A tremendous amount of blather and megabytes were expended on the newly-minted public-private investment plan (PPIP) over the last week (see details of the plan here), but none of it grasped that banks can’t really sell a lot of “legacy” assets to public-private partnerships. And if they can’t, the plan won’t do much to “unclog bank balance sheets.” However, PPIP (and a freshly-expanded TALF) may achieve more modest objectives of aiding price discovery and invigorating trading in private label MBS, CMBS and ABS. And more active, better bid markets for these securities will help to reduce unrealized losses to the banks that really can’t sell them to private-public partnerships. But before I explain why PPIP can’t, on a large scale, “free up capital and allow U.S. financial institutions to engage in new credit formation” (as the Treasury’s White Paper would have it), I want to explain why I think those people responsible for policy formation and translating Treasury initiatives into Main Street English missed the point. I think talking heads, reporters (and their editors, who are even more financially illiterate than folks on the finance beats), bloggers and twitterers missed the point because the ur-TARP and now the PPIP are based on clichés. I think the law makers and even the economics- and finance-trained policy makers have been reading their own press for so long they now problem-solve using a tiny vocabulary of received notions and cant. Assumptions are no longer questioned. Definition of the problem and identification of the solution are inextricably bound up in self-evident truisms. The two biggest bromides of this stage of the financial-economic disaster, the notions that substitute most efficiently for actual thought and analysis, are: • Toxic assets clog bank balance sheets and prevent them from lending; • “Excessive liquidity discounts [are] embedded in current legacy asset prices.” The first appeared/appears in every story about the old TARP/the new PPIP. Everyone says it, so it must be true. The second is a quote from the Treasury’s White Paper on PPIP. I am not saying there is not a grain of truth left in these chestnuts, I am saying that they have been invoked so incessantly by the leaders and followers that they are now treated as irrefutable facts rather than the theories that they are. If you say legacy, I’ll scream Let’s start with “toxic” — or as we now call them following the Treasury’s deft re-branding, “legacy” assets. These are both euphemisms for BAD loans and BAD securities. BAD investments. And they are not inherited! They are not select properties, classic movies, or coveted cars. They are not “troubled” either — as if, like teenagers, they can grow out of it. These are questionable assets acquired using deposits and other liabilities, along with a dollop of capital, by bank managers in pursuit of the widest possible net interest margins given the investment powers permitted by bank charters. Augmented in the case of many of the largest banks by hinky off-balance-sheet funding mechanisms. In the last banking crisis – that one in the 1980s that resulted from lending into a commercial real estate bubble, fragile “emerging” economies and, on the thrift side, from accounting practices that concealed the effect of interest rate mismatch, unconscionable deregulation and fraudulent abuse of deregulated investment powers and deposit insurance – in that crisis, at least law and policy makers stuck to cleaning it up and had the decency not to address the problem with metaphors like “legacy,” “toxic,” or “clogging.” Where’s plumber Joe when we need him? Saying banks’ balance sheets are clogged is like calling for the Liquid Plumber or a high colonic, and then sitting down and waiting for the cash to flow through the system again. Or like promising the “plan” will work like the metaphor. (Not that I don’t like metaphors or use them to explain things. Lots of metaphors and similes may be used in this discussion. I merely believe they shouldn’t be allowed to ossify.) If you want a metaphor, let’s call these assets vampires. They are draining the life out of the banks that have too many of them in relation to their capital. The euphemists can complain all they want about the unrealistic, unfair accounting, but for far too many of these bad investments, the economics WILL (I love not being a regulated analyst anymore so I can use promissory language) catch up with the accounting, the liabilities will suck more cash than the assets can throw off and the hapless holder will have to be closed. It follows that asking the government to own them is to risk bankrupting the government. The solution in the last crisis was to face the unadorned facts, close the banks using a variety of cash-conscious stratagems still in the FDIC’s “tool kit,” and find the best execution for the problematic assets. The FDIC managed this without creating a special vehicle like a “bad bank” or Resolution Trust Corporation (RTC), largely because it moved with reasonable alacrity to address problems. The FDIC ran out of insurance fund, but