After months of speculation and false starts, the Treasury Monday announced a new plan to deal with the so-called "toxic assets" that have been weighing down the financial sector and clogging global credit markets.
The announcement by Treasury Secretary Tim Geithner was greeted by a big rally on Wall Street but leaves unresolved some major hurdles that have plagued the rescue plan since October, when the Bush administration first floated an idea to deal with the troubled assets. And the new plan leaves unanswered the biggest question echoing from Wall Street to Main Street: Will it work?
With private investors still loath to step up and buy mortgage-backed securities and related assets, the latest Treasury plan shifts much of the risk to taxpayers. By partnering with the government, a few big investment funds will have a chance to profit off the toxic assets, sharing any proceeds with the government. But if the investments don't pay off, taxpayers will bear most of the risk.
“There is no doubt the government is taking risks,” Geithner told reporters. “You can’t solve a financial crisis without the government taking risks.”
In addition to the risk of taxpayer losses, there is also the risk that the government could set such a low price on the toxic assets that it could actually worsen the credit crunch.
The new plan will draw on up to $100 billion in funds already approved by Congress under the Troubled Asset Relief Program, as well as additional funding from the Federal Reserve. The government will match private investment dollar-for-dollar, and the Federal Deposit Insurance Corp. will put up significant backing, up to $6 for every $1 invested, in exchange for a fee.
The FDIC funding will be in the form of “non-recourse” loans, meaning private investors will be allowed to walk away from their investment if it goes bad, leaving the government with the failed investment and any losses on the loan.
After months of preliminary discussions with potential investors, the Treasury is now moving quickly; private firms have to apply by April 10, and the government will respond by May 1. Some of the nation’s biggest money management firms, including PIMCO and BlackRock, are considered likely candidates. The Treasury is expected to limit the list to a half-dozen firms at most.
What's the 'market' price?
At the height of the housing boom, investors couldn’t get enough of the mortgage-backed bonds Wall Street was churning out by the boatload because these investments offered a good return for what seemed like little risk.
But when it became apparent that sloppy mortgage lenders had doled out hundreds of billions of dollars to people who couldn’t pay it back, no one wanted to touch investments backed by mortgages. With no way to sell them, banks are now stuck with trillions of dollars worth of assets they can’t properly value. That’s clogging up the global flow of credit.
Though roughly 90 percent of mortgage holders are still making payments, investments backed by mortgages are selling for only 30 to 60 cents on the dollar. The reason is that — with unemployment rising and home prices falling — no one knows which mortgages will be the next to default. So banks have been forced to write down the value of these investments and take huge losses to cover the write-downs
The Treasury is hoping that by jump-starting the private market with a massive shot of government investment and lending, prices of these assets will stabilize and banks can either sell them off or assign them a more realistic value on their books.
The plan still faces a major hurdle that’s dogged rescue efforts since the Treasury first unveiled a plan to buy mortgage-backed bonds last October. If banks in the deepest trouble need to raise cash by unloading their troubled assets on the cheap, much the way they're dumping foreclosed houses at distressed prices, that “market” price for one set of bad loans could force other banks to take bigger write-downs on their holdings.
Banks may also have second thoughts about selling their “toxic” investments at any price, because bankers believe that most of these assets won’t be toxic forever. Since most mortgage holders will eventually make their payments, many of these investments should recover much of their lost value once the housing market and economy stabilize. If the Treasury purchase program sets a market price that’s too low, banks could decide to sit on these investments for years — producing the opposite effect the Treasury is trying to achieve.
Some market watchers say that with the banking system showing early signs of stabilizing, the government may not face the same urgency it did when the crisis began last fall. A sharp cut in interest rates engineered by the Federal Reserve has helped big banks shore up their battered balance sheets. Ailing Citigroup and Bank of America, for example, reported this month that they broke into the black in the first two months of this year after posting tens of billions in losses since the financial crisis began.
The Treasury's buyback plan also could be affected by a proposal now working its way through Congress that would change the so-called “mark to market” accounting rules that force banks to take big losses on investments that may some day recover much of their lost value.
With Congress in an uproar over bonuses paid to executives at bailout-recipient AIG, some potential private investors also have been reluctant to sign on for fear that the rules may change after the game has begun. The Treasury is trying minimizing that risk by promising firms that participate in the purchase plan they won’t be subject to executive compensation caps added to the original TARP plan.
But some on Wall Street fear Congress may yet enact rules that undercut the appeal of partnering with the government.
“The dark cloud on the horizon is this congressional hysteria against pay and redesigning the terms of a contract after they've been written," said Steve Bartlett, CEO of the Financial Services Roundtable, an industry lobbying group. "I think Wall Street is just sort of justifiably holding back because of that."
As anger in Congress has risen, the odds have fallen on the possibility of additional bailout funding. But key portions of the Treasury's plan don’t require congressional approval. That’s because the program draws much of its funding from the independent Federal Reserve and from the FDIC, which can draw on its own assets.
Despite the unimaginably large pile of money being funneled into the financial system, some of those involved in the plan say that — even if it works — it’s only a down payment on the eventual solution.
“Its fair to be optimistic; that’s the way Americans should be leaning," said Bill Gross, chief investment officer at PIMCO, one of the nation's largest bond funds. “But the hole here is a $5 trillion-plus whole in terms of assets and capital destruction. I think we’ve only gone about half of the way and the will be additional programs to come.”