In Bank Aid Plan, a Wall Street Focus
February 9, 2009
In Bank Aid Plan, a Wall Street Focus
Wall Street helped produce the global financial and economic crisis. Now, as the Obama Administration prepares to unveil a revised bailout plan for the banking system, policy makers hope Wall Street can be part of the solution.

Administration officials said the plan to be announced Tuesday was likely to depend in part on the willingness of private investors other than banks — like hedge funds, private equity funds and perhaps even insurance companies — to purchase the toxic assets that wiped out the capital of many banks.

The officials say they are counting on the profit motive to now create a market for those assets. The government would guarantee a floor value, officials say, as a way to overcome investors’ reluctance to buy them.

Details of the new plan, still being worked out over the weekend, are sketchy. And they are likely to remain so even after Treasury Secretary Timothy Geithner announces the plan on Tuesday. But the aim is to reduce the need for immediate federal financing and relieve fears that taxpayers would be paying excessive prices if the government took over risky securities the banks created when credit and home prices were booming a few years ago.

Besides devising a way to bring private investors into the bank bailout, the Treasury plan is expected to inject more capital into some banks and to give many homeowners relief from immediate foreclosures. It also is expected to expand backing for newly created financial instruments that finance loans of various kinds — a step officials say they hope will help revive the private securitization market that once financed many loans but now has largely ceased to function.The Treasury Department had intended to unveil the plan on Monday. But on Sunday Mr. Obama’s economic advisers said they would wait another day, to keep the focus on getting Congress to approve an $800 billion-plus economic stimulus program. Mr. Obama plans to promote the stimulus package at a prime time news conference Monday night.

The stakes for the Obama Administration’s bank bailout proposal are high, economists say. Regardless of the specifics of the differing economic stimulus plans pending in Congress, no spending stimulus is likely to have much long-term effect unless the bank bailout works.

"The simple truth is that a self-sustaining expansion in a capitalist economy absolutely requires a functioning banking system," said Robert Barbera, the chief economist of ITG, an investment advisory firm. There is a general agreement that previous efforts have yet to succeed.

When the Bush Administration introduced its original $700 billion bank bailout plan last fall, the government was supposed to be the primary buyer of the damaged assets — the securities tied to subprime mortgages and other dubious loans whose value has plunged as the financial crisis intensified. But that did not happen, as the government decided instead to prop up the banks by investing directly in them. Half of the $700 billion in bailout money remains unspent, pending Congressional approval of a new Obama plan.

The Bush administration’s original plan — known as TARP, for Troubled Asset Relief Program — called for the government to buy the assets from banks, paying more than private buyers would then pay but less than the assets were expected to be worth once the economy and the financial system recovered.

After it turned out that the banks were in even worse shape than had been thought, the Bush Treasury Department decided it was more crucial to put the money directly into the banks. It was also unclear how the assets would be valued, raising political questions about whether the purchase prices would be fair both to the banks and to the taxpayers. But as those assets have remained on the banks’ balance sheets, they have continued to decline in value, producing more multi-billion dollar losses.

Moreover, economists say that the expectation that the government might decide again to step in may have frozen the market for many of the assets, which take the form of securities backed by mortgages and other bank loans. The securities are both complex and hard to evaluate, and there is little public information about precisely which assets are owned by each bank.

Some prospective purchasers of the securities — including investors who buy fixed-income products — say banks are not making many of them available for sale. They say some banks have put out lists of securities to solicit bids but then refused to accept the prices being offered. The buyers also say there is little or no financing available to help with the purchases.

By trying to bring in private sector buyers to set prices for the toxic assets, and to take some but not all of the risk that the assets will continue to collapse in value, the Obama administration evidently hopes to both restore confidence in the health of the banking system and to avoid the politically perilous course of directly buying the assets at prices that could turn out to be far higher, or lower, than their eventual value.

The securities were the product of a securitization market that grew rapidly in the past two decades, in which loans made by banks, and sometimes by others, were packaged into securities that bore different risks. Some of them would lose money only if others that ranked lower were wiped out. Those were viewed as being very safe, even though the loans themselves were risky.

When the securitized assets were being created, federal regulators declined to regulate the rapidly expanding shadow financial system. Alan Greenspan, then the chairman of the Federal Reserve, argued that the complex securities were transferring risks outside of the banking system, thus improving the safety of that system.

A possible model for the way the new Treasury plan could work would be the sale by Merrill Lynch in July of $31 billion in securities for 22 cents on the dollar. The buyer, the Lone Star group of private equity funds, put down only a quarter of the purchase price, and had the right to walk away, forfeiting only the down payment, if it later turned out the securities were worth even less than it agreed to pay. Thus Lone Star stands to receive the upside if the securities prove to be valuable, but has only a limited downside risk if they do not. In this case, it would be the government that stood ready to absorb losses if they were too large, and that provided some of the financing for the purchases.

Any government-assisted deal would probably need much more disclosure, some economists say. Merrill and Lone Star, which did not use government help, did not reveal exactly which securities were involved. Presumably, the government would want such packages to be shopped widely, to get the best price.

“They must disclose fully exactly what the government is buying, or insuring, or providing financing for,” said Simon Johnson, a professor at the Massachusetts Institute of Technology and former chief economist of the International Monetary Fund. “Congress is really hyper-sensitive to this issue right now. Believing you can get away with the opaque deals we saw in Citigroup or Bank of America would be a misconception.”

In those deals, in which the government either assisted a takeover or tried to shore up an institution’s balance sheet, the government provided insurance against further losses on portfolios of assets, but did not disclose details of the assets.

The securities Merrill sold, known as collateralized debt obligations, are indicative of the type of securities creating the problem. They are not backed directly by mortgages, but by securities that in turn are backed by mortgages. Thus their eventual value depends, indirectly, on how many loans are repaid. And that in turn, will be affected by how successful the Obama administration is at repairing the financial system and stimulating the economy.

When they were created, probably from 2005 to 2007, the Merrill securities were rated AAA, the safest rating there is. The fact Merrill was eventually willing to sell them for less than a quarter of face value indicates how far off those ratings were.

The banks now argue that the few trades of such securities that are taking place are at unreasonably low prices that would be justified only if foreclosures, and losses on foreclosed mortgages, are far higher than now seem likely. They have tried to get Congress to overturn accounting rules that force them to record as losses the declining value of the securities. But the banks have shown little interest in buying more of them from one another.Moreover, banks have sometimes been unwilling to trust other banks that may have such securities. That has begun to affect the international trade financing system, in which one bank advances funds for a shipment after a bank in another country guarantees the payment by the company importing the goods.

If many of the assets are off bank balance sheets, and others seem to have a clear market value, economists hope that banks would feel freer to lend, rather than hoarding capital to have available if values continue to fall and create more losses.

Stephen Labaton and Vikas Bajaj contributed reporting.
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