Despite news yesterday that the Treasury's Public-Private Investment Program (PPIP) is going forward, people are still talking about why it failed. That's because, despite the fact that the program still exists, if it works at all, it will likely be scaled way down in comparison to what was originally intended. The Wall Street Journal's Real Time Economics blog offers a theory today from guest contributor Lucian Bebchuk, professor of law, economics, and finance at Harvard Law School. He blames the PPIP's failure on the mark-to-market rule changes announced this past spring. I see things differently. I would contend that the PPIP, even if only marginally successful, could actually nullify those mark-to-market rule changes.
Before getting into any analysis, I wanted to provide readers some background and explain some jargon.
The PPIP is the program under which the Treasury hopes to entice banks to sell their toxic securities (like mortgage-backed securities) to a group of nine investors it announced yesterday.
Banks must "mark-to-market" securities that they hold periodically so that a market-based value for those securities is shown on their books.
One of the problems that banks had faced in regard to toxic securities was that, since the market was so bad for them, the prices banks sometimes would settle for in order to get rid of them were fire-sale prices, i.e. very low prices agreed to because of desperation to get rid of the junk. Some argue that the hold-to-maturity values of many of these toxic assets are much greater than the values the securities had been sold for over the past year. That led banks to complain that they shouldn't be forced to value those securities at the market value. In other words, they should not be forced to mark-to-market, because those prices did not accurately depict the securities' value.
Congress heard banks' complaining and pressured accounting regulators to make a change. In response, a few months ago, shortly after the PPIP was announced, Financial Accounting Standards Board (FASB) -- the body that sets accounting rules/standards -- announced that they were changing mark-to-market requirements. The change essentially gave into banks' complaint explained above, and suspended the requirement for marking the toxic securities to market. The new standard basically said, if the market is sufficiently inactive for a security (even if not wholly inactive), then you can ignore market value. Only when you sell it do you have you have to recognize any associated gain or loss. For those keeping score at home, that rule is called "FAS 157-e."
Got it? Good. Now I can actually do some analysis.
So Professor Bebchuk thinks that, since banks no longer need to mark toxic securities to market, they have no reason to participate in the PPIP. After all, perception is reality in finance. If the values of toxic assets shown on banks' balance sheets don't get worse, banks' potential investors might no be as scared of them anymore. The whole problem with toxic securities in the first place was that investors couldn't tell just how ugly banks' balance sheets really were because nobody knew the value of the toxic securities. That's why the PPIP was developed -- so banks could get rid of those securities to comfort their investors.
My first critique of Bebchuk's point might already be clear: investors should be smart enough to call shenanigans. If banks suddenly look healthy, but nothing has changed except for their accounting requirements, then that's very suspect. Are investors dumb enough to trust health via accounting rule change? I certainly hope not. In reality, investors have become more comfortable due to banks' recent acquisition of new capital and adequate capital levels having been outlined through the government's stress tests.
But I think there's an even more interesting and very subtle point to be made. What if the PPIP makes the accounting rule change irrelevant? Even if mark-to-market requirements have been relaxed, there are still some banks that are likely to want to get rid of these assets. As I mentioned yesterday, the smaller banks will likely be most interested in the PPIP, since they aren't too big to fail according to the government and probably haven't scrounged up as much capital as the big guys. So maybe fewer securities will change hands through the PPIP than originally thought -- perhaps only something like $50 to $100 billion are traded, far less than the potentially $1 trillion envisioned. That should still be enough to declare an "active market" for most of those various types of toxic securities.
One of the original purposes of the PPIP was to create an active market for these toxic securities. And as long as there's an active market for those securities, then the accounting rule change is irrelevant. Those securities now must be marked-to-market, just like before. The new accounting rule only applies if there's a relatively inactive market. But even a marginally successful PPIP should create an active enough market to require those securities' market value be reflected on banks' balance sheets.
So what you could see here is the small banks turning the tables on the large ones. If enough of them choose to participate, they could force the big banks to mark-to-market their securities.
Mr. Inviglio: So if I'm following your thesis correctly, you believe that investors (the potential buyers of toxic assets under the PPIP) are smart enough not to be fooled by the mark-to-market change and how it makes the banks' books look healthier than they really are. Instead, you think that investors will participate in the market for toxic assets because they "have become more comfortable due to banks' recent acquisition of new capital and adequate capital levels having been outlined through the government's stress tests." In other words, the mark-to-market rules change is beside the point.
Wrong. The stress tests, and the mark-to-market change, were done not to prove to the world that all these banks were sound. No, they were done to COVER UP the fact that many of these "too big to fail" banks are in fact barely keeping their heads above water.
So why are the investors listed by Treasury REALLY participating in the much-reduced PPIP? Two reasons. First, hardly ANY of THEIR money is actually at stake. Under the plan, the minimum amount that the PPIP firms must bring to the table is $500 million in private sector cash. However, the minimum amount that the PPIP firms THEMSELVES have to put in is $20 million. That's it. Whatever the private sector raises will be matched by Treasury. So the taxpayer is, automatically, on the hook for 50%, while the PPIP firms are, potentially, on the hook for less than 1%. But it gets worse. Treasury has agreed to debt finance the ENTIRE EQUITY stake of the PPIP firms. THIS IS OUTRAGEOUS!!!! It's not enough that the firms have to put almost ZERO skin in the game. No sirree, the taxpayer has to front them even THAT tiny amount. They get the lion's share of the potential reward at almost NO RISK to themselves.
Did you even READ the press release?
Second, remember when the regulators woke up for about 30 minutes and said no to the banks' proposal to the government to let them bid on their own toxic assets? Well, unless I'm mistaken, at least one firm has found a way around that impediment. PPIP firm Blackrock is 49% owned by Merrill Lynch. Merill Lynch is 100% owned by Bank of America. Bank of America is holding a garbage barge full of toxic assets, both its own and the enormous amounts it inherited by its purchase of Countrywide. Hmmm. No conflict of interest, nope, not at all. Move along, there's nothing to see here.
