Mr. Geithner’s plan to remove bad assets from bank’s balance sheet is finally out and is a roaring success with the market, which rallied about 7% today.
The plan is divided into two parts; the first part deals with the problems of “Legacy Loans” (formerly known as toxic assets). The second part is an expansion of the TALF program about which I have written earlier, so I will only write about the Legacy Loan program in this post.
Here is how the Legacy Loan Program will work:
1. Since the whole idea behind this program is to rid banks off their toxic assets — they will be asked to identify which assets they wish to sell. For example – Krypton bank decides it wants to sell its cattle ranch at Krypton, which has a face value of $1000.
2. After the banks decide what they want to sell, they approach the FDIC and get their assets evaluated.
The FDIC plays a very critical role in this plan.
- It insures the debt that will be issued to fund the purchase of the bank’s asset.
- It determines the level of leverage that is safe for this transaction. The maximum leverage that FDIC can allow is 6:1.
Let’s say Krypton Bank approaches the FDIC, which thinks that a 6:1 leverage is good for the cattle ranch at Krypton.
3. Once FDIC determines the leverage — the pool of assets is sold off in a bidding process. The highest bidder will have to bring 50% equity, he will get the remaining 50% from the Public Private Investment Program (Government).
Now, this is the most interesting part. Suppose you always dreamed of buying a Cattle Ranch on Krypton, but never had a thousand dollars. In fact, all you have is 50 dollars.
You can put up that 5o dollars as your equity, the government will match that up with 50 dollars of their own. So, the total equity is now 100 dollars. Since the FDIC has approved a leverage of 6:1 — they will insure loans up to 600 dollars. It won’t be too difficult to raise the money because the FDIC is insuring the debt — so you put in a bid of 700 dollars (50 dollars of your own + 50 dollars from the government + 600 dollars of debt).Â This 700 dollars happens to be highest bid for the Krypton Cattle Ranch.
4. If the bank agrees to the highest price, the buyer will issue debt that is guaranteed by the FDIC. The asset will then act as a collateral for the FDIC guarantee.
In our example — Krypton Bank is only too happy to sell you the ranch and you issue debt to raise the money and become the proud owner of a Cattle Ranch in Krypton. Of course, you have to keep the ranch as a collateral to FDIC, which has insured your debt.
5.Â The buyer will manage the asset from here on and hopefully make a profit on it. All the best with the ranch.
We will soon know how well the plan will work. As soon as the first block of bank assets come up for sale and the buyers start bidding, we’d know where this is going. If the government has to increase the leverage or the equity participation then that is not a good sign. On the other hand, if the sales start taking off, then that means that the plan is working.