Just when government bond investors were growing concerned at fast-deteriorating public finances and huge new supply of bonds to pay for stimulus plans and financial system bailouts, along came a new group of buyers to cap rising yields. Politicians and policymakers know they need to restore confidence to the markets, and central bank quantitative easing, creating money to buy government bonds, certainly looks like a confidence trick.
With 10-year US treasury rates rising 80 basis points from the start of the year, the signs of imminent panic were rising, until the Federal Reserve announced it would buy up to $300 billion of US treasuries of between two- and ten-year maturities over the next six months. That is equivalent to 15% of total outstandings and 30% of forecast new issuance in that period.
Following this announcement rates traders report a stronger tone in the markets, with other buyers looking to extend duration and even go down the credit curve into agencies and government-guaranteed debt.
Can US Treasury secretary Timothy Geithner pull off a similar trick in another distressed and over-supplied asset class: residential mortgages and other toxic real estate loans and bonds?
His plan for a public-private investment programme, long in gestation, finally emerged last month with much hype obscuring a rather elegant simplicity. It enables new private investors to put up as little as $6 in equity which the Treasury will then match and also guarantee up to six times leverage against, allowing for a purchase of up to $84 in face value of distressed loans originally valued at $100.
Geithner has learnt much from the private sector in the presentation of his plan, like investment bankers sounding out initial price talk on a deal at $84 and hoping the debate will centre on whether a fair price is from $82 to $86, rather than somewhere between $60 and $30. And legacy assets sound so much more enticing than toxic ones.
Let’s not be fooled. The Treasury might as well have used an example of leveraging $3.50 of private equity, to fund a purchase price of $49 against original face value of $100 on some toxic assets. And for securities, it has been more conservative, promising to match $6 of private equity with $6 of its own and between $6 and $12 in financing guarantees for buying power of $18 to $24.
The plan achieves two limited but important goals. It guarantees that there will at least be a floor price somewhere above zero, although not, of course, where that price will be. And it eliminates the illiquidity discount now applying across the board to all distressed assets – indeed to most performing assets. Investors will be left instead to focus on the fundamental value of the underlying assets and the sustainability of cashflows depending on how bad the economic downturn gets.
Previous downturns have shown that wonderful things can suddenly happen when such discounts to original face value open up on toxic assets. New buyers have a very different relationship with troubled borrowers than do original lenders. If they have bought loans at 49 cents on the dollar, sharing upside and downside with the US taxpayer on six times leverage, and assuming that cash flows from the assets will wash through the interest costs on the debt taken out to purchase them, it only needs the borrower to suddenly find it can repay its original debts at 56 cents on the dollar and the new investor has doubled its money.
That’s how fortunes are made in distressed debt.
Geithner can stress that the taxpayer will take half of the profit. Of course, someone is left with a loss: in this case, shareholders of the original bank lender which no doubt will now include the taxpayer.
It remains to be seen whether bidders will pay prices that banks and other holders can sell at without wiping out their capital. Other bad asset classes have emerged in the months while the Treasury has been devising this – not over-complicated – plan to address the original problem of mortgage-related assets. Plenty of defaulted corporate loans on both sides of the Atlantic are now trading at well under 30 cents on the dollar.
But confidence counts for a lot. And just having buyers try to calculate the potential returns from picking up cheap assets sends a positive signal, even if it does entail the taxpayer buying a winning position for one pocket by taking a loss in another.
