Treasury Unveils Plan to Remove Toxic Assets
March 31, 2009
By: Tom D.D. Graff, Managing Director

After nearly five months of anticipation, the Treasury Department and Federal Reserve have finally released a plan to remove toxic assets from bank balance sheets. This is a crucial step in ending the vicious cycle of asset valuation declines, requiring further bank bailouts, which then results in more fear and more asset valuation declines.

Unfortunately, the plan may not be all it could be. The plan has two major parts: the Legacy Securities Program and the Legacy Loans Program.

The outline of the Legacy Securities Program suggests it will be a smashing success. It is aimed at securities that have been severely impaired from both a credit and liquidity perspective: collateralized loan obligations, residential asset-backed securities, commercial mortgage-backed securities, and so forth.

The Treasury will turn these credit- and liquidity-impaired sectors into just credit-impaired sectors, which will improve the value of these securities. Since financial institutions have already marked these securities to market, an improvement in the actual value of the instruments ought to result in an improvement of balance sheets.

Unfortunately, the outlook for the Legacy Loans Program is much weaker. Loans are generally not accounted for on a mark-to-market basis, but as book value less a loan loss reserve. The reserve is estimated based on the next two years of expected credit losses. Very few loans are currently held at less than 90% of the original book value. Unless the Treasury buys assets at $90 or more, banks won't sell.

While we do not know the final rules under which the Public-Private Investment Funds (PPIF) will operate, we can start to make some estimations about how much the PPIF might be willing to pay for certain assets.

For example, CCM has calculated that a typical portfolio of high-quality prime home equity loans would be valued by the Loan Program around $82. At that price, no bank will sell. CCM has estimated that Bank of America has roughly $250 billion of high-quality home equity loans with greater than 90% loan-to-value. The bank seems to have about 10% in losses provisioned on this portfolio. In effect, these loans are "marked" at $90. If they sold at $82, they would suffer an 8% loss versus their capital, or $20 billion. Currently Bank of America has tangible equity of $48.9 billion. Clearly the bank cannot afford to make this sale.

This is not to say that the Program will have no effect, but it will not likely be used by relatively strong banks. It is more likely to be used by weaker banks to raise cash, or possibly even by the FDIC in consort with selling off the assets of failed banks. Rather than prevent bad banks from failing, the program may allow for a more orderly dissolution of failed banks.

The program will also serve as a ready bid, even if it’s at a relatively low price, for any bank asset. This could in turn create more confidence in good bank’s liquidity position.

Regardless, we do not see this plan as substantially improving bank capital nor creating more visibility around residential lending losses. In such an environment, gauging the risk/reward of any financial bond or stock is nearly impossible.