Toxic assets are about to be given a $500 billion antidote, though one that may cause painful side effects.  Once it goes live following its comment period, the government’s new toxic asset program seems set to be a boon for investors…and riding shotgun with them are the taxpayers as co-investors and lawyers and other professionals as trusted advisors.  With new programs now being announced around various categories of legacy assets, the U.S. government seems to be committed to a trifecta of action: cleaning up muddied bank books, rejuvenating credit markets and restarting securitization markets.  In the process, the remedy may prove a painful one for some, forced to take “mark to market” valuation hits or, in the extreme, outright winding down. 

With Federal Deposit Insurance Corporation (FDIC) Chairwoman Sheila Bair, the head of a systemic risk regulator, openly touting how much money participants stand to make, it’s not hard to see why markets seem so excited.  Toxicity comes in various flavors, leading to multiple government cures.  Both put the private sector near the center of the program, with the government squarely at the center.  However, with peals of praise still ringing out, issues may yet erupt. Among the possible issues are mark-to-market valuation risk; Troubled Asset Relief Program (TARP) restrictions; restructurings and even winding down – all a part of what is (arguably) a back-handed bailout.  This list is a start, though far from complete, and seems likely to be joined by taxation concerns, among other issues.

Essentially, there are two government plans that were announced yesterday – each addressing a different form of legacy asset. The first addresses legacy whole loans (i.e. actual loans, or pools of them, still sitting on financial institution balance sheet), while the second addresses legacy securities (i.e. pooled loans that had been combined, sliced and securitized).  The details of these programs are still being worked on, but what the government has already made clear is that it intends to remain focused (at least initially) on real-estate assets – both those tied to residential real estate and mortgage markets, and their commercial equivalents.  Participation in both programs is intended to be broad:  Subject to certain eligibility requirements, any institution may be a buyer or seller, no matter how small (and small sellers will actually receive added pooling support from the FDIC on one program).

Equity – or the lack thereof – has received much of the early focus of the newly announced government plans.  Though not quite as equitable as they sound at first, both programs center on public/private investment partnerships, funded through evenly split capital contributions – i.e. equity.  Financing (aka “leverage”), as explained below, will be further available, in the form of government-sponsored debt.  The essential breakdown of their roles: The private sector is charged with contributing both capital and pricing expertise, while the government (through various arms) is charged with putting up ½ the risk capital and all of the additional debt financing.  Any private sector player may act as buyer, so long as it meets certain eligibility requirements and puts the necessary “skin in the game” (i.e., capital contributions).

Speaking of leverage: debt is to be fully provided by the government, under structures that vary by program. Legacy loans are to have leverage available in the form of FDIC-guaranteed debt (up to a maximum 6:1 leverage ratio) – consider this an extension of another bailout program, the Temporary Liquidity Guarantee Program (TLGP). Legacy securities will make leverage available in the form of direct Treasury financing – consider this an extension of the Term Asset-Backed Securities Loan Facility (TALF) program.  The TALF extension will provide loans to investors allowing for the purchase of legacy securitization assets that include non-agency residential mortgage-backed securities and commercial mortgage-backed securities that were originally rated AAA.

Pricing expertise – and its close cousin, insistent negotiation – are the other main contributions expected from private sector participants.  These valuation issues have been a sticking point from the start, centered around two concerns.  The first has been the government’s reliability as price-setter and this new structure is squarely aimed at that. The second, though, remains a serious concern: collapsed under the rubric of “mark to market”, it’s really the risk-filled need for banks to face up to pricing realities and adjust their internal carrying values for assets.  Essentially, the sale of assets by one bank will lead to downward marks by all banks that own like assets.  The involvement of the private sector as price-setter will settle this once and for all – though not necessarily to everyone’s great pleasure.

With this level of government involvement, the alphabet soup of government programs (among them: EESA – the Emergency Economic Stabilization Act, TARP, CAP – the Capital Assistance Program, and ARRA – the American Recovery and Reinvestment Act) along with an array of related restrictions may be a concern.  The government claims that the toxic assets program is distinct from TARP and thus not subject to restrictions, particularly those relating to executive compensation.  They are trying to draw a distinction between those “bailed out” by the government (and thus subject to restrictions) and those merely “participating in government programs”, whether as buyer or seller, and thus not so restricted.  A stretch, you might say, at least as to sellers under the new plan, as any a practitioner will tell you that asset sales and equity sales are both routes to recapitalization.  One government program that the FDIC insists will apply: the new Home Loan Modification Program will apply to any whole loan purchased through the FDIC-financed Legacy Loans Program.

Restructurings and winding down are spoken in more hushed tones, but they are the other subtext of the current plans.  As FDIC Chairwoman Sheila Bair said on her Monday announcement call, not every bank will make it through this process whole.  The involvement of the FDIC (which is a systemic risk regulator and not just the deposit insurance provider) and its history of winding down banks is a sure cue.  Set against a backdrop of systemic risk concerns and bank stress tests, it seems certain that some banks will be restructured out of existence as a part of this process.

While stock market reaction shows a very excited group of markets, that is as yet premature.  The program launch is still several weeks away, with FDIC officials alluding to a time period of 8-10 weeks before first auction occurs.  There are several steps to go through – between comment periods, negotiation with banks, due diligence, among other tasks – things seem set to yet change.  What appears set to remain is an opportunity that has not been seen since the days of the bailout of the Savings and Loan companies by the Resolution Trust Corporation.

Published: March 24, 2009