A Public-Private Partnership?

To Chris’ comments  about the banks and the knowledge of the debt that they hold, this is generally my view of things although I suspect that it is not as much that banks do not know what they are holding (they most certainly know what is in their portfolios) as it is that they have yet to fully grasp the extent to which there are toxic assets in their respective portfolios.  No one should expect an accurate assessment at this point.  There are so many different factors in play between asset valuations, economic conditions and the real estate markets that this will not be determined until all the uncertainties (the buried bodies if you will) play themselves out and conditions in both the economy and the financial markets stabilize.   Furthermore, this is not going to be a fast process since a lot of the 2005-2007 vintage debt is still in the markets in sizable quantities (I think this is where a lot of the problems lie because underwriting standards were very relaxed if not nonexistent in certain sectors).  It could take banks, conservatively speaking, 12 to 24 months to figure this out.  In the meantime, commercial banks will proceed slowly, lending on a very selective basis and using the belt-and-suspenders approach to manage its risk exposure on new loans.  With the so-called “shadow banking system” completely out of the picture as it is now and with commercial banks taking it very slowly, under current conditions, we could be well into 2010 before we see anything different than what we are seeing now.  I don’t expect politicians to sit idly by.

What to do? Although I admit there being a real possiblity of at least a temporary bank nationalization (something six months I would have dismissed outright), I think the government-as-shareholder model is a terrible idea and so conflict-ridden that it should only be considered as an absolute last resort of all last resorts (hat tip to Kip at A Stitch in Haste).  I do not think there is more I need to say on this note.  I think restoring TARP to its original purpose is a potentially interesting alternative; however, it is not without its problems.  My biggest concern is that with billions of dollars of loans outstanding in vast worldwide financial markets with bad assets all over the place, it is going to be incredibly difficult for a single government body, even working in conjunction with the banks, to be able to develop criteria, a strategy and be able to execute it in a timeframe that I think is necessary right now.

Although it would probably be politically unpopular, and I would like to consider the possiblity of a decentralized public-private partnership strategy.  Private capital to the tune of billions has been raised to target distressed debt.  Most of that capital has yet to be deployed due primarily to 1) market conditions and the expectation that prices have not bottomed out; and 2) the bid-ask spreads between what buyers are willing to pay for discounted loans and what banks are willing to sell them for (likely the value on the bank’s books) are very wide (30%-50% differences).  I am also confident that the people in these markets have extensive knowledge of where the opportunities exists and can target them very quickly.

The government’s role would be akin to an insurance program where it would guarantee some miniumum value (or return) to the investors with the purpose of eliminating a considerable amount of the downside risk in these transactions.   While a market manipulation to be sure, a measure such as this would be aimed to reduce the amount of uncertainty that is factored into market pricing.  Basic principles of risk and return suggest that with lower risk, investor return requirements will also be lower.  As such, either investors would raise prices to the point where banks holding “toxic assets” would be willing to transact or new investors with a similar risk profile would enter into the market.

I understand that it is far from perfect.  For one, there is no guarantee that the banks themselves would sign on to such a plan and I think it would be difficult to convince lenders to sign on if the bid-ask spread does not tighten sufficiently enough.  I would find it distasteful to have to force lenders into this sort of arrangement although I would probably (and very reluctantly) be amenable to this scenario if taxpayer money continues to shore up the balance sheets of these banks in the way it is being done at the moment.  There is also the problem of cost.  While I envision a program like this not to require large outlays at first, it is going to take time to determine the true extent of the toxic assets in our financial system.  I have no idea what this will cost and I will not even pretend to make an estimate. 

However, I think a compromise can be reached on a point that could be particularly sticky: to the event a deal generates a return higher than the miniumum (or some other benchmark), the government participates in the upside.   Using broad numbers, if the minimum return is 5% and a deal generates 15%, then the cash proceeds that generate the return in excess of the guaranteed minimum would be divided between government and investor based on some predetermined percentage.  Otherwise, it is yet the potential of appearing like another program where the losses are socialized and the profits are privatized.  Given the amount of risk borne by the taxpayers, I think this program would be a tough sell (if it isn’t already) if the potential liabilities of such a program are not at least in theory partially offset where deals perform above expectations.

This is an idea I have kicked around in my head and this is the first time I’ve made any attempt to put it to paper.  Whether or not people agree with my idea, I do believe that the private sector can play a significant role in shoring up our financial markets, at least as it pertains to idenfitying and attempting to purge the bad blood out of the system.  In my opinion, possibilities involving public and private sector coordination should be explored to their fullest extent before the discussion of bank nationalization gets legs.  I do not pretend to know the answers to these difficult questions but I hope this discussion can at least get people thinking in this direction.

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3 thoughts on “A Public-Private Partnership?

  1. Several problems:

    1) Why would we guarantee 5 to 15% returns for private investors? It would be more efficient to just invest directly in the crap assets and take our chances.
    2) What would be the macroeconomic ramifications of the government guaranteeing a 5% return? If the government were to guarantee 5%, why on earth would anyone buy a treasury with a 4% coupon (10 year note is at 2.5!!!)? And if the government were to GUARANTEE a 5% return, you would have every private equity firm levering up and gobbling up the crappiest assets around knowing that they will be assured 5%.

    3) What of the political implications of the government handing over a check for $200MM to the KKR or Blackstone to “make them whole,” while kids go without health insurance?

    4) The problem is larger than the banks are letting on. The banks have written bah bah billions of bond default insurance in the form of credit default swaps, hidden in special purpose vehicles off the banks’ balance sheets. The notional value of these credit default swaps exceeds the value of the assets, acc. to some estimates, by ten-fold. In other words, you can buy all the crap assets you want, but the banks will still be on the hook for default insurance that, if triggered, would wipe them out… maybe 10 times over. Of course, you could encourage the holders of default insurance to close out their position, but that would cost the government as well.

    The only solution is for the banks to get real about the valuations of their holdings of crap mortgage backed securities. The last large-scale purchase of MBS was a few months ago (by lonestar) at 20 cents on the dollar. Banks are currently valuing these assets far higher by using exceptions to mark to market accounting. Banks should be forced to value their crap assets at 20 cents on the dollar or lower. This would wipe out shareholders, and likely bondholders, but who cares… yes, pension funds, poor widows, blah blah blah, but i have no appetite to pay for any more baby boomer screw ups. our generation is already forced to pay for trillions of dollars in debt b/c of the bad decisions of the boomers… who i have renamed, in the spirit of tom brokaw, the “Worst Generation.”

    Anyway, the banks would give bondholders their worthless stock, thereby shedding debt. This solution has its own problems, but it seems more equitable to wipe out those people who make bad investments.

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