Animal Farm

Yesterday the PPIP was extended for a further two weeks and the entrance criteria relaxed for those who wish to participate. That interest levels were low is no real surprise. I struggle to think of any of these Government schemes which have succeeded in garnering much investor enthusiasm.
At the heart of it, we need to ask if this new plan is any improvement on the TARP. It is more complicated for sure but not really much different and as such, it is encountering the same stumbling block, namely the absence of a mechanism to determine a fair price for the assets. This was always going to be a problem and indeed the FASB accounting changes have only served to compound said issue. You now have an asset worth 50c, marked at 90c, because that’s what the new changes allow you to do, why would you sell below 90c? You wouldn’t, and why would you pay 90c, you wouldn’t? Stalemate

Something I found curious is that the main idea behind this plan, is to leverage our way out of the mess. 6-1 leverage! Now “leverage” is a BAAAD word and a BAAAD thing, right? Everybody has told us that. The greedy bankers, the hapless homeowners…too much leverage. Leverage is the undisputed king of Credit Crunch buzzwords; green shoots, 2nd derivative, crossover and carry trade ain’t got nothing on leverage. It seems however that not all leverage is equal, some leverage is more equal than others, and if the Big Dawg decrees, leverage is actually a good thing, a carrot to be dangled! Financial Animal Farm.

This could be a great deal for the handpicked fund managers across the street. There’s a good article in Inst Risk Analyst on this. In essence the PPIP is the purchase of toxic assets by the government and the sale by the government of a 5 year call on ½ the principle to private participants for a 3% premium i.e. half the implied option value of 6%. Now I ‘m not an options guru but that sounds cheap to me.
The IRA article goes on to say…

“There is no market for options on the toxic real estate assets of banks per se, but there are options on REITS. REITs are not bank owned toxic real estate assets, but they are real estate pass throughs and have had their prices marked down much as value of the toxic real estate assets of banks.
The "junk" and beyond nature of some of toxic assets also suggests that they would trade more like equities than fixed income instruments. A quick and unscientific survey of near the money 6 month options on REITs reveals implied volatilities in the neighborhood of 80% and prices near 15%: That's 15% for 6 months versus 6% (adjusted to reflect the full, 100% of the upside in the PPIP deal) for 5 years.”


As it says, it’s unscientific, but food for thought. In any case it probably won’t be of much consequence if the interest levels in the PPIP remain derisory. So what happens if the plan falls on its face? Maybe more talk of nationalisation, although I can’t imagine the fallout would be as bad as when it was announced TARP wouldn’t buy Toxic Assets from banks back in November. The FASB changes allow more breathing space for banks holding these assets and I would think also that when TARP was announced there was greater hope that it would succeed/backstop bid the banks. The experiences since then have surely made even the Bulls somewhat less sanguine about the chance of success.