Geithner Plan Favors Investors

Highlights include Bank of America Corp. (BAC - Analyst Report) and Blackrock, Inc. (BLK - Snapshot Report).

Can the Public Lose and the Private Win in a Public-Private Partnership?

The biggest positive in my eyes of the Geithner plan is that we should finally get a good handle on how much the toxic assets are really worth. At least this process is likely to provide the most transparent answer, provided the system is not "gamed." At the level of the individual package of loans or securities, by investing side-by-side with private investors, it is clear that if the investor makes money, The Treasury will also make money. If the Treasury loses money, the investor will as well.

However, the rewards and risks are skewed. If the investment works out, the investor makes lots and lots of money, while the upside for the Treasury is relatively limited (see my previous post). This means that the program as a whole has a very real possibility of losing money, even as the private investors make a very nice return.

Let's run through an example. Suppose that Bank of America Corp. (BAC - Analyst Report) has 100 pools of loans that will be sold. (I am using BAC as an example here, but could have used any of a score of other major financial institutions.) Half of these will turn out to be ultimately be worth $0.20 on the dollar, and half will turn out to be worth $1.00 on the dollar. Nobody knows which is which.

Let's also suppose that Blackrock (BLK - Snapshot Report) -- starting out, there will only be five firms in the program, and it is a slam-dunk that BLK will be one of them -- turns out to be the winning bidder for each of these. As a whole, BAC has already marked these assets down to $0.80. The expected value, however, would be $0.60 (0.5 x $0.20 + 0.5 x $1.00).

Due to a bidding war with the other investors like Pimco, BLK ends up somewhat overpaying for the assets. So each loan package ends up being bought for $0.70. BLK puts up $0.05 in equity capital, and the Treasury also puts up $0.055 in equity capital. However, the other $0.60 is lent to each of these deals by another arm of the government -- either the Fed or the FDIC. At the end of the investment period, all of the loans are at their true values.

So what has happened?  The true value of the assets was $0.60, yet $0.70 was paid. This is a $0.10 subsidy to BAC. Instead of having to write-off another $0.20, they only have to take a $0.10 write-down.

BAC, however, is now out of the picture. No more toxic assets on their balance sheet, they can presumably go about their business as a nice clean bank (provided of course that the $0.10 additional write-off that they take does not bankrupt them).

Now on the good loans, which are worth $1.00 at the end of the period, the partnership realizes a $0.30 profit, or $0.15 for each partner. This marks an extraordinary return for BLK, since it only put up $0.05. For the government, it is also a nice return, but not as mouthwatering, since they had to put up $0.65.

However, what about the other half of the loans? They are worth only $0.20 at the end of the period. On those loans, BLK losses 100% of its investment, but it is just $0.05. Since the loans are non-recourse, the lender (another arm of the government) will have to eat the loss. The Treasury losses its $0.05, and the lending arm will lose $0.40, for a total loss of $0.45.

So what is the expected return for Blackrock of this transaction?  Heads they win $0.15, tails they lose $0.05 or:

(0.5 x 0.15) + (0.5 x -0.05) = 0.05

or a $0.05 taken as a whole.

How about the government?  Heads they also win $0.15, but tails they lose $0.45 or:

(0.5 x 0.15) + (0.5 x -0.45) = -0.15

or a -$0.15 loss expected on the whole batch of transactions. So in other words, BAC wins, BLK wins, and the taxpayer loses. At this point, this should come as no surprise. Of course, if BLK were to buy the assets (with the taxpayer along for the ride) for $0.60, then its profits would be even greater on the upside, and the Treasury's losses on the downside would be less.

However, in that case, BAC would have to take a $0.20 write-down, one which it could not afford to take. In that case, there would be relatively little uptake on this program. Not from the lack of buyers, but from a lack of sellers. A lack of sellers would tell us one thing very clearly.

It will definitively answer if this is a liquidity problem at the banks, or a solvency question at the banks. I strongly suspect that it is a solvency issue. If that is the case, this is a back door and expensive way of bailing out BAC, especially to the extent that the price paid for the asset was more than the true expected value (the $0.70 above vs. the $0.60).

In the process, we have also greatly enriched BLK as well. However, BLK and the other investors will provide a valuable service in providing the "true" pricing of these assets. This process is much better than the government trying to bid for these assets on its own, and there is a real incentive for BLK not to overpay.

If the market for these assets remains dead -- because even with the very generous incentives BLK is not willing to bid up the prices of these assets to levels that BAC can afford to sell them ($0.60 in the above example) -- then there will be no choice but to go down the Swedish route and nationalize, reorganize and sell-off the troubled banks. I still think that is the way we will eventually go, and would prefer to do it sooner rather than later.

However, if politically going that route is not possible yet, this plan is as good of one that we are likely to get. The Treasury is likely to make money on at least some of the transactions, which will partially offset the losses on the other transactions and thus hold down the overall coast of this program. But make no mistake -- there is likely to be a cost.