Capital Markets

How Much Is That Toxic Asset in the Window?

Can Treasury's attempt to create a working marketplace for banks' so-called toxic assets succeed? It depends on whether those assets can be legitim...
Sarah JohnsonMarch 23, 2009

In U.S. Treasury Secretary Timothy Geithner’s latest strategy for fixing the economy, he has returned to the concept his predecessor initially floated: buy up the troubled, mortgage-backed securities that are weighing down banks’ balance sheets.

This time, the government — and taxpayers — won’t be the only purchasers or risk takers. The new plan, called the Public-Private Investment Program, the government will try to create marketplaces for banks’ mortgage-backed securities and loans that they have been either unable to offload or unwilling to sell at prices they could fetch today. Under this strategy, unveiled today, the government will spend $500 billion to $1 trillion to fund the transactions.

What’s different from former Treasury secretary Henry Paulson’s plan, introduced last fall, is that the government will be sharing the risk of investing in the so-called toxic assets with such private investors as participants in hedge funds, private-equity funds, mutual funds, and pension funds. The investments will be partly capitalized by Treasury funds, with financing help by the Federal Deposit Insurance Company and the Federal Reserve.

Currently, the marketplace is broken, with sellers far outweighing buyers as sellers want to get rid of assets whose creditworthiness has plummeted, explains Curtis Arledge, managing director and co-head of U.S. fixed income at BlackRock, Inc. the big investment-management firm.

Nevertheless, the Financial Services Roundtable, which represents 100 financial services companies, believes the plan will improve liquidity. “By offering incentives in terms of matching funds or loan guarantees, the government is helping to break through the Gordian Knot,” says Scott Talbot, senior vice president of government affairs.

But the fundamental problem with the government’s original proposal for bailing out the banks still exists: How much are those assets truly worth? The current marketplace views much of the assets as “uncertain or depressed,” according to Geithner, which has led to large writedowns and a clogged credit system, as banks have become reticent to lend.

Geithner’s strategy stops short of predicting what specifically will happen once his plan is put in place. He leaves it up to banks and investors to nail down truer values of mortgage-backed securities that have been stuck in illiquid markets. “Over time, by providing a market for these assets that does not now exist, this program will help improve asset values, increasing lending capacity to banks, and reduce uncertainty about the scale of losses on bank balance sheets,” he wrote in a column summarizing his plan in today’s The Wall Street Journal.

Indeed, say observers, it’s not the Treasury’s responsibility to value assets. In fact, that was a main criticism of Paulson’s plan: government officials would attempt to be valuation experts. Geithner’s plan puts the valuation work in the hands of the private sector. “There’s nothing government can really do to help the issue of valuation other than to create a market,” says Brett Barragate, a partner at law firm Jones Day whose clients include financial institutions that have received funds from the government’s Trouble Relief Asset Program.

Under the new plan, it’s up to banks to package pools of loans and offer them to the government-established funds. Geithner hopes investors will fight to take part in the funds and gain access to the government funding. It’s unclear which types of investors will participate, although Treasury is encouraging a variety of them, including hedge funds, to sign up. Barragate doubts that such investors as pension funds, however, will want to risk their reputations by purchasing toxic assets.

To be sure, the success of the plan depends on the “participation from both willing buyers as well as sellers, in addition to the substantial government assistance being provided in the proposed policy package,” notes Bill Gross, founder and co-chief investment officer of PIMCO, an investment management firm that plans to participate in the plan.

Also interested is BlackRock, which believes the Treasury’s plan will increase the number of willing buyers and improve the supply-demand system, according to Arledge.  

However, “willing buyers and sellers” don’t automatically translate into a working market, observers say. Geithner’s plan doesn’t go beyond the first transaction between the first round of buyers – the private/public funds – and the sellers – the banks. “Without a second half of the market, all we’ve done is created is a mechanism to get the bad assets off the balance sheets of banks onto the balance sheets of the public-private funds,” says Barragate. “They’ll have to wait out the bottom and see what happens, because who would buy the assets off these entities?”

The government is trying to help reestablish effective trading, explains Dwight Grant, a managing director at financial advisory firm Duff & Phelps. Grant believes that result won’t be apparent until the bid-ask spread for the mortgage-backed securities in question narrows significantly from current levels.

Geithner’s strategy is a step in the right direction for closing up the wildly different views buyers and sellers have of the assets up for grabs, Grant adds. Substantial differences do not reflect “the normal language” of a functioning market, he says.

Indeed, Geithner’s plan could result in higher values for the toxic assets, which many view as substantially undervalued. Yet to be determined is how high they will go. Grant believes the plan, if successful, should give us a realistic view into the asset’s current value, forcing banks and the government “to face the truth, whatever it is.” And the truth may result in Geithner once again going to the bailout drawing board. “These asset values could show that some financial institutions are more insolvent than we thought,” Grant says.