March 16, 2009
By Malay Bansal
Note: This write-up was published on the Seeking Alpha website here.
On Feb 10, when the Treasury secretary Tim Geithner announced the Financial Stability Plan, which included a Public-Private Partnership Fund to remove bad assets from banks’ balance sheets, the markets reacted very negatively because of disappointment with lack of details on the plan. According to news items, the announcement of details is imminent now. Given the magnitude of reaction to the original announcement, many in the market await the plan details with interest.
That Fed should provide financing to private investors, instead of buying toxic assets itself (to help remove these troubled assets from banks balance sheets), is accepted by a lot more people now. By involving private capital, the government can minimize use of public funds and provide a mechanism for determination of fair prices for these toxic assets based on competitive bids by multiple private investors (my follow-up and original articles describe the reasoning).
Although no details have been announced, and the details are likely to change till the program is finalized, recent news articles have suggested that the administration is considering setting up multiple Investment Funds, with a Private Investment Manager running each fund. The Investment Managers will put up some equity, and government will provide financing to the funds. The private investment managers would run the funds, deciding which assets to buy and what prices to pay. Since there would be a limited number of funds, they would most likely target all types of assets rather than focusing on one specific type of distressed security. In addition to providing financing, government will also add equity to the fund alongside the private manager and would share in any gain or loss with the manager.
Even this simple description has couple of factors that are significant and bear watching.
First, if the government sets up a limited number of Investment Funds, it will reduce the competition for assets. One of the major results desired is for the selling banks to get the highest rational price possible for these assets to avoid further losses to them. With just five to ten investment funds bidding, the banks will be less likely to get the highest possible price. Instead of setting up just a few Investment Funds, the financing should be available to all investors – whoever has the highest bid on the legacy assets being sold should get it. Let various people and companies who have expertise in different types of assets assess and bid on them. Greater expertise and competition will result in higher sale prices.
Second, the idea of government putting in equity in these Investment Funds is less than ideal. The logic for doing this, of course, is that the private investors will benefit from the plan, and so the public should benefit too by investing alongside them. However, the goal of government in this endeavor is not to take investment risk for any potential gain, and Treasury should not be risking public money in this manner.
Also, saying that public should benefit alongside the private investors implies that the private investors are getting a sweet deal from the government and would make outsized returns by using government’s help. Suggesting this would only generate opposition to the plan from the public. Reality is, and should be, that the private investor should be taking the first loss risk. No public money should be at risk of loss till the private investor has been fully wiped out. This risk is what justifies the higher returns the private investors will get, if the asset performance does not turn out to be worse than pricing assumptions. Their returns will be less than expected if the asset performance is worse than assumed at the time of pricing. It will be very important to explain this aspect to lawmakers and general public to promote understanding and to avoid criticism and opposition of the plan. Private investors should not be asking the government for additional guarantees, and should clarify the risks they are taking to avoid backlash from general public and lawmakers.
Another justification offered for Treasury to put in equity in these funds may be to increase the total amount of funds used to buy toxic assets. Using simple numbers of let’s say 50% equity and 50% financing, the argument may be that, if the private investor puts $100 million, then government will put in another $100 mm resulting in total $200 mm of capital. If however, the government also put in $100 mm of equity alongside the $100 mm of private investor’s capital, then the total of $400 mm will be available to purchase assets. However, this logic is flawed. In this example, the government will be putting in $300 mm of capital and private investor $100 mm. If the government only provided financing, using the same 50% equity and 50% financing, it will be able to get total of $600 mm to purchase assets.
The TALF program has undergone significant changes since it was originally announced. In fact, the Public-Private Program could even be modeled along somewhat similar lines.
The Public-Private Partnership program will play an important role in the cleanup of bank balance sheets, which is one of the prerequisites for eventual return to normalcy for credit markets. We watch with interest what it would look like when the Treasury announces the details.