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The Junk Game Within the Junk Game

By John Batchelor on April 7, 2009 at 9:45 AM in American Consumers, Banking Institutions, Economic Stimulus, Economy, Tim Geithner, Toxic Assets, treasury department

From the John Batchelor Show blog. Susan’s Note:
I can’t state enough how important it is to read this article.
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Pirate Bankers Rising.

Francesco Guerrera, FT, reported to my financial roundtable on the show, Sunday 5, rnewtljs.gifthat the bankers are preparing to game the junk assets on their books.  Here is the part of the scheme that I like best so far:  The banks have discovered that the Tim Geithner plan called PPIP provides that the federal government will contribute 85% of the purchase price of the toxic waste on the books of the now insolvent banks regardless of who bids on the junk.   Let the games begin.

Let us stipulate that the bidders are going to pay top dollar for the junk asset.  If the bank that holds it claims it is worth 80 cents on the dollar (and even if you know it is worth well under 33 cents on the dollar), you still bid 80 cents.  This means that if Citi bids on $10.00 of Chase’s junk — and is willing to pay full value — Citi puts up $1.50 and the feds put up $8.50.  Simple.  Now why would Citi want to pay even $1.50 for junk that is possibly worthless and will certainly be impossible to price candidly?  Two reasons:

 1.  Because Chase is meanwhile buying Goldman’s and Goldman’s is buying Citi’s, in a daisy chain of junk buying and selling, all underwritten by the feds at 85% of the costs; and

2.  Because it gets the junk off each bank’s books and so makes their stocks rally, since the reason they are undesireable to investors is that they cannot now price their junk for sale nor find any buyers at any price.

Once the junk is gone, the lone problem the banks have is the $1.5o they each put at risk.   (Not now exploring the high probability that the banks have formed third party entities with hedge funds to buy a ton of calls on the bank in order to profit when the junkless stock rallies.)  From Businessweek.com:



PORTFOLIO SWAPPING

For all the talk of toxic assets, some banks may want to hold on to their suspect loans in the belief that they will eventually pay off. The Treasury and the Fed, however, are breathing down the banks’ necks to unload problem debts.

What to do? A bank could effectively swap its existing portfolio of junky loans for another one very similar–only this time limiting the downside by using government loans and guarantees. The bank would auction off its loans to a public-private partnership. Then, using a portion of the auction proceeds, it would set up a different public-private partnership that would of course have access to government loan guarantees and matching funds. The bank would use the new partnership to buy a portfolio of similar problem assets twice the size of its old portfolio. The bank would then split any gains from the new portfolio 50-50 with the feds–but risk no more than the sliver of equity it contributed to the deal. The Administration may seek to block such maneuvers.


Solving the $1.50.  

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The additional game is that the banks then cut up the junk portfolio that they individually acquire with the backing of the feds money and then sell the bits to new entities, such as hedge fund and private equity outfits and pension funds — and even individual investors — all of whom get the same 85% credit backing from the feds.  In sum, the fed money is used twice for the same rubbish.  There is no end to this cutting up and reselling.  The insolvent Citi and Bank of America not only get the junk off their books, they also distribute the junk to so many secondary junk buyers that there is no risk whatsoever.  Ahha!  This sounds like the original folly that got us here.  Not yet, because none of this will be rated better than junk — as opposed to the old triple A.  From Businessweek.com:


LAYERS OF LEVERAGE

Perhaps the most intricate maneuvers will likely stem from “layering” the government’s many programs of the last six months.

Starting with some of the capital infusion received last fall from the Treasury, a bank could invest in a private partnership that buys toxic assets using a loan guaranteed by the FDIC. Those assets could then be chopped up and sold as securities to other investors–who put together the financing for the deal by availing themselves of another program of low-risk loans from the Federal Reserve. Thus the original bank’s capital at risk in this web of deals would be almost nil. “[This] is going right back to the practices that got us into this problem–except using government leverage,” Young says. “It might lead to an even wilder party than we saw before.”

How much leverage could investors or banks pile up? “As much as you can get away with, of course,” says the bank analyst at one investment management firm. He thinks the recent outcry over bonuses at American International Group (AIG) may promote some self-restraint. “You’re going to get caned in public these days, rather than getting caned in private,” the analyst says. “There’s not much appetite for that.”

One government planner counters that if each program’s safeguards are good, layering “shouldn’t be a problem.” Final rules are expected in the next several weeks. Banks and investors, meanwhile, will keep trying to get the most out of Washington.


What Is Wrong With the Picture?

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The feds may be waking up to the gaming and establishing new rules that limit the above plans and add the usual federal fantasies schemes to a project.  For example, Treasury now says that applications are due by email by April 24 and that it specially favors small businesses, women and minority owned enterprises to participate.  

The rules will continue to adjust until we see a program with the scale and headlessness of the Pentagon contracts program.  What is wrong with the picture when the feds are involved is that the picture is always foggy and arbitrary and does not ever show an end to the shenanigans.  I note that the new rules still have not changed the game so far of bidding on other people’s junk with other people’s money and selling your new possession to other people for a profit.  From the WSJ:


In Monday’s documents, however, the Treasury made clear that firms that don’t meet all of the criteria won’t necessarily disqualify a proposal. The Treasury added that it is particularly interested in program participation by small, minority and women-owned businesses.

“There are several ways smaller firms can partner with fund mangers including as an asset manager, an equity partner or a fund raising partner,” the Treasury said in a notice Monday morning. “Other ways to participate include providing such services as trade execution, valuation, and other important financial services.”

To better accommodate increased participation, the Treasury also announced that it is extending the deadline for email submissions of applications to 5 p.m. EDT on April 24. Additionally, the Treasury now expects to inform applicants regarding preliminary qualification on or before May 15.