it did not create a meteor crater where its fund should have been as the thrift regulators did. The thrift industry’s problems were allowed to grow and their ability to make bad investments using hot money was dramatically expanded by a deregulating Congress. They made so many and such an array of bad investments, special teams had to be assembled under the RTC to auction off or securitize the junkyard. Rumor has long had it that during that crisis there was one insolvent bank that was deemed too big to fail. It was allowed to zombie along until it earned its way out of its hole, thanks to the Federal Reserve’s willingness to hold rates down until the voodoo potions wore off. (You all know which one I mean, even then it was one of the very biggest in the world. It may even have been occasion for coining the doctrine “too big to fail.”) Labeling bank investments “toxic” or “legacy” makes it sound like all the banks have just caught the same disease. It sidesteps the question of individual management’s ability (or right) to survive self-inflicted wounds. In the same way, it’s not individual balance sheets that are clogged. No, “a variety of troubled legacy assets are currently congesting the U.S. financial system,” according to the PPIP White Paper. Which leads us to the euphemistic “reason” why banks aren’t lending. Of course, everyone “knows” banks are not lending because members of Congress have been holding hearings and lambasting CEOs of the big banks who received TARP for not lending. But then, what do these elected representatives know anyway? They also use “reserves” and “capital” interchangeably and worry that the same mark-to-market rules apply to bank investments in securities, bank loans and in IRS estate valuations. (Sorry – I’m a little bitter to discover that elected representatives who’ve landed coveted seats on financial services and banking committees haven’t bothered to bone up on banking basics.) The other reason we know banks aren’t lending is because the press repeats what the elected representatives say. The anti-bank lobbies and twittospherics say so everywhere too. Avoid sweeping generalizations Just bear with me a little bit longer and I’ll get to the flaw in PPIP. I just have to say something about bank lending. As a matter of fact, some banks may not be lending, some banks may not be lending to some kinds of customers and some customers have stopped borrowing, the better to survive a business downturn. BUT in aggregate, the banking system has grown despite everything. Commenting on Q4 08 results in the Federal Reserve Flow of Funds data, FTN Financial analyst Jim Vogel says of banks: Not to get all political, but an easy conclusion from [a chart showing commercial bank consumer and business loans, excluding mortgages growing faster in late 2007 and 2008 than in the 2003-06 period] is TARP worked in the fourth quarter. Consumer lending and business loans increased throughout the banking system. There was real asset growth that followed government support of larger banks and the belief the support would continue into 2009. Don’t forget the Treasury is now surveying lending activity at the 21 largest banks in the Capital Purchase Program. Despite worsening economic conditions, the latest report shows lending in most consumer lending categories was increased in January versus December. (Small business lending will be added in future months.) Mortgage origination volume rose significantly as well with declines in mortgage rates. On the other hand, C&I and commercial real estate (CRE) lending decreased due to weakening demand. Says the Treasury (bear in mind, this is the reporting side of the Treasury, not the policy & program marketing side Treasury), loan demand declined as businesses “focused on preserving liquidity and strengthening their balance sheets.” Businesses “remain cautious in taking on new debt obligations.” Are banks massaging the message they are giving Treasury? Maybe, but they are also reporting the normal historical response of business customers to economic downturns. It is normal for banks to tighten credit standards and for businesses to reduce loan demand in a recession. Federal Reserve data indicate that commercial bank loan growth has followed this cyclic pattern for decades. We cringe when they do it, but we know it’s the prudent course of action for individual banks and businesses. We want them to survive to play another day. Emperor has no clothes accounting Enough on toxic constipation! It’s time to move on and rail against cliché public enemy number two: market prices ain’t fair because markets aren’t trading. Not entirely true. Price discovery is difficult, and buyers and sellers do not necessarily frequent private MBS, ABS and CMBS markets at the same times. But the money managers I’ve talked to have managed to whittle away their positions in “distressed assets” through this long difficult period. Mortgage research analysts continue to report prepayment and credit performance and make relative value recommendations for AAA-rated assets. They even continue to maintain