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How Wall Street wants to solve the credit crisis

In contrast to the academics, bureaucrats and politicians who are working on the government bailout in Washington, the traders and bankers in New York's capital markets have their own solution.

By William Cohan, Contributor
February 6, 2009: 11:42 AM ET

(Fortune) -- So far the Obama Administration's talk about fixing the economy through buying toxic assets, creating a bad bank, and deploying more TARP funds has left many financiers cold. That's why some leading Wall Street heavyweights including Thomas Flexner, the global head of real-estate investment banking at Citigroup, Wes Edens, the CEO of Fortress Group, and Barry Sternlicht, CEO of Starwood Capital Group, have been quietly circulating their own proposal. FORTUNE recently obtained a copy.

The idea, as drafted and as articulated by Citigroup's Flexner, is for the government to create a massive new fund to lend money at a fair price to professional investors -- pension funds, hedge funds, private equity funds and endowment funds -- for the sole purpose of providing reliable long-term financing to allow these investors to buy the various "toxic assets" in the secondary market that are now frozen on the balance sheets of financial institutions the world over.

This is a practitioners' plan, born of an inviolate belief that the way out of the current crisis is to create a dynamic where frozen assets can be bought and sold and a semblance of normal trading can resume. A version of this idea has surfaced before, most notably in an October 2008 Bloomberg column by Sandy Lewis, the onetime Wall Street arbitrageur and son of Cy Lewis, the legendary senior partner of Bear Stearns, where Lewis called for the creation of a Public Value Fund to help spur trading in the toxic assets. But unlike Lewis, Flexner, Edens and Sternlicht are still in the game and have serious Washington connections, especially with Senator Chris Dodd, chairman of the Senate Banking Committee.

The key, Flexner believes, is to get private capital flowing back into the credit markets and the banking system. Or as he writes, "Government backstops and guarantees may serve as temporary expedients for preventing a dislocation from quickly mutating into an Armageddon scenario, but they are not substitutes for the return of real investors willing to take real risks," he wrote in a paper making the rounds at the New York Federal Reserve and in congress.

"The reality," he writes, "is that government guarantees substitute the creditworthiness of the United States Treasury for the creditworthiness of underlying borrowers and merely create a broader range of risk-free market alternatives for investors to pick from -- you don't like Treasuries, buy some guaranteed asset-backed paper or perhaps a guaranteed bank bond. Capital is flowing but largely within and among markets that enjoy explicit government backing. Capital is not flowing into unsupported credit sectors where risk is perceived to exist."

Think of it this way: The credit markets are like a perfectly good neighborhood where housing prices have fallen 50% from their highs. There are reputable landlords around who want to buy these houses at a fair price, spruce them up, rent them out and when the market comes back in a couple of years try to sell them for a profit. They are willing to make a bet that things are close to the bottom and will improve. The problem? They can't get a mortgage to buy the homes. Not at 6%, not at 10%, not at any reasonable percent.

The new government fund would get banks, hedge funds and other investors what they desperately need, want and can't find, a reliable source of long-term secured financing to allow them to make the bets using their own equity, to get their desired returns based on a belief that the value of the rogue securities has been driven down to absurdly low levels since there simply is no market for them.

The bet would be that these securities would increase in value over time. "Loans would be extended under this facility to enable these investors to acquire a broad array of both rated and unrated outstanding credit instruments -- in the secondary market-including commercial and residential mortgages and securities, leveraged loans, high yield bonds, auto and student loans," Flexner wrote in his proposal. "The financing would be non-recourse, have a term of perhaps five to seven years, require no margin calls and be fully pre-payable without penalty. Pricing could be 2% to 3% over the Treasury's own cost of funds. Investors would use these loans to leverage their own capital in purchasing secondary credit instruments."

Under the Flexner plan, the government would not guarantee the underlying asset or absorb the first-loss risk of the investment -- unlike what it seems to have done in various other of the existing bailouts. That risk would be borne by the investor through his equity investment -- in the above example equal to 30% of the cost of the investment. What the government fund would do and which is "vitally important," Flexner said, "is provide investors with the certainty of financing over the life of their investments."

Such patient, long-term capital has been non-existent since the onset of the credit crisis in June 2007. Exacerbating that problem for professional investors -- like Edens and other hedge-fund honchos -- has been a wave of mass redemptions from their limited partners and unit-holders wanting their money back -- impatient capital -- effectively preventing them from buying these undervalued assets because they no longer have the cash to do so.

