Will the banks take the bait?
Geithner's plan hits many high notes, but it's not clear whether it does enough to bring sellers on board.
NEW YORK (Fortune) -- Investors have embraced Tim Geithner's toxic asset plan. The question now is whether the banks will go along too.
Geithner said Monday the government will invest alongside private parties in funds that will buy troubled loans and securities from banks. The government will also lend the buyers money.
By providing a source of cheap, abundant financing, officials are hoping to bring together buyers and sellers in the troubled-asset marketplace. That market has been at a stalemate for months, with banks unwilling to accept the distressed prices vulture investors have been dangling.
Observers said the latest Treasury plan could help unlock the marketplace for troubled assets by raising the prices investors can afford to pay while still generating an acceptable rate of return.
"This is a very intriguing plan, and it's generating a high level of interest," said Edward Gainor, a partner at law firm McKee Nelson in Washington who represents funds dealing with distressed assets.
That interest translated into a level of optimism rarely seen in the stock market of late. The Dow Jones industrial average rose nearly 500 points, or 6.8%, Monday. Banks such as Citi (C, Fortune 500), Bank of America (BAC, Fortune 500), JPMorgan Chase (JPM, Fortune 500) and Morgan Stanley (MS, Fortune 500) all posted double-digit percentage gains.
But as popular as the plan seems to be on Wall Street, it remains unclear whether the availability of federal financing will bring prices high enough to entice the banks to participate.
The Treasury's plan for the sale of legacy loans highlights the fix the banks are in.
The Treasury proposes a hypothetical transaction in which a bank would seek to sell a pool of residential mortgages with $100 in face value through an auction process and receives a bid of $84 for them. The FDIC would then provide cheap financing to the winning buyer.
While this scenario is only meant to illustrate the process and not to provide guidelines for actual bids, one mortgage industry observer says the Treasury's example is more than a bit rosy.
"The continuing unaddressed issue is why the banks will sell to market bidders under this program when they haven't been willing to sell to market bidders previously," said Brian Olasov, a managing director at law firm McKenna Long & Aldridge, which represents distressed loan servicers, investors and sellers. "Cheap leverage through FDIC guarantees helps, but won't bridge the bid-ask spread for a number of distressed debt investors."
Dick Bove, a bank analyst at Rochdale Securities in Lutz, Fla., wrote in a note to clients Monday that another reason banks may not participate in the legacy loans program is because doing so might expose them to further writedowns.
That could also put them at risk of failing the stress tests regulators are performing this spring on the largest institutions, since they would likely need to sharply increase the reserves they carry on those loans.
But Bove believes the legacy securities program, which will let banks sell investments backed by residential and commercial mortgages as opposed to the actual loans, is more likely to be a success.
That's because many banks have already substantially written down the value of their securities holdings, thanks to mark-to-market accounting rules. The provision of cheap financing may bring funds' bids for bank securities above the level at which they have marked their troubled bonds.
Another factor that could limit the program's success is fear among investors that Congress will reprise its role in the AIG (AIG, Fortune 500) bonus scandal of recent weeks and decide after the fact to impose restrictions on participants.
"The rhetoric of Congress might increase the risk premium investors demand, which would reduce prices," said Todd Cohen, who manages the CRA Qualified Investment fund, a medium-term fixed-income fund that invests in government-related securities. "Last week added a lot more risk to the program."
Offsetting those worries, perhaps, is the observation that Geithner has managed to structure the program so that it's as fair to taxpayers as can be expected at a time when the government has acknowledged the need to spend money to get the economy working again.
Because the government and the private buyers will share equally in the losses and gains on investments, the program "isn't going to be gamed" by hedge fund types, said Eric Falkenstein, a former hedge fund manager and bank executive.
What that means, he said, is that "for once, there's very low downside - even if Geithner fails here, it doesn't cost us anything."
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