Wednesday, March 25, 2009

Public-Private Investment Program - A good Start (Part II)

How does a foreign investor choose a pipe for returning trade receipts to the US financial system? At the end of the day, it's all about brand power. Investors rely to a significant extent on the reputations of bankers. But the banker's brand is not the only one at work. No matter who brings them the deal, many investors insist that the deal be rated by American ratings agencies. Or maybe the investment banks won't sell them unless they are so rated. Either way, the rating is an important part of the process. Thus, if the ratings are unreliable, the credit flow seizes up, as the investors lose faith in the pipes.

The ratings problem is pervasive because everything gets rated. If an investor is unsure whether a given security is going to pay off, the investor can buy a credit default swap, or insist that the issuer buy financial guaranty insurance. But what's the first thing an investor asks about the provider of those backstops? Yep, “What's its rating?” I guess it's a bit like the actuary who carried a bomb with him on airplanes on the theory that the odds against there being two bombs on the same plane were astronomical. Two AAA-rated securities would have to blow up for the holder of AAA bonds backed by an AAA CDS to lose money.

But things are never that easy. If it turns out that the AAA rating on the underlying securities is bogus, the first natural reaction of the CDS holder is to wonder how good the CDS issuer's rating is. And as soon as enough people start to wonder about the creditworthiness of a company, it immediately becomes less credit worthy, because the doubts impair the company's ability to borrow, and a company that cannot borrow is more vulnerable than one that can borrow, and so deserves a lower rating. Thus does the mis-rating of the debt underlying a CDS – or underlying several – undermine the rating of the issuer of the CDS, without that issuer ever having lost any of its fundamental value or strength.

Before there were ratings, investors relied on the probity of investment bankers: the brand really counted for something. With the advent and predominance of ratings, investment bankers came to be relied upon more for their ingenuity – their deal-making ability – than their diligence, at least when it came to the acceptability of their offerings. Now, ratings are everything. So with ratings in disrepute, everything has become nothing.

The loss of foreign appetite for US AAA-rated paper has a more pernicious effect than merely reducing the flow of credit into the US. Many banks hold on their balance sheets loans and securities that they intend to sell to raise more money to lend. How these loans and securities are valued determines how well capitalized the bank is, and how well capitalized a bank is determines how much money it will be allowed to lend. So, while the loss of foreign dollars may impair a banks lending ability somewhat, the loss of value in its assets as a result of the foreign investors' unwillingness to buy them can shut the bank's lending down entirely. The rules for valuing bank assets are complex, but suffice it to say that suspicion about the quality of US ratings has caused enough bank assets to be devalued to cause regulatory capital issues for banks that are perfectly sound on an operations basis.

Banks' inability to value these assets reliably has caused their balance sheets to be suspect. That's why the assets themselves are considered “toxic.” The PPIP is intended to solve this problem by removing some of these toxic assets from the banks' books and, more important, by establishing for the rest a fair value that is sufficient to render the banks solvent again. Of course, it's not at all clear that the banks will want to part with any more assets than is necessary to establish a price. Once a value is established, the assets may provide as much credible capital as the cash they could get for them, and banks may conclude that the price being offered by the PPIP entities is less than the assets are worth to the bank. The prices will have to rise to historic pre-crisis levels before the banks are willing to sell new loans to the PPIP vultures.

The PPIP “detoxifies” bank assets in two ways. First, it detoxifies the ones that are actually sold; it puts them in the hands of an entity whose balance sheet is irrelevant. Second, the plan detoxifies assets that the bank holds onto; it does that by establishing a value for them thatpotential coutnerparties will take seriously. Yes, the value offered by the PPIP investor is not a true market value in the sense that the PPIP investment is subsidized, but a counterparty should not care why a bank has a buyer for its assets so long as the buyer is reliable. More important, the subsidized price offered by the PPIP investor will still be substantially less than its manager thinks the bonds will produce on a discounted present value basis. Thus, a potential counterparty deciding whether to lend to a bank that holds these assets can treat the asset as being “worth” at least the PPIP offering price in assessing the bank’s ability to repay loans.

By pricing the loans diligently, and taking a risk on them, the PPIP investor effectively stands in for the discredited ratings agencies. The PPIP manager is saying, in effect, “we at the management company have kicked these tires, and we think the loans will pay off sufficiently to cover our offering price and then some.” That is a source of confidence to potential bank counterparties (the aforementioned foreign investors), which is why the program may be very helpful in restarting the flow of money and credit.

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