U.S. Treasury Plan to Cleanse Toxic Bank Assets Gains More Definition

In both legacy asset programs, the Treasury will provide a public capital contribution on a 50/50 shared basis with private investors. In the case of the legacy loans program, the Federal Deposit Insurance Corporation will also provide guaranteed debt financing under a maximum debt-to-equity ratio of 6 to 1. In the case of the securities program, the Treasury will provide loans to a more conservative maximum debt-to-equity ratio of 1 to 1.

Funding for the legacy loan program will come from TARP ($75–100 billion), while the securities program will be folded into the TALF program (which has capital commitments from the Treasury of up to $100 billion and funding from the Federal Reserve of up to $900 billion). Both programs will benefit from extremely low debt capital costs—and term debt costs would certainly be lower than what the banks are paying currently—which should provide a boost to the price that investors would be willing to pay for the troubled assets.

With respect to the tricky issue of pricing the securities, the loan pools would be auctioned by the FDIC to private investors, with the highest bidder determining the price. In the case of securities, in principle, prices would reflect the underlying riskiness of the securities.

It is our view that the loan pools would be easier to price: loan collaterals are typically more transparent, and with a closer match between the duration of assets and liabilities, and much lower costs of debt financing, potential investors should be able to get a line of sight to reasonable discounts on the loans. Thus, the likelihood of transactions under the loans program is relatively high.

The issue of price discovery under the securities program is definitely trickier. It will likely be more difficult to assign collateral to pools of securities, and more difficult to match duration of assets and liabilities. In addition, securities would be subject to much higher levels of market risk. For these reasons, the securities program has much lower gearing, and the required discounts by investors on securities are likely to be much steeper than loans, thereby reducing the likelihood of a successful transaction. The securities program will likely require more solid signals of an impending economic recovery before gaining traction.

The bottom line here is that the Treasury has moved the ball a long way downfield—starting from near their own goal line after Geithner's speech on February 10—in terms of providing more definition and structure to the programs for financial sector stabilization. However, they are still some distance from the desired goal line of executing successful transactions for legacy assets that would give banks a fresh start. We would not expect transactions under the loan program until perhaps late in the second quarter. And it could be late in the third quarter before the legacy securities program starts to see transactions.

Overall, however, one ray of light to the resolution of the financial crisis is better than no ray at all, and markets gave this next phase of the program a relatively enthusiastic endorsement.