PPIP: Will banks just end up selling to each other?

By Felix Salmon
April 3, 2009

There’s been a lot of speculation about banks gaming the PPIP system by setting themselves up as investment funds and buying the very assets they’re meant to be selling, only this time with lots of government subsidy. I thought such worries were laid to rest with the explanation that very few people would be allowed to bid on the toxic assets. But now here comes the FT, reporting:

US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system…
Spencer Bachus, the top Republican on the House financial services committee, vowed after being told of the plans by the FT to introduce legislation to stop financial institutions ”gaming the system to reap taxpayer-subsidised windfalls”.
Mr Bachus added it would mark ”a new level of absurdity” if financial institutions were ”colluding to swap assets at inflated prices using taxpayers’ dollars.” …
Public opinion may not tolerate the idea of banks selling each other their bad assets. Critics say that would leave the same amount of toxic assets in the system as before, but with the government now liable for most of the losses through its provision of non-recourse loans.
Administration officials reject the criticism because banking is part of a financial system, in which the owners of bank equity – such as pension funds – are the same entitites that will be investing in toxic assets anyway. Seen this way, the plan simply helps to rearrange the location of these assets in the system in a way that is more transparent and acceptable to markets.

I’m particularly disappointed at the way this issue seems to have become politicized already, with Baucus (rightly) calling the idea of banks swapping their toxic assets at inflated prices absurd, and “Administration officials” going so far as to actively defend the idea.
The administration defense seems extremely thin to me: for one thing, there’s still a big disconnect between bond investors and equity investors, so it’s really not true that the owners of bank equity — especially the owners of common stock — are the same people who are going to be investing in toxic assets anyway.

But insofar as it is true, then that only serves to ratify the dark musings of Steve Waldman, who reckons that the biggest fund managers will be perfectly happy to deliberately overpay for toxic assets so long as that prevents them from having to take large losses on all the bank debt (and even equity) that they own.

Looked at this way, the combination of letting banks bid on each others’ toxic assets, along with the weakening of mark-to-market rules, will serve to maximize opacity, minimize the chances that insolvent banks will be revealed as such, and render the government’s stress tests an exercise in rubber-stamping utterly unrealistic balance sheets. The risks of a Japan-style lost decade seem higher than ever.


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The justification for this PPIP thing is price discovery, but it seems to be a very indirect route to solving the real problem. Getting liquidity into the market for bank assets is not the actual end objective. Nor is it even, for that matter, having banks meet some arbitrary regulatory capital ratio. The real objective will be met when people are willing to put senior debt into banks without requiring a government guarantee or massive premium (JPMorgan recently paid 345bp over mid-swaps for 5 yrs!!!). When that happens we can say that the problem will be well on the way to being fixed.

So I’m going to give you a world exclusive solution (I couldn’t be bothered writing it up in a paper that no-one will read; other than yourself, obviously, who was so very kind as to read my last one). Here goes.

Pick the pricing at which you think a good solvent bank should be issuing un-guaranteed term debt in a rational market. Of course that’s not to say you pick the pricing that banks were issuing at before the crisis, because that was not a rational market. Lets say you’d be happy enough with banks issuing 5 year paper to return 125bp over swaps, representing a good honest term premium.

Now you go to the bond investors and auction them, say, $10bln in 5 year senior debt in each of your major banks priced to return the 125bp over swaps. The “discovery” part is that investors bid not a price but the % of first loss the government would need to take in order for them to buy the debt with that given price. Ta da! The bids expressed in terms of first loss percentage indicate how much new equity the market thinks each bank still needs.

Of course its not perfect, but at least it would be transparent and directly address the issue. On the way you’d even pick up a bit of useful private, and hopefully not fully government guaranteed, funding for the banks as well. As for the government, you’d cap your first loss exposure to a maximum of $10bln per bank, or whatever number you picked as the issue amount, but obviously you’d expect to end up with an exposure far below that based on the actual clearing bids. And when you then recapped the banks based on the information gained in this process, your expected loss on the first loss exposure should fall pretty close to zero.

Always happy to discuss.


If the banks that are already holding toxic debt just end up swapping the loans amongst themselves, with the government providing 93% of the funds, then isn’t all this is really accomplishing is just establishing market prices for assets that banks refuse to sell for less than 85% of face value?

Oh, and now the government will be explicitly guaranteeing the banks’ debts instead of just implicitly backing it up. That sounds like a big benefit for the banks. Since this will make the job of running banks easier, maybe the execs won’t have to get paid so much.

So let’s say BofA has John Doe’s $300K mortgage, and Citi has Joe Smith’s $300K mortgage. Citi buys the Doe mortgage for $255K, and BofA buys Smith’s mortgage for $255K. Except that each bank only puts up $21K, the govt puts up $21K, and then loans them $213K. Each bank takes the $255K they get for the loans and pays down their debts, and is no longer holding a $300K loan, just half of a $255K loan that has the first $213K covered by the govt. Is this how it will work? Instant solvency?

since the banks’ toxic debts get de-toxed for free, it almost sounds like the financial equivalent of a perpetual motion machine, except that the govt is providing the backstop. They can do this because they are allowed to print dollars. I’ve always heard about the magic of the free market, now I see what the magic really is.

Posted by KenG | Report as abusive

This FT article bothered me too. None of the large banks receiving stress tests should be allowed to buy toxic assets with P-PIP monies. Further, bank regulators should be applying pressure on these mega banks to prevent the large banks from buying debt securities with equity-like yields. Zombies love to buy up toxic waste and they hate to sell it. (See ssrn.com/abstract=1343625). The government should discourage not encourage distressed or insolvent mega banks from buying speculative securities.

Price discovery is not the isse here – for we don’t need it, as there are already scores of active bidders for these assets and current marks. The problem is simply that the banks don’t like the prices – and until Uncle Sam stops sending them billions of tax payer dollars with little strings attached to plug the gaping holes in their capital bases, why would they sell at market? For evidence of what the prices look like – and there are marks out there – please see the FDIC’s own pricing data on their website for the actual loans they have sold – a link is in the following story. http://zerohedge.blogspot.com/2009/04/ex posing-utter-hypocrisy-of-fdic-and.html
TALF and PPIP is nothing but a concocted federal scheme to artificially inflate asset prices to a level where banks might consider selling – this is not price discovery. It’s Ponzi. Worse they are attempting to accomplish this price inflation via leverage. The PPIP will fail just like the TALF has just like the TARP has. The inmates are truly running the asylum.

Posted by Chad Morgan | Report as abusive