Tuesday, March 24, 2009

Seller Financing

Wow, I didn't realize how apt the Buffalo Springfield quote ""There's something happening here. What it is ain't exactly clear" I used yesterday was for the PPIP. After lying awake last night tossing and turning over the realization that the sellers of the questionable assets are the ones financing the trade (with an FDIC guarantee of course) it's becoming clear to me.

The reason seller financing (without risk) is such a troubling concept when applied here is that it basically proves that the problem wasn't that the sellers needed the proceeds from the asset sales (because they are not getting the proceeds - they are financing a large portion of the trade) or that the sellers didn't have the capital to offer financing - the problem was that the asking price was definitely wrong. Now, for almost 18 months, we've been saying that the problem is that the sellers had a value (say 80c) for the assets, and the buyers disagreed on the proper value (they thought it was more like 30c). It's clear that the sellers KNOW they are wrong about their asking valuation. How? let's step back to July, 2008 when Merrill Lynch sold its CDO portfolio to Lone Star.

In that transaction, MER sold the CDO portfolio for roughly 20c on the dollar. But there was a catch - MER also provided the financing for 75% of the trade on a non-recourse basis to LoneStar, with the CDO portfolio as the collateral. This isn't as complicated as it sounds - what it means is that LoneStar put up 5c on the dollar, and MER loaned them 15c, to get to the 20c sale price. If the CDO's turned out to be worth nothing, LoneStar would lose 5c on the dollar (its entire investment), and MER would have effectively sold its portfolio for 5c on the dollar. If the portfolio ended up being worth 20c or more, LoneStar would reap the profits, and MER would have recognized a 20c sales price.

Contrast this to the PPIP, where the seller (let's use Citi as an example) sells its assets for, say 84c. As we went through the math yesterday, the PPIF will put up 6c, which will be matched by another 6c from the Treasury. The remaining 72c will come from FDIC guaranteed financing - but as I realized in my edits last night, the FDIC is not lending money - the seller is not receiving the 72c. The seller is LENDING the 72c to the buyer (by buying FDIC backed debt from the buyer, collateralized by the assets in question!) So, why do we need the FDIC at all? Why do we need Geithner's master plan? Why couldn't the seller have just done this in the first place - just like MER did last summer? Some people said there wasn't enough capital to soak up the assets. That's bullshit - Geithner's plan isn't creating any capital - all its doing is taking the risk from Citi and transferring it to the FDIC/taxpayer.

So, if the assets bought by the PPIF turn out to be worth less than 84c, Citi doesn't eat the loss, because the FDIC has stamped its guarantee on the box full of crap (there's that Tommy Boy quote AGAIN for you). This brings us back to my assertion that Citi knows full well that the crap isn't worth 84c. If they really truly believed that the assets were worth 84c, they'd be happy to provide a non-recourse loan to the buyers in order to finance the purchase of the assets, and the FDIC/Treasury/Geithner guarantee would be unnecessary! Perhaps this is why the detail of the seller financing was buried in the details of the plan.

The fact that this new plan's main offering point is that the FDIC is taking the risk that the selling banks didn't want to take is all the evidence we need that the problem wasn't a lack of liquidity, lack of capital, lack of confidence, or a temporary dislocation - it was that the sellers have been asking too high a price for the assets, and they know it. So, won't an auction of the assets result in an accurate and fair market price? Well, I already illustrated several ways that process could be bastardized, and I'll leave you with one more, a quality post today from Steve Waldman's Interfluidity Blog, where he explains why PIMCO and Blackrock may be so eager to participate in this program:

"Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner's plan, PIMROCK's $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK's $10B is wiped out entirely, as is the Treasury's investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss. But...these were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing."


1 comment:

Anonymous said...

Great post. Talking with a guy who knows plenty of ABS structuring quants. Says the problem is that the banks marked up the value of the positions they held on their balance sheets from the get-go. So they'd do a deal, keep a piece, then mark it up to $1.15X immediately. Did all this so they could jack up PnL to get bigger payouts.

Fast-forward to today. Those same assets are on bank books at $0.80X. So the banks have taken a write-down, but most of that write-down is just offsetting the initial inflated mark. Sure, they've taken a little 'real' PnL hit. But the big PnL hits still have not happened.

So there's why we see banks offered at 80 and the world 30 bid. The banks are lying, have been for several years now. It's a bad, bad situation. Senior bank management knows what's going on, that's why Crittenden was moved overseas. They all know the game, they know they are lying, and they are praying to god that this new Geithner hosing will save their skins.

It'd be great to subpenea about 50 quants, give them immunity, and let them tell the world just what's going on.

P.S. Love the 'Tommy Boy' quote, as well as the MER/Loanstar flashback.

P.P.S. MER lied about the price Bloomie paid for its stake in Bloomberg, got only about half of what the press reported. Another big old lie. Heard it from the horses mouth. Well, not *the* horse, but a very senior horse in Merrill's technology group (no longer with the firm).