When Good Assets Go Bad

With the release yesterday of the Public-Private Investment Program (PPIP) Fact Sheet, we have not only another acronym to add to our alphabet soup of bank rescue plans, but finally some detail on this long-awaited program. US Treasury Secretary Timothy Geithner has remained consistently on-message with his contention that the main problem facing the US economy is a lack of liquidity due mostly to the inability of the banks to free-up enough cash to provide adequate levels of lending to businesses and consumers. Geithner places the blame on the so-called “toxic assets” that continue to clog the balance sheets of major financial institutions and because no investor is prepared to buy these assets, the banks cannot liquidate these holdings and use the cash to bolster their lending arms.

Toxic assets? – that does sound bad doesn’t it? Who in their right mind would buy assets labeled as toxic anyhow? Turns out, there are a number of potential buyers but the real problem is that the banks aren’t willing to sell at the prices being offered. In other words, the banks don’t like the current market prices so they would rather sit on these assets and hope that prices rebound down the road – or more realistically, lobby for some kind of government bailout.

No one is arguing that these assets are no longer worth anything near to what the banks booked them at originally. Estimates differ, but it is safe to say that the collapse of the housing bubble has reduced these assets – securitized mostly by pools of now questionable mortgages – anywhere from 40 to 70 percent. Despite these events, the banks continue to price these securities at or near their original book value which only ensures there is no active market for them. The banks claim that hey have no choice as pricing them at the current market price would force them to suffer losses so significant that most of the US banking system would be wiped out overnight. This is clearly something the Obama administration wishes to avoid.

To deal with this stalemate, the PPIP will provide potential investors with lending capital and other provisions designed to entice new investment. Geithner is counting on the government’s pledge to match private investment on a dollar-to-dollar basis – together with a six-to-one leverage ratio and other loan guarantees – to provide sufficient incentive to convince a large hedge or pension fund to make an offer for a pool of securities that the holding institution can accept. There is potential for some of these assets to regain some of their value but this requires a long-term buy and hold strategy. For the right investor, this could be an excellent opportunity to purchase a large position with very little in the way of upfront costs and even less overall risk.

Geithner is also hoping that if he can apply enough influence to get one deal completed, this will establish the pattern for other deals. The success of the PPIP will ultimately be measured by how many transactions actually result from the new program, but one thing that is certain is that Geithner’s future is very much dependant on this plan. His competence has been questioned lately and Congress will not likely provide more money for further schemes unless it sees meaningful progress from the actions taken so far.

This article is for general information purposes only. It is not investment advice or a solution to buy or sell securities. Opinions are the authors; not necessarily that of OANDA Corporation or any of its affiliates, subsidiaries, officers or directors. Leveraged trading is high risk and not suitable for all. You could lose all of your deposited funds.