The PPIP: It’s NOT the Liquidity, Stupid. It’s the Marks.

You can say something about the current Administration: they are really trying. The recently released Public-Private Investment Program (“Program”) details show both a lot of thought and some really good ideas. Unfortunately, the essence of the Program and its messaging are still missing the boat on a few important fronts. The main issue: the Government perceives the problem to be one of investor liquidity and the ability to finance broken asset portfolios. The problem is that they are wrong. It is all about banks not wanting to own up to inflated balance sheet values. But here are some other problems with the Program and its positioning:

• Still enamored with short-term stock market movements. Larry Summers stated that the Administration is “gratified” by the stock market’s reaction to the Program. Why, oh, why, do Senior Government officials, especially those with ostensibly high IQs, say such stupid things? Guys, the focus should be on doing the right thing for the long-term, not on what will goose the market for a day or two. And while Summers et al claim to be all about the long term, then why do they keep on talking about stock market reactions to policy decisions? If there is one thing we know for sure, it’s that the market is very, very jittery and volatile, and is apt to make sharp moves in response to almost any news. While the Dow could rally 500 points today, it could just as easily fall 500 points if liquidity fears rear their ugly head, another bank runs into trouble, populist rantings by Congress spook the markets, Pandit is given a long-term employment contract, etc. Bottom line: the Administration needs to stop talking about and caring about short-term stock prices. Stock prices are not unlike the Treasury yield curve: easy to manipulate on the short-end, difficult if not impossible to impact for a sustained period on the long end.

• Forgetting the appetite of the supply side. The Program, with all the benefits provided to approved buyers – equity matching funds, cheap leverage, etc. – lists only a single line when addressing a key weakness: Participant Banks don’t actually have to participate. Participant Banks can submit portfolios for auction, Approved buyers can line up, valuation firms can estimate the worth of portfolios submitted for auction, buyers can submit their bids and Participant Banks can say: no. I fail to see how the Program is a material departure from the current landscape, except for the fact that the Government is providing cheap financing. The buyers are still running equity risk regardless of the 1-1 Government match (as they should), and will only submit bids that reflect their assessment of risk and return. This may result in prices that are still far out-of-line with current bank carrying values, causing banks to reject the highest bids in a move to avoid further asset write-downs. So even a protracted auction process could result in a whole lot of nothing. What does Larry Summers think a failed auction will do to stock prices? I shudder to think.

• Perpetuating entrenched and failed managements. The Program is a vehicle for helping broken firms liquify broken asset portfolios. What it doesn’t do is help broken firms get rid of broken managements that got us into these problems in the first place. In the rush to protect major lenders from going out of business (and protecting stockholders and debtholders in the process), the US taxpayer is given scant protection from the cadre of poor leadership teams that led firms into troubled waters. Why is AIG the sole whipping boy for the Government when plenty of other firms were complicit in damaging the financial system? While legacy AIG management deserves much of the scorn they’ve received, most broken bank executives have gotten off with nary a scratch. This I do not understand.

• Not reflecting the true magnitude of the Government’s involvement in the numbers. If I read the materials properly, it seems as if the only money being counted against TARP are the equity matching funds being provided. What about the leverage being guaranteed by the FDIC? Depending upon the values realized for the purchased portfolios, those guarantees might come into play, increasing costs well beyond the equity commitments. This is more an issue of truth-in-advertising. While yes, having the private sector side-by-side is a good thing, the Government via the FDIC is providing the debt guarantee. If this isn’t incremental exposure to the US taxpayer, then I don’t know what it is. This needs to be clearly factored in as an explicit cost of the Program.

My program, as discussed many, many times on this blog, is different than PPIP in one major respect: it does not rely upon the banking sector’s willingness to participate; it forces the issue. Maybe banks will finally be willing to separate themselves from loan and securities portfolios at prices less than their marks. But I don’t think so. The Government’s plan is predicated upon the assumption that a lack of investor liquidity is the issue. But they are wrong. The issue has almost nothing to do with investor appetite and everything to do with banks avoidance of facing into the market values of their portfolios. And when push comes to shove, they will beg off and avoid selling into auctions that will validate the inadequacy of their capital positions and invalidate the quality of their marks. The only way they will do do is by force. This means Good Bank/Bad Bank, Crisis Style.

Why is the Government wasting so much time and taxpayer money dancing around the issue? If my read of the situation is wrong and the Program is a smashing success, I’ll be the first one to say so on this blog. But if my perception is right – the same perception I’ve had for, oh, nine months – then I’d like Treasury, the Fed, the FDIC and the President to move quickly to address the toxic asset issue once and for all. The PPIP contains many of the mechanics necessary to pull of Good Bank/Bad Bank: the main difference is compelling the supply side – the big, broken banks – to participate. Guarantee depositors funds without limit. But say goodbye, stockholders. Goodbye, unsecured debtholders. Goodbye, loser managements. Hello private investment in Good Banks. Hello, private investment in Bad Bank assets with profit sharing along with the US taxpayer at current market levels. Can’t we just skip the PPIP and go straight to this? Because we know who will participate in my program: Everybody.

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