers become more profitable for the banks without being exploited.

MacDonald still has faith that a public-private program can be successful, citing Grant Street National Bank, a subsidiary of toxic loans that was spun off of Bank of New York Mellon’s (BK:NYSE) predecessor in the late 1980s, as well as Kearny Street Real Estate Co., which held a troubled swath of Bank of America (BAC:NYSE) assets in the 1990s.

“I think it can be done,” he says.

No matter what happens are going to be winners and losers in the banking industry because of the traditional idea prudent lending or aggressive moves to write down or even get rid of bad debt before becomes a problem. With government sweeteners, vulture investors can easily steal these risky holdings or assets at low prices according to Fred Fraenkel, Vice Chairman of the Beacon Trust investment firm. He also added, “The current environment should reward banks who keep their balance sheets and lending capacity intact.”

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My Take: I think the banks do need a little more regulation. If they had more regulation, we probably would not be in this massive recession. The money handlers of this world control everything to some extent, maybe even more than I suspect. However, they do have their fingers on the pulse of the world.

I think the main idea here is to help the average citizen with their loans from these banks. If a bank is in trouble, they get nervous and start making outrageous demands on people who cannot fulfill those demands because the economy. It turns into nothing more than a vicious circle.

When someone is stuck between a rock and a hard place, they do not have very many options open to them. I think this program will help remove either the rock or the hard place and give people and businesses a few more options than they have otherwise.

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