Lever me up

How much is enough? Cheap government financing represents the juice in Treasury secretary Tim Geithner’s plan to sweep problematic real estate-related assets from US banks’ balance sheets. The truth of the matter is that the private sector simply would not turn up without it. Leverage represents an implicit subsidy to private sector investors who, on the flip side, will be putting their own capital on the line to absorb possible losses on loans and securities.

It is noteworthy, then, that the government will guarantee debt totalling six times the equity invested to buy whole loans. Yet when it comes to securities, such as residential mortgage-backed securities, the Treasury only wants to lend 50 cents for each dollar of equity. Under certain circumstances, it will consider matching equity dollar for dollar. To put it another way, private money invested in loans (excluding the government’s equity stake) will comprise just 7 per cent of the overall buying power. For securities, it could be a quarter to a third.

So, the subsidy on offer to buy securities looks far smaller than that for loans. Yet it was losses and subsequent downgrades on securitised assets that originally began to eat holes into banks’ capital. Has the government undercooked its enticements to potential securities buyers? Perhaps not. Such securities are more likely to be held in trading books, and therefore to have already been written down sharply, notes Rochdale Research’s Dick Bove. Getting investors comfortable with paying close to banks’ marks is what this scheme is all about. Here the securities firms that have marked most aggressively, to levels that include a discount for poor liquidity, stand to do well.

Book values for loans, however, are less likely to have been slashed. Instead, losses are recognised once imminent rather than to reflect market values. That is why the terms for this side of Mr Geithner’s plan appear so much more generous. It is also why getting buyer and seller to agree will be far more tricky.

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