Toxic assets on bank balance sheets have chilled lending and business activity, and until most of these assets are liquidated, the economic recovery will remain handicapped.
In 2008 the Troubled Asset Relief Program was supposed to address this problem. Tarp, however, morphed into a capital-injection program. In 2009, the Public-Private Investment Program was created to provide attractive liquidity and leverage to the buyers of toxic assets. Though PPIP will probably help to some degree, price remains a key impediment to banks' ability to sell large amounts of toxic assets.
Potential buyers, eager for a good deal and perhaps distrusting the sellers' cash-flow projections for distressed-asset pools, generally bid low.
Though this was not a surprise, low bids put banks in a difficult position. Do they agree to sell assets at prices they believe are too low (thus effectively transferring value from their shareholders to the asset buyers), or do they keep the assets and work them out over several years?
If their cash-flow projections prove accurate, then holding the assets is the right business decision. Unfortunately, holding on to these assets does not clear balance sheets, and overall economic growth therefore remains subpar.
The key to breaking this logjam is the development of a pricing mechanism that improves the price received by the seller, but also provides an attractive return to the buyer. Also necessary is the achievement of a true, nonrecourse sale of the assets so the seller no longer needs to hold capital against the toxic assets.
Innovative private-sector financial strategies can be developed to reach these disparate goals without government aid or intervention.
My idea for addressing the problem is a "planned asset liquidating security" structure to achieve a higher sales price for the sellers of toxic assets. In brief, PALs use a real estate mortgage investment conduit structure that bifurcates the toxic assets into a senior "A" tranche that would have sufficient subordination to achieve an investment-grade rating and a "B" tranche that contains most of the remaining assets.
Though achieving a good price for the A tranche is not problematic, it has always been difficult to achieve a good price for the B tranche given the risks associated with the cash-flow projections on pools of troubled assets. However, though this pricing problem has been historically difficult to overcome, it is not impossible. The key to improving the sales price for the B piece within the PALs structure is the addition of what I call "return stabilization warrants."
The RSWs are bundled with the B tranche at the time of sale. As the name implies, the RSWs act to stabilize the return to the buyers of the B tranche by moving in value inversely with the cash-flow generation of the underlying assets. The owners of the RSWs are granted the right to buy one or more shares of a $100 par value preferred stock at a sliding scale that is based upon the cash generated by the pooled assets. If the toxic assets achieve or exceed the original cash-flow projections, the RSWs expire without any value. Conversely, if the actual cash flows fall short of the cash flows estimated at the time of the PALs sale, the exercise price of the RSWs declines to a level designed to make the B tranche investor whole.
For example, if the buyer of the B tranche expected total cash flows of $1,300 by the end of year three, but the pooled assets only provided a return of $1,240, the investor would be $60 below their expected return. At this point the exercise price of the RSW would adjust to $40 allowing the RSW holder to purchase a preferred stock worth approximately $100 per share for $40. The resulting $60 gain on the preferred stock has the effect of making the B tranche holder basically whole.
The bank that sold the security appears likely to achieve sales treatment since the bank is never under any obligation to pay out any cash to stabilize the return to the buyers of the toxic assets. In fact, this structure has the serendipitous benefit in that the only cash transaction after the sale of the assets would be a capital injection into the bank if the RSWs are exercised.
Though there are numerous other issues not discussed here that are involved in such a structure, the key takeaway is that innovative, private-sector solutions for the successful disposition of billions of dollars worth of toxic assets can be developed if the capital markets are allowed to function.
Overreliance on governmental programs to fix private market problems typically results in suboptimized solutions for the economy and taxpayers. The time has come for private-sector leadership to reassert itself in the development of solutions for the problems that face our nation's banks.
