Monday, March 23, 2009

The Geitner Plan---Great Work If You Can Get It

My screen's all green so I know the markets are loving it today. The details of the Geithner plan to unload toxic assets from US banks' balance sheets aren't in ---maybe this will work, maybe it won't ---- but one things for sure, the private equity folks who are lucky enough to be invited to bid are going to make a killing! It's like the scene in Trading Places, when Ron Bellamy and Don Ameche of the mythical Duke & Duke investment firm, revealing the finer points of their business model to Eddie Murphy explain, "The good part is that no matter whether our clients make money, or lose money, Duke & Duke get the commissions."

What's my point? There are 3 flavors to the Geithner plan. If you're not up to speed read here. In one of them, the Treasury Department will provide $75-$100 billion of equity capital to join with private investors, at a ratio of 4-1, to bid on pools of toxic assets. The FDIC will then lever those investments with non-recourse loans for as much as 85% of the purchase of the pool. The simple math says if Treasury allocates $100 billion to this flavor, then private capital will come in for $25 billion at the 4-1 ratio. Now the $125 billion of equity will be levered up 6.7X by FDIC loans allowing ~$840 billion to bid at the toxic assets. Paul Krugman calls that FDIC facility a huge subsidy. But thats just for starters. Presumably the private money will be raised by investment managers forming special purpose LLCs to invest in these assets in a "private-equity" model. These types of investment funds typically carry a "2 and 20" remuneration structure, where the managing partner, collects 2% of the assets under management (in this case just the unlevered equity) and 20% of any investment gains. The toxic asset pools will be auctioned to the highest bidder. To make it simple, lets assume we form our own LLC and raise enough money to bid and succeed in winning all the auctions---so we are managing $25 billion of private equity along with the Treasury's $100 billion. And, in typical fashion, our fund will lock up investors' money for 7-10 years-- to give it time for things to work out. Now, if we bid right and the "toxic assets" we bought go up a mere 15% in value over 10 years to ~$965 billion of value (less than 2% annual appreciation) then everybody's happy. The FDIC gets their loan payed back in full, the equity investment has doubled in value (ie +$125 billion) and we (the general partners of the LLC) make a fortune on our 20% of that $125 billion in profit. Do i need to spell it out---$25 billion (yes, with a "b") for the LLC. And presumably if we're very smart or very lucky or both, we can do much, much better than that. But, the sword cuts both ways and if we're wrong and overpay and the toxic assets decline just 15% to $710 billion in value, the FDIC would still be repaid roughly in full but the Treasury's investment (meaning tax payer dollars) and our private equity investors are wiped out. And obviously if we're really wrong and the value of the toxic assets is even lower, then tax payers get hurt again as the non-recourse loans can't be paid back in full. This is the part Dr. K is talking about in his blog today when he says
the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.
But here's where we start channeling Duke & Duke, for no matter whether the private equity investors or the Treasury make any money or are wiped out, no matter whether the FDIC loans are repaid in full or something approximating zero, our LLC will have earned $2.5 billion annually, or $25 billion cumulatively, over the 10 year life of the fund! Great work if you can get it!! So I'm not surprised that some investment managers who plan on bidding are already on the tape today saying its such a good plan. And the Obama administration was also out in force yesterday saying these new guys are "friends" who won't get AIG'd and have their profits ex-post clawed back through an unconstitutional retroactive tax (don't get me started on this again).

Maybe I'm just misunderstanding all of this or it won't seem as bad when the details appear in the fullness of daylight. But, my concern is that we are throwing a lot of leverage at fixing a problem of too much leverage to begin with and that the incentives here may be very misaligned for optimum success. I'm a taxpayer and don't want to see any more of my dollars put at risk on half baked ideas where somebody (besides me) has an opportunity to make huge gobs of money, while risking my family members future social security and medicare payments, that I never get to share. The way I see it now, the banks, who will not participate in the upside once they are rid of the toxic assets, want to maximize the sales price today---making it harder for bidders to make money on the backend and easier for the taxpayer (through the Treasury investment and FDIC loans) to lose. And the private equity managers, playing with other people's money get to win, even if they lose, as long as they get to manage a huge pool of money to buy those toxic assets with---so their incented to pay up and win the auction. This cures the short term problem of ridding the banks of their toxic assets and allowing them to recapitalize and go back to the business of providing loans to grease the economy to start moving forward again. All good. But the long term is less clear given the potential problems for recouping tax payer dollars. After all these months of waiting, is this really the best plan ?? Are there not alternatives to consider??

One idea offered by our friends at the Baseline Scenario has the government offering up the investment opportunity to non-institutional investors (ie little people) on a no-fee basis. Yet another idea from my friend Gary Syman (not a blogger..yet) has the banks able to split the "2 and 20" with the LLCs who buy their toxic assets, so they can make up on the backend in return for accepting a somewhat lower price at auction. My simple idea would be to have the Treasury participating pari passu in the economics of the LLCs , ie earning 80% of the fees so that we the taxpayers get our fair share of the potential windfalls. Maybe this is part of the plan but I won't know until I see the details.

Enough for now

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