How Geithner's vulture funds may work

(breakingviews.com) -- Tim Geithner may go down in history as the man who does most to spur vulture investing - provided he manages to get his public/private investment fund airborne.

But for his scheme for cleaning up bank balance sheets to work, the U.S. Treasury secretary will have to induce banks to sell toxic assets and private investors to put up capital to buy them.

Geithner hasn't said how he will achieve such a feat. But one solution would be to provide the vultures with lashings of cheap non-recourse loans. They wouldn't have to repay the non-recourse loans if the investments bombed, effectively giving them downside protection. With some heroic assumptions, it is even possible to work out how big and cheap these loans will have to be.

The first thought is that banks will need to be offered a premium to market prices to part with their assets - after all, the value of the assets on their books may already be well above a true market price.

We've chosen a 20% premium. Equally, vultures will need to see a way to make a good profit to venture in where angels fear to tread. We've assumed they will need a 25% internal rate of return.

The next assumption concerns what these toxic investments will ultimately be worth. If investors think they will end up worth less than they have to pay, there is no point becoming a vulture.

But if they believe asset prices have partly been depressed by lack of liquidity - and that some of the value will return - they might want to take the plunge. We've assumed that the ultimate value will be 40% above current market levels.

There are then two further assumptions. One is how long investors hold the assets. We've plugged in five years. The second is the cash flows from the assets in the meantime, which can be used to service the non-recourse debt and even to generate a profit.

We've assumed the assets generate annual cash flow equivalent to 8% of their current market values. In order to simplify the math, we've also assumed excess annual cash flow is held in the vulture fund and earns an annual return of 10% until the fund is finally liquidated.

Putting all these assumptions together, it turns out that Geithner can square the circle. But he has to be pretty generous. He has to provide the vultures with 85% of their total funding requirement in the form of non-recourse debt; and he has to charge them a mere 5% interest.

It would be interesting to hear what Congress thinks of that.