Tom Barrack Jr. is an old hand at turning a profit on distressed financial assets. During the savings and loan crisis of the late '80s, he was one of a handful of young financial whizzes helping Robert M. Bass strategize the Texas financier's $400 million purchase of American Savings Bank, the country's largest failed thrift, from the federal government. The deal turned into a huge winner for Bass and his crew.
Fast-forward to today. The government has rigged up a mechanism to rid banks' books of toxic assets by offloading them to private equity firms and hedge funds. Barrack, now the CEO of Colony Capital LLC, says he supports the plan, known as the Public Private Partnership Investment Program, which Treasury Secretary Timothy Geithner announced March 23.
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But Barrack believes the government's latest asset dumpathon may not
go as smoothly as the one in the '80s, when the feds seized the failed
S&Ls outright and sold their soured assets to the highest bidders.
Clean, quick and effective. "One thing all of us in the market back
then knew was that those assets were going to trade, and trade at the
best market price," Barrack says.
Today, for a host of reasons, the government isn't seizing control.
Instead, the PPPIP, targeting $1 trillion or more in shaky mortgages,
commercial loans and securities, leaves it up to the banks which assets
to sell and at what price.
And there's the rub. Since many regional banks have yet to mark down
rickety business and construction loans from their original "par"
value, selling them at anything close to their true market value surely
would set off a tsunami of write-offs that would further damage banks'
capital ratios and cripple their earnings.
Banks could escape that pain by simply deciding not to sell. "If you
leave pricing in the hands of banks and there is no accountability for
them not to sell, it's unlikely they're going to sell at a realistic
value," Barrack says.
Investors also may be just as reluctant to buy assets. Now, the
bid-ask spreads for troubled financial assets are "very wide," says a
PE investor. And it is not at all clear that the subsidies the
government is offering to PPPIP participants will end the gridlock.
The subsidies are quite generous: The Fed would put up 93% of the
total purchase price, 86% of it through a loan and 7% as equity that
would match the private-sector contribution, which also would be
equity. The Fed's loan must be repaid before the equity collects a
penny of profit.
Now consider how the arrangement might pan out in reality -- and the
downside risk to investors who happen to overpay: Imagine that a bank
sells off troubled loans for 16% below par, or 84 cents on the dollar.
If the loans end up recouping 90% of their original value, the private
investor would score a 51% return on investment. But suppose the loans
make back only 72% of par value. In that case, the investor's equity
would be wiped out. By contrast, the government would lose 8% of its
outlay. That sort of arithmetic weighs against PE and hedge funds
bidding up too blithely.
"We don't think of the [subsidy] as something that is going to
magically increase the value of the assets," remarks Mani Sadeghi, a
managing partner at Equifin Capital Partners. "We aren't going to overbid just because someone is going to lend us 80 cents to do that."
What's more, a proposed change to the Financial Accounting Standard
Board's "mark-to-market" accounting could make banks even less inclined
to shed assets. The proposal, FAS 157-e, which would give banks great
leeway in marking "available-for-sale" holdings," was up for a vote
last Thursday.
If the PPPIP fails to end the standoff between banks and bidders, as
many expect, the government may have to step in and strong-arm banks
into selling the dicey assets. But the tough-guy tactics may not be
necessary, one distressed-securities investor says: "Some banks that
have been more realistic on markdowns are going to sell first, and then
I think other banks will see there is a huge advantage to doing that.
"That is because the first banks that recapitalize and start making
loans again are going to pick up a lot of market share and be the first
to recover."
