Monday, May 18, 2009

Time to ditch the PPIP

You know the world has changed when you go out for a drink with a banker (from the “legendary 19”) and he orders “anything without government in it”! Out of curiosity I seconded the order, and we both received a commiserating look and a vodka tonic.

Anyway, the topic du jour is the PPIP… Revisited after several rounds of thinking, as well as conversations I had with a (small) sample of eligible buyers and sellers. And I am convinced more than ever that the scheme has become useless.

I mean, literally. First of all, in the post-stress test era, I’m having trouble to understand why we need to subsidize investors with taxpayer money to bid up the prices of the banks’ legacy assets.

Think about it… IF (big IF) we were to take the results of the stress tests at face value, banks are fine (we are told), provided they can raise the amount of capital they were instructed to, privately or otherwise. This is because the stress tests have already taken into account the expected losses on banks’ assets (over 2 years), including the “legacy” ones, even under an extremely bad scenario.

But if that’s so, banks shouldn’t need additional help in the form of artificially high bids for their legacy assets. At best, they could sell them to the private market and fetch prices consistent with the government’s own analysis. At worst, they could keep them in their books for a couple of years, possibly more, and still be comfortably capitalized and ready to lend to businesses, mortgage borrowers, you and me. So, why PPIP?

One reason could be that the stress test results are a joke. But let’s not be so harsh… Even if the stress tests results are sound, the PPIP might still be useful if it could facilitate the process of “price discovery” for the legacy assets. But this is not the case.

The whole point of providing private investors with cheap government money is to encourage them to bid up the prices and help bridge the gap between what sellers would love to receive and what buyers would be prepared to pay in the current market conditions. (The idea is to avoid having sellers incur massive losses that could force the government to acquire unacceptably high equity stakes in banks and be accused of the N-word.)

But this is not “price discovery”. It’s a subsidized purchase. As such, it will do little to catalyze market activity in banks’ illiquid assets more broadly, since buyers will not risk bidding high for assets that are not covered by the government’s funding. It is even questionable whether investors would be willing to take the risk to buy securities with maturities longer than the government’s funding.

Ironically, price discovery is happening already in private markets, at least for some “legacy” assets. I am not in this field so what follows is anecdotal, but I understand that at least some “legacy” securities and even loans are being sold and bought as we speak.

Indeed, if you want to see price discovery, you might not have to go further than the sales of loans and securities conducted by the FDIC itself! These are asset sales on behalf of the numerous banks that have been going bust every other Friday or so and that the FDIC (shhh!!) nationalizes before turning them around and re-selling them to new private owners.

True, the prices fetched may not be prices that the FDIC (or the taxpayer, for that matter) likes. But the merit is a swift turnaround of the failed banks, which can then be run by new (better) owners and start lending again. At the same time, the “legacy” loans are passed on to investors with better expertise in distressed assets, loan work-outs and the like, who should be able to maximize the value of these assets (sure, for their own benefit, but also at their own risk!)

Then you also have the problem with the sellers. I mean, what’s in it for a seller? Oh, really? Higher prices? But take a look at the cost…

First, per my fellow drinker’s quote, eligible sellers loathe the idea of having anything with “government” in it. So that’s the starting point. The question is, is there anything that can incentivize them to participate anyway?

Well, one could be the government’s stick. But how strong is that stick? Post-stress tests (and related recapitalization), the government’s case for forcing banks to sell their illiquid assets has become weaker.

Beyond that, the incentives are few to none, especially in the absence of forced collective action. The reason is a big free-rider problem: An individual bank has every incentive not to sell anything, and wait (hope) instead that the participation of the other banks in the PPIP will improve financial market stability and lift asset prices more broadly. At which point, it will go ahead with its own sales, benefiting from the PPIP without having to bear the brunt of Congressional oversight or the public’s wrath for its taste for private jets.

So is there a solution?

Frankly, my preference has been, since time immemorial, for a fully government-owned vehicle to take over banks’ illiquid assets swiftly, at close to “market” prices (or at least prices consistent with a given probability distribution of economic scenaria).

The government could then manage these assets to maximize shareholder (taxpayer) value. Management would include, of course, selling these assets in an orderly fashion to private investors—only that taxpayers have all the upside (and the risk, of course, but they bear most of the risk now anyway).

This never happened because of concerns about heavy writedowns and concomitant bank nationalizations. Fine. But post stress-tests, the landscape has changed: The government’s case for a taxpayer subsidy to banks and investors is weak, especially as banks have been raising capital in private markets and trying to issue debt free of FDIC guarantees.

So maybe it's time to ditch the PPIP and let buyers and sellers sort things out privately, including bank recapitalization. If the latter becomes forbidding for some banks, the taxpayer can step in, with all the strings attached to maximize taxpayer value but also with the due arms-length approach to bank management that allows that value to flourish (something that is not happening right now in some cases).

Ultimately, you can't satisfy buyers, sellers and taxpayers all at once--something has to give. In my world, sellers are forced to take action (as in writedowns), but with the promise of a predictable, reliable and prosperous field ahead for private enterpreneurship (and bonuses!).

Because if there is anything all three groups agree on is the following: Nobody likes to have the government meddling in their affairs!

1 comment:

Richard K. Green said...

This is a good post, but I am not sure it is right. Suppose legacy assets really are worth more (in some fundamental sense) than buyers are willing to pay, because discount rates are screwy (and spreads suggest that they perhaps are). Then a non-recourse loan at a low rate might lower the weighted average cost of capital to something appropriate, given risks, and therefore force price discovery. Should the assets be truly underpriced in the current market, the government will be repaid, and ex post the subsidy will be quite small.

On the other hand, if buyers are already pricing things appropriately, PPIP is just a hand-out, and we are indeed screwed.