The new fund could rectify that problem. As Flexner envisions it, the new fund would have "No recourse, no margin calls, no ongoing mark-to-market, no risk that the government will demand repayment at will, and therefore no risk that the investor will either have to raise additional equity capital or involuntarily and prematurely have to sell the investment in order to pay back the loan."

At the moment, this kind of financing is simply not available in the private markets. "One of the biggest obstacles to unthawing the credit markets is the lack of acquisition financing on terms which themselves do not impose additional risk on the investor," Flexner wrote. Going back to the example of the landlords trying to get a mortgage, assuming for a moment they could even get a bank to give them a mortgage, the cost and terms would be so onerous as to make the investment imprudent.

To Flexner, this is also a reference to the longtime practice among Wall Street securities firms of obtaining cheap short-term financing in the overnight "repo" markets by using what became their toxic assets as collateral. When these short-term lenders, such as Fidelity or Federated Investors, decided to no longer lend against these assets, the traditional investment banks found themselves in very serious financial trouble. The writ-large example of this phenomenon was the "run on the bank" that occurred at both Bear Stearns, in March 2008, and at Lehman Brothers, in September 2008.

Flexner, a former vice chairman at Bear Stearns, saw the effects of this phenomenon first-hand a year ago. Hedge funds and other non-depository institutions have had many of these same problems, causing a number of them to go out of business as well. Very few investors are currently willing to use traditional repo financing anymore, Flexner said, because the providers of it have proven that they will pull the plug on it, in their sole discretions (as is their right, under the terms of the agreements), at the most precarious moments. No investor or financial institution is willing to take that risk anymore after witnessing the fates of Bear Stearns, Lehman and Merrill Lynch.

Flexner believes that a new government fund would be the first, essential step to unclogging the system. There would be some strings attached for those investors who want access to the money:

First, the money would be available only to buy existing securities in the secondary market. Flexner believes this is essential in order to tighten existing credit spreads, where the yield on existing securities is far in excess of the potential yield on a new issue in this market. Flexner believes "the secondary market is crowding out the primary market" because the yields on existing high-yield debt or mortgage-backed securities have risen so high as the price of the underlying securities have been driven so low that investors simply won't buy new securities that are yielding less but have similar risks.

The Flexner plan would also require that the new government financing be available for six months only, on a first-come, first-served basis with to-be-determined limits on the amount of money any one individual investor could borrow. Investors wanting in on the action would have to get off the sidelines and put their money to work immediately. "By all accounts, including my own direct observations, significant pools of private capital currently sit on the sidelines waiting for price capitulation from sellers," he said. "This facility will enable investors to capture, via its user-friendly financing terms, the economic equivalent of price capitulation. And no investor will want to be left behind."

Wes Edens, the CEO of the Fortress Group, has reviewed Flexner's proposal and thinks it makes a tremendous amount of sense. He said such a fund would begin to get the so-called "shadow" banking system, the buyers of loans and other forms of debt that the banks have been selling for years, energized again to take the kinds of financial risks that they have not be willing to take since June 2007. "This is a critical issue that needs to be addressed very badly," he said. Of course, Fortress and Citigroup, institutions whose balance sheets are clogged with toxic securities, would benefit from the fund by being able to make the desired investments or by selling the bad assets to investors. But the overriding idea is to get the market functioning again.

And both Flexner and Edens agree if investors could obtain the loans from the government to help them buy these assets, the prices paid for them would increase, helping to improve the value of all the comparable assets on balance sheets everywhere. Banks would then begin to be able to reverse the writedowns already taken, increasing their equity accounts. "It will enable a natural and self-curative process of rebuilding the equity capitalization of the banking system, without relying on government guarantees, cash infusions or 'bad bank' asset purchases," Flexner concluded.

At first glance, the Flexner plan might seem like more welfare for Wall Street, but this may be one of those rare cases where self-interest and the common good intersect. As taxpayers, our hopes for a return on the trillions of dollars we have invested in our ailing financial system so far can only be realized when normal trading can resume and capital can begin flowing to those who need it and will pay for it. Only then is there a real shot at getting our money back and a decent return on it to boot.

Cohan is author of "The Last Tycoons: The Secret History of Lazard Freres & Co" and the upcoming "House of Cards: A Tale of Hubris and Wretched Excess on Wall Street." To top of page

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