I want Treasury Secretary Tim Geithner's plan to save the banks to work. I want banks to jettison all the crap on their balance sheets and allow taxpayers to profit. Everyone does. It'd be the ultimate victory during an economic collapse where nothing has gone right
But I'm also a realist. There are several reasons to think that
Geithner's plan to form a public-private investment partnership will not only fail, but will become a massive wealth transfer from taxpayers to banks. When the plan first came out last week, I didn't think such a transfer was likely. With a simple example, I now realize otherwise.
No buyers, no sellers
The gap between what banks like Wells Fargo (NYSE: WFC) or Bank of America (NYSE: BAC) are willing to sell for and what investors are willing to pay is gigantic. If AIG
(NYSE: AIG) wants to sell an asset for $0.80 on the dollar, yet private
investors are only willing to pay $0.40 on the dollar, we get nowhere.
To solve this dilemma, Geithner's plan provides 85% nonrecourse
financing to private investors. The Treasury then splits the equity
50/50. So, to buy an asset for $100, private investors only have to
risk about $8. While that seems like an unfair risk for taxpayers,
private investors theoretically won't overpay, because they can lose
every dime they put in. In all likelihood, that'll prove to be the case
most of the time.
Yet with a little creativity, it's
easy to see how banks could sell assets at extravagant prices --
perhaps 100 cents on the dollar -- while dumping most of the risk on
taxpayers. Private investors who participate in this plan, you see,
have sole authority to set the bid price on assets. As the Treasury's
recent press release states:
The highest bid from the private sector … [will] define the total price paid by the private investors and the Treasury.
Hence, banks have a huge incentive to get someone to bid exorbitant prices. Who is that "someone"? Well, that's where things could get shady.
According to the Treasury, investors who meet a few simple criteria
pre-qualify to participate in the plan. For example, pre-qualified
investors must have:
All pretty simple. Oodles and oodles of hedge funds and private equity funds fit those requirements.
Trouble is, you can draw a straight line from banks to some of those
seemingly "independent" private investors. Hedge funds in particular
have extraordinarily tight relationships with investment banks like JPMorgan Chase (NYSE: JPM), Goldman Sachs (NYSE: GS), or Morgan Stanley (NYSE: MS) that often play ball on the same court.
In fact, private investment partnerships can actually be owned by
banks themselves. For example, Lehman Brothers invested in, provided
management for, and supplied office space to a hedge fund called R3
Capital Partners last year. It then sold $4.5 billion worth of assets
to R3 at undisclosed prices. For whatever reason, Lehman essentially sold assets to itself through an "independent" entity.
Welcome to the ingenuity of Wall Street -- throw in a little
creativity and fancy structuring, and suddenly the distinction between
banks selling assets and private investors buying assets is blurred.
Here's a simple example of how this could derail the success of Geithner's plan:
full price for the asset -- $100, in this case.Bank A receives $100. Expect something similar to Citigroup 's (NYSE: C) famous "We're saved! Everything is fine!" memo to follow.
due time, the asset's true value -- $30 -- is realized. Since Private
Investor B only put up a sliver of equity, it loses its $7 and walks
away. No biggie.
Now connect the dots:
… the taxpayer
nonrecourse leverage is involved, banks can simply overbid for assets
via "independent" investors and funnel most of the risk onto taxpayers.
Heads they win, tails you lose.
Like I've said before, 2+2 is never going to equal 100, no matter
how many bells and whistles you slap on these bailouts. If the goal is
to recapitalize banks in an efficient manner, there are other sensible ways to do it. Giving banks the ability to write their own ticket isn't one of them.
© 2009 UCLICK, L.L.C.