Tim Geithner and the PPIP

The debate continues over how much the new Public-Private Investment Program will help in the recovery of the U.S. financial system. The pessimists insist that asset managers will only pay fire sale prices for toxic assets. The optimists insist that the result will be a mass writing-up of toxic asset values. As with most things in life, the truth is somewhere in the middle.

Thus far, the focus of mark to market has been with toxic asset-backed securities. Securities are subject to MTM accounting. Of course, some banks insists that no market exists for some securities and places them in a so-called Level-III assets bucket. This is the home of securities which are too illiquid or esoteric to properly value (or so the banks say). Some banks have substantial sums of Level-III assets. One large New York-based banked moved $80 billion of toxic assets to Level-III in November. Even considering Level-III the PPIP could (should) be helpful to banks and the capital markets. However, its effectiveness could be limited by the toxic loan portion of the plan.

Loans are not marked to market. They are usually considered as being held to maturity and are not marked. Many of these loans are not worth 100 cents on the dollar, nor will they ever be. Gains obtained by selling toxic securities at prices higher than where banks have them marked could be moderated (but not necessarily offset) by falling loan values, should the government force banks to sell their most toxic loans as some expect.

Why sell loans at depressed prices when they can be held and worked out over time? Because investors (institutions such as hedge funds and asset managers) will not fully commit to investing in banks until toxicity is acknowledged and then removed from bank balance sheets. The result could be more capital injections into banks with the most PPIP losses and, in extreme cases, a change to the corporate structure (divestitures) of some banks. I do not believe we see outright failures of large U.S. banks.

Some banks, such as PNC, could experience significant write-ups as a results of its acquisition of National City. When one bank acquires another, the assets, including loans, of the acquired bank are valued at the time of acquisition. The results is that PNC has marked down the values of NCC loans. PNC could experience price recovery on both asset-backed securities and loans. Banks such as Wells Fargo may not experience such recovery as many of the loans it acquired in the Wachovia deal were pay-option ARMs. A pay-option ARM permits the borrower to set monthly payments within a stated range. Many such loans have experienced negative amortization as borrowers have not made payments sufficient to reduce principal. Couple that with declining home values and it is apparent that the values of these loans are low. Impaired asset values is why Moody's issued a report stating that BAC and WFC could be forced to undertake a preferred to common equity exchange similar to Citi. This may be necessary in spite of the PPIP and possible changes to MTM accounting.

Many equity cheerleaders have credited potential changes to MTM accounting as the reason for the latest bear rally in the equity markets. Although this has helped, the rally began in earnest when Treasury Secretary Tim Geithner announced details of the PPIP. The announcement placated some of the bank vigilantes, but not all of them.

Although the stock market has experienced its sharpest recovery since 1982, the bank and finance sector of the corporate bond market has only experienced modest gains. The credit default swap market has actually worsened with the price to purchase protection rising. What could cause such a divergence of opinion? Speculation and apprehension are the most likely causes. Some market participants are apprehensive to become bullish on the banks because they are concerned that bank losses via the PPIP could be worse than expected. They are also concerned that changes to MTM could make it so banks do not have to acknowledge many of their losses on toxic assets thereby rendering the PPIP impotent. The vigilantes want the toxicity of the balance sheets. Leaving the glow-in-the-dark assets on bank balance sheets will be viewed as a negative by the credit markets. Why trust the banks' valuations of toxic assets. They are not exactly impartial parties.

Does this mean fixed income investors should avoid bonds and trust preferreds of large money center U.S. banks? Not at all. The government has taken extraordinary measures to ensure that these institutions remain solvent and out of default. If one can tolerate volatility one can obtain attractive yields on senior and subordinate debt.

Following my piece on foreign bank leverage, a reader responded with information that a certain German bank had leverage of over 50 time as of last autumn. I have heard similar stories about a number of European institutions, but have been unable to verify actual numbers. I am often asked about other shoes to drop. One large shoe could be the European banks. That may be a sector that all but speculative investors should avoid.