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The U.S. Treasury’s announcement last week of a wide-sweeping plan to buy and house distressed assets sent structured finance investors into a frenzied dissection of the bailout, Debtwire reports. While questions abound regarding what type of assets will be purchased, from which institutions, and how long they will be held, the primary concern among the investors is how much the government will pay for the toxic loans and securities.
Trades in residential and commercial mortgages chronically stalled over the past year because buyers and sellers could not agree on a fair price for assets. If the government picks up those loans now before the market sets a clearing price, U.S. taxpayers will shoulder the brunt of the losses anticipated as defaults mount, two buysiders and a sellsider said Friday.
Buyers of structured product have a vested interest in seeing the bailout fund buy assets at lower clearing prices than those currently on offer by financial institutions. There is plenty of money waiting on the sidelines for prices to come down to a range that accurately reflects underlying credit quality, the sources said.
But for now, the gap is far too large to be bridged. Lehman Brothers, for example, failed to find buyers for its massive commercial real estate portfolio this summer because it refused to lower its offer price to a realistic market value, as previously reported by Debtwire. The portfolio – still making rounds last week – is valued by the failed bank at a 90 price range, but no investor is willing to pay more than 60, said the buyside sources.
”If the government wants to take [assets similar to Lehman’s] in at 90, we will be in a ... load of trouble,” said one of the buysiders. “We need a competitive bid process.”
As proposed, the bailout fund will buy assets from troubled financial institutions via reverse auctions in which the buyer submits bids to the seller, beginning at a high price and proceeding lower until a bid is accepted, according to reports. However, that structure favors the sellers when the buyer is one of last resort and a process involving multiple buyers will yield fairer pricing, said the sources.
A precedent for competitive auctions emerged in the ABS market earlier this year when failed SIVs Cheyne Finance, Rhinebridge Plc and Mainsail II Limited were liquidated . In each of the cases, a portion of the SIV holdings were auctioned and sold first to preferred bidders in order to establish a market value; the value was then applied to the remaining portfolio upon Goldman Sachs’ purchase of the assets.
Assets auctioned from Cheyne Finance garnered an aggregate bid of 40 cents on the dollar on 17 July. Roughly 31% (USD 5.9bn) of the failed SIV’s assets were auctioned, including a 42% portion of subprime RMBS, along with other assets such as ABS CDOs, CLOs, commercial real estate CDOs and CMBS.
Without a competitive auction the government will likely end up buying similar assets at inflated prices from a bevy of banks in the same situation, said the sources. Such a scenario would result in the U.S. government footing the bill of the deleveraging process, the sources said.
Because the government may buy the assets prior to determining their market sale price - the current plan will differ significantly from the Resolution Trust Corporation set up to clean up the savings & loans crisis, the sources said.
”This is no RTC,” said one of the buysiders. ”In the RTC days, private market participants made the market by bidding the assets and taking the risk. This is the opposite. What is Henry Paulson, on behalf of the government, going to bid? What is market? Will he bid RMBS based on cumulative loss assumptions of 23% or, 14%?”
Regardless of how the government prices the assets to be purchased by the new fund, tax payers will inevitably endure the pain from the deleveraging, said Credit Suisse Chief Economist Neal Soss on a conference call Friday.
”The loss is there – now the question is who will bear it and how,” Soss said. ”And the judgment that is being made here in a collective sense is that society will bear this price, and the price will be smaller if you have an orderly way of absolving this process,” Soss said.
Speculation that inflation will pay for the bail-out is unlikely, according to Soss, who expects inflation to decline in the near-term. The Fed is also likely to keep rates stable until late next year, Soss said.
Soss said he expects Congress to act quickly on the plan, which could come to fruition in as little as a week. The initiative is part of a three-part plan announced by Treasury Secretary Henry Paulson today to improve liquidity in the U.S. financial market; Paulson also announced an increase in GSE and Treasury MBS purchasing and the curtailment of financial sector short selling.
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