Could you profit from Obama and Geithner's toxic assets plan?

Xin Lu — Wed, 25 Mar 2009 01:27:28 +0000

This week the United States Treasury announced the Legacy Loans Program. The program is meant to be a partnership between the government and private investors to clear "toxic" assets off the books of banks. Some large financial firms have expressed that they may set up mutual funds to buy these assets. Could you possibly profit by buying these funds as an individual investor?

First of all, lets explain how this plan from the Treasury works. First, banks pick out the loans and mortgage backed securities they want to sell. Then private investors would bid for these assets through the program, and the highest bid wins. Presumably these investors should have done their research and evaluated how much they are willing to pay for the assets. Next, the FDIC will finance a significant part of the purchase at a subsidized rate for the investor. The Treasury will kick in another portion of the purchase price, and the investor puts in cash equivalent to the amount the Treasury puts in. The amount the FDIC finances is at most six times of what the investor contributes.

Here is an example with actual numbers from the Treasury press release:

Sample Investment Under the Legacy Loans Program

Step 1: If a bank has a pool of residential mortgages with $100 face value that it is seeking to divest, the bank would approach the FDIC.
Step 2: The FDIC would determine, according to the above process, that they would be willing to leverage the pool at a 6-to-1 debt-to-equity ratio.
Step 3: The pool would then be auctioned by the FDIC, with several private sector bidders submitting bids. The highest bid from the private sector . in this example, $84 . would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.
Step 4: Of this $84 purchase price, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.
Step 5: The Treasury would then provide 50% of the equity funding required on a side-by-side basis with the investor. In this example, Treasury would invest approximately $6, with the private investor contributing $6.
Step 6: The private investor would then manage the servicing of the asset pool and the timing of its disposition on an ongoing basis . using asset managers approved and subject to oversight by the FDIC.

Why is this attractive to investors? First of all, it is possible that they will be getting a significant discount on performing loans and securities through the bidding process. Also, the investors are putting up a much smaller stake than the government so the leverage gives them bigger returns. Lets revisit the sample investment. Suppose the $84 investment ends up being worth $90, then the net profit is $6. Of this $6, the investor gets $3, and the Treasury gets $3 because they put up the same amount of equity in their 50/50 partnership. The FDIC gets its $72 loan paid back. This means that the investor gets a 50% return on their principal of $6 while the government technically gets a 3.8% return on its principal of $78. The goverment will also get some fees and loan interest paid by the investor related to the FDIC loan, but for the government to get a 50% return these fees and interests would have to add up to $36, and that is very unlikely.

So what happens if the assets are actually worthless? The loan the FDIC makes to the investor is a non-recourse loan, which means that the investor could walk away and the most he or she would lose is $6 plus any fees and interest paid in case the $84 investment is worth nothing. On the other hand, the government or taxpayers stand to lose a combined $78. So basically, most of the downside of the investment will be shouldered by the American taxpapyers.

It should be interesting to see how this plan turns out. Personally, I believe that some investors with deep pockets could potentially profit handsomely from this plan if they manage to somehow bid intelligently on the assets they buy. Currently at least three mutual fund companies are considering starting mutual funds to buy these toxic assets, and these funds will allow smalltime individual investors to get in on the action. However, these assets are still extremely risky because noone seems to know what they are actually worth so they are truly a gamble. I definitely would not bet my retirement on these funds, but considering that I already pay tens of thousands of dollars in taxes to support the program, perhaps it is not a bad idea to invest on the side that may give a positive return.

This article is from Xin Lu of Wise Bread, an award-winning personal finance and credit card comparison website. Read more great articles from Wise Bread:

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Could you profit from Obama and Geithner's toxic assets plan?