Sunday, April 5, 2009

5 more ways to scam the bailout

Voltron says: what a great time to be a bankster! But now that mark to market accounting has been thrown out the window, the banks have no incentive to participate in any of these bailout programs.

From Businessweek:


Banks may be able to finance the sale of their own troubled loans, lending money to the public-private partnerships that buy the assets. A bank's loan to the partnership would be buttressed by an FDIC guarantee. Administration officials confirm that the Treasury may allow such seller financing. The move essentially replaces junky mortgages on the bank's books with an FDIC-guaranteed loan. With its risks so limited, the bank has every reason to pass off its weakest assets as better than they are, argues Fuqua School of Business finance professor Campbell R. Harvey. "They will want to unload the worst possible things at the highest possible price," he says. "And if they're doing the financing, it's even more likely that they will be able to do that." Government officials say they will charge more for loans used to buy the riskiest assets.


Say a private investor in one of the partnerships owns big stockholdings in a bank putting assets out to auction. By overbidding for the bank's sludge loans, the investor could help drive up the banks' shares and make a tidy profit. His stake in the partnership might take a hit if the assets eventually aren't worth what the auction price suggests. But the government would shoulder most of any big losses. As long as the private investor's stock market gains exceed his loss in the partnership, the deal's a winner.

Government officials see this ploy as too risky for most investors to try. But the Treasury would be hard-pressed to prevent such maneuvers, short of barring a slew of hedge funds and other big bank investors from bidding in the auctions at all. Besides, it's impossible to disentangle all the connections between banks and money managers. "How do you find a private money manager that doesn't have a relationship with a bank?" asks Albert "Pete" Kyle, a University of Maryland finance professor.


In the public-private partnerships, the private partners are supposed to figure out how much to bid for assets, keeping the government well away from the business of pricing deals. But the way the deals are structured, the FDIC and Treasury will absorb as much as 93% of any losses, while getting to keep just half of any profits. "The government's going to be on the hook for the [deals] that are bad," says Brookings' Young. With their own downside so limited, the private partners are likely to be drawn to the riskiest deals, which offer the highest potential payoffs—and the government the biggest potential losses. One option under consideration is including multiple private partners in each partnership as a check on one another's excesses.


For all the talk of toxic assets, some banks may want to hold on to their suspect loans in the belief that they will eventually pay off. The Treasury and the Fed, however, are breathing down the banks' necks to unload problem debts.

What to do? A bank could effectively swap its existing portfolio of junky loans for another one very similar—only this time limiting the downside by using government loans and guarantees. The bank would auction off its loans to a public-private partnership. Then, using a portion of the auction proceeds, it would set up a different public-private partnership that would of course have access to government loan guarantees and matching funds. The bank would use the new partnership to buy a portfolio of similar problem assets twice the size of its old portfolio. The bank would then split any gains from the new portfolio 50-50 with the feds—but risk no more than the sliver of equity it contributed to the deal. The Administration may seek to block such maneuvers.


Perhaps the most intricate maneuvers will likely stem from "layering" the government's many programs of the last six months. Starting with some of the capital infusion received last fall from the Treasury, a bank could invest in a private partnership that buys toxic assets using a loan guaranteed by the FDIC. Those assets could then be chopped up and sold as securities to other investors—who put together the financing for the deal by availing themselves of another program of low-risk loans from the Federal Reserve. Thus the original bank's capital at risk in this web of deals would be almost nil. "[This] is going right back to the practices that got us into this problem—except using government leverage," Young says. "It might lead to an even wilder party than we saw before."

How much leverage could investors or banks pile up? "As much as you can get away with, of course," says the bank analyst at one investment management firm. He thinks the recent outcry over bonuses at American International Group (AIG) may promote some self-restraint. "You're going to get caned in public these days, rather than getting caned in private," the analyst says. "There's not much appetite for that."

One government planner counters that if each program's safeguards are good, layering "shouldn't be a problem." Final rules are expected in the next several weeks. Banks and investors, meanwhile, will keep trying to get the most out of Washington.

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