The Markets Dissect the "Plan"

The stock market was volatile yesterday and will likely remain that way as investors digest the Stimulus Plan and get more details on the Geithner Plan. The objectives expressed by our new Treasury Secretary have many facets but no specifics yet. We believe the structure of each part will be crucial to fixing the credit markets, improving the banking system, and re energizing our economy.

We have been thinking about the Public-Private Investment Partnership to buy toxic assets from the banks. The government needs to attract as many investors as they can in order to grow this fund to a size that will be large enough to effectively clean up bank balance sheets. Given this objective, Mr. Geithner needs a very flexible structure to capture the diverse investment styles and needs of private equity funds, hedge funds, and many other investors.

The distressed assets held by the banks are predominantly either mortgage related or corporate bonds/loans. Generally the investors for these securities are not the same as the vultures who might participate may not want to buy a package of mixed securities. Hence, we would advise Mr. Geithner to create many investment funds which will be segregated by different classes of securities. This will maximize the investor base as specialized funds can buy what they want while multi-strategy funds can participate in many partnerships to buy a diverse set of securities.

The investor universe also has different risk/return profiles. Some investors want leverage while others don't. Therefore, the government needs to offer a leverage option to any investor who wants it but not make it a requirement for everyone who participates in the fund.

Finally, the enormous quantity of toxic assets will scare many institutions from wanting to be first in to buy these securities. No investor is wants to be the first to buy a pool of securites when billions if not trillions more will be for salethe next day, at perhaps lower prices. We would suggest Mr. Geithner should offer some loan loss protection for the first buyers and as assets are removed from the banks' books, the loan loss protection should decline.

Under our framework, the government would create a leveraged loan partnership. The investors in this fund would have the option of receiving some amount of leverage from the government at low interest rates. The early investors could get somewhere between 20% and 50% of downside protection. This will get private investors to be excited to join the government in its quest to clean up the mess. After the first slug of assets are bought by the partnership, the government will likely be able to reduce the loan loss protection and perhaps even the leverage as a larger universe of investors will want to join the partnership. This concept is very similar to the marketing concept of the early adopter.

The above strategy should be used for each asset class that the government pursues from the balance sheets of the banks. A committee of investors should determine the price to bid for each security as they will have the expertise to value them. The government should also commit a large amount of capital to each of the partnerships. This program is the one which will likely be profitable for the U.S. taxpayer and perhaps make up for some of the other losses.

If the government acted alone to buy these toxic assets, they would be assuming 100% of the losses as well as any upside. The public would be distrustful of the prices they paid and perhaps this plan could fail quickly. Therefore, our suggestion to initially offer large loan loss protection wouldn't put the government at any greater risk than if they had purchased all the securities without the help of the private sector. A combination of enough loan loss protection and leverage should be enticing enough for the private sector to partner with the government in its pursuit to clean up the bank balance sheets. If executed well, asset prices will rise as more of them move off the books of the banks. The result will be an improvement in credit markets and a stronger banking system. Of course, the government will need to inject more capital into many financial institutions as these assets are written down by the banks.