"Got it? Good. Now I can actually do some analysis." Yeah, if only.
Claudius,
Believe it or not, I actually agree with most of what you're saying.
I never claimed, or even implied, that the stress tests and mark-to-market rule change were legitimate moves by government. Both are highly suspect.
I also never claimed that investors were suddenly eager to embrace toxic securities simply because of the accounting rule change or stress tests. They're willing to embrace them through the PPIP program, because they've got very little to lose -- just like you point out. I also lament the fact that taxpayers seem to be taking on the brunt of the risk. Again, I never claimed otherwise.
Then it should be clear that the thesis of my argument is: if the PPIP manages to create a market for these securities (which it might because, as you say, it's a great deal for investors), then that might nullify the mark-to-market rule change, because an active market will exist for those securities.
I hope it makes sense now, because given that we seem to agree on my premise, my conclusion should be plausible.
Yes, you're right, it might nullify the rule change. But it won't be a real market. It will be a fraud. Its only purpose is to facilitate, under the veneer of "free markets", the tranfer of ownership of toxic assets in a way that makes the banks whole. It does this is by putting all the risk on the taxpayer.
Sorry I got your name wrong, and I apologize for the snark in the previous posts. I'm just...enraged that the people who are supposed to protect the taxpayer's interests--Treasury, FDIC, the SEC, even the Fed--are not only abetting the bad behavior of Wall Street, but are finding new ways to continue it. Who does Geithner work for? The taxpayers, or Wall Street?
In this instance I agree with you Mr. Indiviglio, so let's try an analogy and see if it works.
On a public street (Wall Street), there is trash everywhere ("toxic assets"). The local government comes along and cleans it up. After a number of times doing this, someone comes up with the idea of placing a trash can (or a few) on this street (PPIP). The object of the trash can is to encourage people to throw their trash into the recepticle. The recepticles get filled (banks selling the assets) and emptied (investors purchasing the assets) and the street is now clear of garbage.
In this instance, I agree with your thesis that having the PPIP program is valuable, in a sense. Like you I am upset that taxpayers are on the line for half of the sale price.
But if it functions as the clearinghouse that it is set up to be, the typical market principle of "buy low, sell high" will apply - only in the inverse.
Banks that participate will sell the assets at a rate that "market" is willing to bear, and the investors buy them at that "market" rate. Once the trading begins (barring anything stupid like repurchase agreements in the sale), the activity should turn a profit for both sides until the inverted curve changes and the toxic assets become valuable again - at the prices set by trades in the PPIP.
Dan: I'm sorry to keep posting on this, but no real market will ever exist for most of these toxic assets for the same reason no real market exists for them now--the assets will never be anywhere near as valuable as the banks that own them need them to be. With PPIP, the government is giving the banks an escape hatch--an asset transfer to the government, which is where almost all of the securities will end up.
More than half of the money used to "buy" the toxic waste will be the Treasury's stake. Chances are most of the money used by the private sector in the "deals" will be debt-financed by the taxpayer. So almost all of the money will be taxpayer money. I wonder what the terms of that debt financing will be? I don't know, but strongly suspect, that there will be a clause in the contracts saying that the private investors can forego repayment of the money fronted to them if they cede their share of the toxic asset to the Treasury, which will be majority owner anyway. And, to top it off, the private investors could potentially deduct the loss from "their" nominal investment from their taxes.
Like I said, a fraud.
Whoa lot of text/comments here, so forgive me if this was already said, but under FAS 157 (etc) a transaction at "fire-sale price" does not necessarily mean same/similar securities need to be marked, as a matter of fact, the language is quite clear (as far as FAS language gets) here. If management believes a pricing information is "fire sale" they don't have to mark down their holdings accordingly as it represents a distressed sale.
Okay, I didn't want to get this deep into the weeds, but let me explain. There are three kinds of assets:
Level 1: Normal stuff, very active market, easy priing.
Level 2: Stuff that gets traded once in a while, so not an entirely inactive market, but you can find a price somewhere.
Level 3: No market, next to impossible to get pricing.
Once the stuff hit the fan last year, most of the so-called toxic securities became Level 2 assets, which were still subject to mark-to-market requirements. So every time one of these securities got traded, everybody had to change their marks. These might not have been true "fire sale" prices, but that's what most bankers considered them, because they were well below the internal valuations they believed in.
The accounting change specifically addressed those Level 2 assets. Again, you can quibble with me whether those were truly "fire sale" prices or not, but that was essentially the contention by annoyed bankers.
This is my understanding after speaking with a partner at a prominent accounting firm I in April about this stuff, when this accounting change was announced. Feel free to correct me/him if you know better.
Of course, if the accounting change didn't really affect the toxic asset market values, then I'm not sure the argument in the WSJ piece I'm addressing makes any sense to begin with.
The accounting change, to my knowledge only affected the hold price. With no market available, the banks can rely (like in the 80s) on their own internal valuation.
This makes it less likely for a sale to be conducted until the trading price reaches what the bankers holding the assets think they are worth.
Take the Merrill sale to of ABS CDO's to Lone Star last year, what amounted to a pennies-on-the-dollar trade. If you're holding similar for investment purposes you aren't "required" to mark those assets to the Merrill price under FAS 157 (etc).
I'm no expert, however, you should check out Francine McKenna at re:theauditors, because she (and her readers) is (are). www.retheauditors.com
Also, check out Edith Orenston at the Financial Executives blog http://financialexecutives.blogspot.com/
Both are very knowledgeable about this sort of stuff, far more than I am, that's for damn sure!