weekly series of indicative spreads on some generic types of private MBS bonds. For example. This past week another analyst at FTN Financial, Walt Schmidt, who runs the mortgage research unit, was able to work up, from trader valuations, a table of general, mid-market indications for the senior portion of jumbo, Alt-A and subprime fixed rate paper and jumbo, Alt-A, subprime and Option ARM paper in pertinent vintage buckets. Schmidt’s levels are composites, intended to add valuation “color” to the harder facts of actual delinquency levels across the same collateral groups. That he can derive these composite valuations demonstrates that the market provides enough information to make this a meaningful exercise. This data is also far more detailed than the ‘30 bid for bank paper, 60 required by banks’ news stories that have been passing around recently. That’s more simplistic thinking revved up into urban myth. Schmidt set out to make an even more profound point; he wanted to illustrate how low valuations are relative to current delinquency pipelines. In other words, he was answering the BIG question: why does performing paper get priced like distressed paper? The anti-fair-value crowd has been screaming this pricing embodies an excessive illiquidity premium, not a credit premium. Even the new Secretary of the Treasury has given credence to this assertion. Schmidt finds the answer readily enough in the actual delinquency data (he’s using the standard First American Core Logic Loan Performance Data for all private residential mortgage products except home equity and HELOC, so the same results can be seen elsewhere). “Quite frankly, the growth rates in and levels of serious delinquencies and severities in all sectors are alarming. What began as a ‘subprime problem’ in 2006 has morphed into a generalized deterioration of the housing and mortgage markets.” As time has passed, the rate of delinquencies in every sector of the mortgage market has accelerated. Delinquencies in the weakest loans undermine the performance of the strongest loans, which now show the kind of accelerating deterioration subprime did in 2006. If you follow Schmidt’s reasoning (and, in my opinion, he illustrates what any realist’s gut should have told them about market pricing and, more fundamentally, why risk-averse investors have largely abandoned the market) you’ll conclude that the so called ‘liquidity premium’ is in fact a ‘credit risk premium.’ Here’s what Schmidt says — and for my money, it’s the sanest comment I’ve read on this topic yet: “The main reason for price deterioration in this sector has been and continues to be deleveraging [he’s referring to credit deleveraging as the support bonds are written off]. Losses are being realized at a very high rate. … Now potential investors are demanding to see a “bottom” in the performance of these assets before forcing the bidside higher. Through the PPIP, the government is trying to force a bottom before it actually occurs in asset performance.” Amen. No one knows the long term value of these troubled toxic legacy assets, because know one knows where the bottom is because no one knows when the housing stabilizes (and this will be a local phenomenon). This is credit risk, just like a weak balance sheet indicates credit risk even though the company is still servicing its debt. Selling distressed securities permanently consumes capital So let’s talk about why PPIP won’t induce banks to sell their troubled assets. They will realize a loss that will reduce earnings and capital. Right now, according to FDIC call report data for q4 2009, in aggregate, US commercial banks categorize a bit more than 90 percent of their debt securities as available-for-sale (AFS). In the FDIC’s standard large bank cut of the data (511 institutions with assets greater than $1 billion), 93% of their debt securities are classified as AFS. Quick accounting refresher: AFS securities are measured at fair value. A change in fair value does not affect earnings, but gains or losses over amortized cost are accumulated in a component of equity called Other Comprehensive Income (OCI). This running cumulative total is also referred to as unrealized gains or losses. Unrealized losses reduce equity capital and are taken into account by equity investors, BUT they are not included in calculations of regulatory capital. It doesn’t matter if PPIP pushed up the bid for distressed assets. Schmidt’s illustration should convince you they will not push the bid back up to amortized cost. So, if the bank sells a security that currently has an unrealized loss, the loss is realized – it reduces earnings, shareholder’s equity and regulatory capital. Good old-fashioned prudence should be the first capital constraint on lending, but regulatory capital would be the second. If the goal is to get banks to lend more – and at more liberal terms than the current downturn implies – the last thing policy makers should do is encourage banks to destroy capital. This, by the way, is the same problem that made me think the TARP, as Paulson originally proposed it, was either (1) a cynical ploy to get a lot of dough to rescue Goldman and ilk from assets like CDS and leveraged loans, or (2) a hopelessly naïve project hatched up by people too sure of themselves to consult with regulators who perform the dirty, toilsome job of examining banks — like, say, the FDIC –- and who would know first hand the accounting consequences of selling distressed assets at a price the government could support. You want an idea of the magnitude of unrealized losses currently out there, standing between banks and PPIP? The quickest way I know is to look at the Federal Reserve’s statistical release H.8, which contains weekly survey data from about 60 of the largest U.S. banks. According to the H.8, unrealized losses in AFS securities were almost $66 billion as of March 18 (the March 27 report). Those losses are not necessarily credit driven – prices of relatively credit-insensitive instruments like Treasuries, agency debt and agency MBS vary with interest rates. We can put that $66 billion in slightly better perspective by noting that the largest banks hold $149 billion of non-agency mortgage-backed securities in the investment account (investment securities may be classified as either AFS or held-to-maturity – most likely they are predominantly AFS). These are subject to credit losses. By contrast, they hold about $727 billion Treasury and agency securities in the investment account. Banks could sell some AFS or held-to-maturity securities that have been deemed OTTI (other-than-temporarily impaired) and already written down to a distressed market value, with the loss previously passed through earnings and permanently recorded against capital. Assuming the PPIP price is above the “fire sale price” forced on the holder by auditors (who are subject to stringent sanctions under Sarbanes-Oxley), they might want to do so and realize a gain. However, any advantages of selling OTTI securities into PPIP bids are likely to vanish soon. The FASB is presently in process of adopting new guidance for OTTI (FASB Acts!, see the story here) will only require holders to permanently write off the credit portion of the loss — and the remainder of the impairment (difference between cost and fair value) is carried in OCI, not reflected in earnings or regulatory capital. If, as proposed, this guidance is effective for annual and interim reports made after March 15, that would mean it would be reflected in Q1 09 earnings. Certainly no bank will sell securities they see slipping toward OTTI until after FASB meets (April 2) to evaluate comments and proposes any adjustments in the proposed guidance. (Somebody out there may be scratching their head and wondering about securities that have been downgraded and their cost of capital raised. Those securities were likely deemed OTTI. A downgrade allows the bank to reclassify held-to-maturity to, for instance, AFS, where they would be free to sell it. But the downgrade has the same effect on market price, PPIP or not, that an accident report attached to an automobile’s VIN number has on its resale value.) There is one spot on the balance sheet where the biggest banks can participate in PPIP for securities. The largest U.S. banks do carry significant amounts of securities classified as trading, from which they could sell into PPIP (smaller banks would not). According to the H.8 trading securities total $442 billion according to the H.8. That’s 28 percent of total securities in bank credit. Of that, almost $271 billion are listed as derivatives with a positive market value and about $99 billion are neither Treasury/agency nor derivatives. This later category is the likely repository of PPIP-able securities (at least under current program guidelines). So when the press reports mega bank X has indicated it will dispose of assets through PPIP-supported markets, they are very likely talking about selling from their trading books. Trading books are also probably where Citi and BofA asset managers were operating when they were “double dipping,” as the New York Post put it on March 25, buying “so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral.” The Post and a lot of copy-cats in the press and blogopoly tried to make this seem like suspicious activity, but they were out of line. So what if Cit and BofA were setting up to sell the bonds back to PPIP? Maybe they just sensed – correctly – that markets were firming on the announcement of PPIP. Or, they could have made astute use of underlying deal data and default models to anticipate a slug of liquidations coming through servicing pipelines. That way they pay, what? 50, 60 cents on the dollar for a AAA-rated bond and get the cash back at par. That’s because the losses realized on foreclosed properties hit the credit support bonds, not the AAA (so, that pesky credit deleveraging process can be played if you can buy the bond at the right price). In any case, making trading profits on distressed securities is not a bad thing to do, TARP money or not. And trading books and funds that support a livelier trading environment are acting like good citizens. If