NEW YORK A succesful U.S. Treasury plan to rid bank balance sheets of poorly performing assets may be the key to unclogging the arteries of global credit markets, but the success of the U.S. Treasury's latest plan itself depends on widespread participation by private investors.
On Monday U.S. Treasury Secretary Timothy Geithner provided further details of the complex program which could rid U.S. bank balance sheets of up to $1 trillion of bad assets. The highlight of the programs was the generous financing offered by the government to persuade private investors to participate.
An earlier smaller $80 bln plan, known as the Super SIV, failed in October 2007, and the original $700 bln Troubled Assets Relief Program (TARP) failed in late 2008 due to a lack of participation by private investors.
Early market reaction to the U.S. Treasury's latest plan appeared to be more positive on Monday.
"My own view is the plan is a sensible one," Byron Wien, chief investment officer of Pequot Capital Management, told the Reuters Private Equity and Hedge Fund Summit on Monday. "This is a PIMCO, BlackRock sort of thing, where some credit-oriented hedge funds will participate."
The plan is being launched at a time when lawmakers are furious about big bonus payments to executives at bailout recipient American International Group.
In an effort to spur investor participation, U.S. Treasury Secretary Timothy Geithner said private partners in his plan will not face the tough executive pay restrictions that apply to recipients of government bailouts.
The main incentive for private investors to participate in the latest U.S. Treasury plan appeared to be generous financing terms to boost the return on the investment.
As well as the initial financing from the Treasury and private investors, the Federal Deposit Insurance Corp (FDIC), a U.S. banking regulator, and the Federal Reserve will be tapped to offer further financing.
Under one part of the plan focused on bad loans, the Treasury will provide up to 80 percent of initial capital alongside investment by private funds. The FDIC would then offer debt financing for up to six times the pooled amount.
In addition, the Treasury will approve up to five investment managers and match their money one-for-one. It will then offer debt financing for 50 percent of the combined capital pool to buy securities banks want to unload.
Two major U.S. money managers, BlackRock and PIMCO, expressed interest in participating in the toxic-assets plan, which could produce big profits.
"From PIMCO's perspective, we are intrigued by the potential double-digit returns as well as the opportunity to share them with not only clients but the American taxpayer," Bill Gross, PIMCO's co-chief investment officer, told Reuters in an interview.
RESTARTING PRICING MECHANISM
One government aim is to get a market mechanism working to restart markets for securities not currently trading and, in the process, relieve investor fears that some form of bank nationalization might have to be considered in the future.
Markets welcomed the plan on Monday, with spreads tightening for corporate bonds and benchmark credit default swap indexes, reflecting reduced risk perception as a result of the U.S. Treasury plan.
Residential and commercial mortgage bonds saw prices firm from distressed levels as they stand to gain most from the plan.
Prices on CMBX "AAA" rated commercial mortgage-backed securities indexes gained 2 1/2 to 3 points, to levels around 63, an investor said, citing a dealer. Subprime residential bond ABX derivatives indexes jumped 2 to 3 points as investors unwound bearish bets.
"Most hedge fund managers feel there's an extraordinary sense of opportunity, because prices have fallen so low," said Alexander Ehrlich, global head of prime services at UBS, during the Reuters summit on Monday.
Before the global credit crisis erupted in mid-2007, yield spreads of U.S. bank debt over Treasuries were in the range of about 1.0 to 1.5 percentage points, said Cam Albright, managing director of fixed income for Wilmington Trust's Investment Management group in Wilmington, Delaware.
Today those spreads trade as high as 6.0 percentage points, a measure of the increased risk of default.
"You would need to get back to the historical relationship between the financial sector and the Treasury market before all this began to explode," Albright said. "That would be a sign things were getting better in the market place and that banks could attract capital from private sources," he said.
Another sign of a recovery will be the yield spread between jumbo mortgages and conforming mortgages and whether those spreads tighten in, said Jeff Given, a portfolio manager for fixed income with John Hancock Funds in Boston.
Late last week that spread was about 175 basis points, Given said. "If you can get that within about 100 basis points that would be a good sign lending is freeing up for larger mortgage loans," Given said.
But the ultimate measure of success will be if the U.S. bank plan can stand the test of time.
"This is perhaps the first win/win/win policy to be put on the table and it should be welcomed enthusiastically," said Bill Gross, the co-chief investment officer of PIMCO. "We intend to participate and do our part to serve clients as well as promote economic recovery."