Another bailout, another outcry from the ‘let them rot in hell’ brigade. For mine, Tim Geithner’s latest rescue plan for the US banking system is the best we’ve seen so far.
The US Treasury is going to start its own hedge fund in partnership with private investors, specifically designed to buy toxic assets from the banking sector.
The government will provide debt funding, up to six times the amount of equity, and also contribute half the equity. Private sector investors will provide the other half of equity and make the decisions about how much to pay for the assets.
To use an example, let’s say a pool of sour mortgage loans with a face value of $1,000 is put up for auction. Several pre-approved private investors bid for the assets, with the highest bid being $700. The winning bidder will contribute $50 of their own equity. Treasury will also contribute $50 in the form of equity and $600 as a non-recourse loan.
If the government had simply bought the assets itself, it’s likely it would substantially overpay or, at the very least, that would be the public perception.
Under the latest plan, the government will be using the private sector to set appropriate prices, forcing those private investors to contribute some of their own capital so that they have an incentive to get their bid price right. There’s also a good chance of the government sharing in the private sector’s profits.
Still, the leverage looks too high. As Paul Krugman noted in a recent New York Times piece, that creates a return asymmetry. Equity investors are incentivised to overpay for assets because they get all of the upside and only have to wear a little of the downside.
But if the loan is priced correctly, there are also plenty of scenarios where the government does much better than the private investor. If we assume the asset in the example given above turns out to be worth only $650, the government would get $625 of its $650 back, and some interest, while the private investor would only get $25 of its $50 back.
Thus far, there have been three or four plans to address the US banking sector crisis. Of the ones that we’ve seen, this is the best. And something had to be done: it remains extremely difficult for even sound, creditworthy businesses to access credit – a disaster for the US economy and, by extension, the world.
But why Geithner chose not to simply start a new, government-backed bank to meet demand from genuinely creditworthy borrowers is beyond me. Surely it would be a highly profitable venture given the current pricing of loans? But in the absence of a brand new balance sheet, this looks like a sensible proposal for cleaning up the old ones.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.