people don’t trade, PPIP won’t succeed on any level. Only the press, elected representatives, or a pack of attention-seeking mongrels would try to make common-sense trading out to be some nefarious activity. Which leads to the real opportunity PPIP may create. Other mark-to-market investors may now be able to sell – and buy – PPIP securities. These include a wide range of money managers, pension funds, mutual fund, hedge funds and so on who always carry their securities at market value. It includes money managers who need to shed these dishonored asset classes to raise new money or move into asset classes with greater stability or likelihood of growth. It includes new money that like distressed assets a lot better when the markets are more active, the exit strategies more diverse and viable. To the extent that trading does perk up – and reports from all corners of the market last week are that it already has a bit, lifting prices for CMBS and some ABS in particular – the liquidity premium should shrink. All the better to reveal the credit risk premium. If it is no longer possible to claim markets are inactive, it should be easier to grasp markets are, and have been, pricing credit risk. It will be possible to say aloud, the emperor has no clothes on. Will the toxic loans sink the FDIC? The PPIP addresses damaged loans as well, a project that puts the FDIC on the hook to guarantee debt financing issued by the public-private investment fund (PPIF) that buys the loans. Here, too, the willingness and ability of banks to sell loans into PPIFs is limited by accounting constraints. Loans are carried at amortized cost subject to impairment. Banks have been recognizing impairment and reserving for losses. They would have to have reserved super aggressively to have loans now marked at or below the PPIP-supported market bid – the only way they can sell without taking a loss or with hope of a small gain. As a matter of fact, the greater fear is that they have not impaired and reserved loan portfolios aggressively enough. Here’s how highly respected mortgage and structured product market analyst, Laurie Goodman, at Amherst Securities Group, explains the impediment to bank selling: Without pressure from regulators, it is unlikely that banks will be sellers of loans. These loans are carried at amortized cost. A sale at market value, which is considerably lower than amortized cost, will lock in losses and hurt regulatory capital. Most banks will find it far more appealing to hold the loans and accumulate loan loss reserves against these loans over time. Moreover, the discount rate that will be applied to these loans [in a sale] is much higher than the rate that was applied when the loan was issued, resulting in a selling price that is much lower than the amount of expected losses. On the other hand, I would add, if reserves already taken were truly aggressive, and housing and loan performance stabilizes, the bank may be able to recover a portion of those reserves if it holds onto the loan. I have so far ignored the incentives (and obstacles) for investors to participate in PPIP, because I believe potential bank participation is vastly overestimated. However, it’s worth adding that as the program is currently described, the banks would continue to service the loans they have sold. I just don’t get what investor -– aside from Fannie or Freddie, who can securitize loan purchases –- would want to buy a loan without the servicing. If there is money to be made in distressed loans, it requires properly servicing them. And servicing is now understood to be an art that prudently manages collecting, escrowing, paying as well as forebearance, modification, foreclosure, property management and REO sales. I wouldn’t buy a loan from a distressed seller and trust the loan would be properly serviced. So why would an investor with the size, experience and ability to raise capital required by the program guidelines be more willing to do that? Either way, supply or demand, I suspect the PPIP for loans will be small. It’s hard to believe the FDIC didn’t come to the same conclusion when they agreed to pursue the plan with Treasury. On the other hand, PPIP might turn out to be a useful open bank resolution tool. But no one should forget that the FDIC has already put together the infrastructure to sell pools of distressed bank assets and has completed one sale in this current crisis already. In any case, the folks in the media and blogoverse who’ve been agonizing over PPIP putting the FDIC’s insurance fund in danger can probably relax. PPIP is unlikely to be big enough to be the problem. The real problem is that the collateral behind a lot of bank assets has turned out to be hot air. Editor’s note: Linda Lowell is a 20-year-plus veteran of MBS and ABS research at a handful of Wall Street firms. She is currently principal of OffStreet Research LLC. Disclosure: The author held investment positions in C and BAC when this story was published. Additional indirect holdings may exist via mutual fund investments.
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