An Open Letter to Hank Paulson: Uncertainty & the Banks, What to do now

November 20, 2008 · Posted in Entertainment, Featured, Finance, Financial Crisis, People in the news, Political Issues, Politics, Social Issues, Society, Things to think about, Thoughts on the economy 

Mr. Paulson:

The capital injections by the Treasury have not done anything to inspire confidence in the banking system by investors or to incentivize banks to start making new loans.

I recognize that it is too much to expect banks to run out and start expanding their balance sheets by writing new loans with so much uncertainty with respect to losses and impact on their capital.

Now that fears are spreading with respect to the commercial real estate market and the consumer loan market, the ability of banks to look at new business is further hampered.

We need to do something decisive and since so many are putting forth ideas, I want to put one out for your consideration.

The problem with the banking system is the continued uncertainty over asset values.  Due to the huge leverage of the banks a small decrease in asset values can blow through ALL of the capital in the banking system including the $125 billion given to the 7 largest banks and billions more given to the smaller banks.

As long as these assets are on their balance sheets, this situation remains unresolved and there is no place to go with these assets.  This is a cancer in the system and must be removed.

The U.S. Treasury is not moving forward with the TARP.  I think this is due to the complexity of the problem as well as the current environment in Congress and I understand your position.

But, with all due respect to you, I do not believe that you can wait and throw this off to the new Administration.

So, where do we go from here? 

I think the U.S. Treasury should convene the largest banks in the country, lock them in a room, with the following mandate:

1) The U.S. Treasury (UST) is going to capitalize a special purpose vehicle (SPV) – a new company – with $100 billion in cash.  UST will own the common stock of the SPV.

2) The banks (I use banks for ease, this could include insurance companies) – are going to contribute $1 trillion of assets to this vehicle with limits for each bank based on size.  The banks and UST will agree on what assets can be contributed and as a group the banks and UST will agree on the value of the assets to be contributed.

The assets that are allowed to be contributed will be broad asset classes, not one-off derivative deals and such.  Commercial mortgages, residential mortgages, consumer loans, large corporate and commercial loans (Shared National Credits, loans broadly held by banks) etc.

The $1 trillion of assets will not be contributed at “market value” nor will it be contributed at “par” value (the original value of the asset).  It will be contributed at a value that reflects the expected recovery of those assets over the life of the assets discounted back to the present (the “Intrinsic Value”).  

3) In addition to the $100 billion of capital injected into the vehicle by the U.S. Treasury the banks will make the following contributions:

a) For each $10 dollars of assets they contribute to the SPV they will contribute $1.00 of common stock.

Combining the $100 billion of cash and the $100 billion of common stock contributed by the participating banks the SPV will end up with $200 billion of capital, which should increase with the stock price of the banks.

b) In addition, the banks will place in escrow $1.00 of common stock for each $10.00 of assets contributed to the SPV.

The stock placed in escrow will be issued to the U.S. Treasury or liquidated at some future date to compensate the U.S. Treasury for any losses from its investment in the SPV and a minimum preferred return.  To the extent recoveries on the SPV exceed the intrinsic value estimate, this is the UST profit on the enterprise and the banks recover the shares placed in escrow.  The shares placed in the SPV are, again, part of the value to the UST from this endeavor.

3) The banks will receive a senior note equal to the value of the assets contributed to the SPC, paying interest at a rate which is equal to the yield on the collective assets of the SPV less operating costs.  The banks will also bear responsibility for providing knowledgeable employees – at their cost – to the SPV to manage these assets.  The SPV will have a Board comprised of respected individuals on a bipartisan basis.

The value in this idea is two fold:

First, by the banks getting a lot of these assets off their balance sheets they reduce the uncertainty in the system which should allow the stock market to re-value the equity based on the core business and not the “unknowns” associated with these assets.

Second, the security which the banks take back from the SPV will be worth more than the value of the loans on their balance sheet.  Consider this hypothetical example:

1) The banks contribute assets, collectively priced by the market at 50% of the par value of the security;

2) A conservative analysis (5% drop in GDP next year and 1.5% growth thereafter, or something like this) suggests that the intrinsic value of the assets is actually 70% of par;

3) The banks contribute these class of securities to the SPV for $1 trillion at the determined 70% “intrinsic value” (the face value contributed will exceed $1 trillion, but the value is greater than the mark to market value);

4) Now let’s say the actual recovery on these securities is $800 billion, the banks hold a senior security on this asset and thus would have first recourse to the $800 billion;

5) The SPV would however have the $100 billion of UST capital and $100 billion (at current market prices) of a portfolio of bank stocks to satisfy the SPV obligations to the banks.

As a result of this structure, the SPV senior securities taken back by the banks would have a tremendous cushion to absorb losses and still be worth par value to the banks which participate.  The break-even recovery in this example is 56% on the original par or face values of the securities contributed.  This should provide considerable ability for the new SPV senior securities on the bank balance sheets to be valued at Par.  This will enhance the asset quality of the banks and likely allow them to mark up asset values on their balance sheets.  

This is how the UST gets the “bang for the buck” that you referenced when you said the TARP could not serve its purpose.

The banks would be healthier as a result of this structure and thus the stock they contribute as capital and to the escrow should be a good store of value.

THE KEY MERIT OF THIS IDEA IS THAT IT REPLACES ILLIQUID ASSETS WHICH NO ONE CAN VALUE WITH A SINGLE ASSET THAT HAS ADDITIONAL SUPPORT AND SHOULD THUS BE WORTH PAR.

The taxpayer is protected by the escrowed stock that the banks contributed to participate.  The escrowed securities first go to compensate the UST dollar for dollar on losses and then up to a preferred rate of return.  Any appreciation in the stocks is split with 50% staying with the UST and the rest returned to the banks.

Since no one will buy bank stocks right now – everyone, I mean everyone who has bought bank stocks in the last two years has been killed – this allows the banks to effectively RECAPITALIZE themselves with some assistance from the UST.

By getting a large part of the troubled assets off the balance sheets of the banks, placing it into a vehicle that is NOT PUBLIC (thus it can sit and hold these securities without concern for the “mark to market” accounting) and replacing those assets with a single security whose credit has been enhanced partly by the UST and partly by the banks themselves, you will dramatically reduce the uncertainty in the banking system.

The banks will still have some troubled assets which due to the unique characteristics of those assets are not appropriate for the SPV.  But the idea here is that by reducing the MAGNITUDE of the problems the banks are facing and enhancing the asset quality of the banks through this program you leave them in a better position to take the write-off on those assets or to work them out themselves.

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4 Responses to “An Open Letter to Hank Paulson: Uncertainty & the Banks, What to do now”

  1. Uncertainty & the Banks: What to do now · Stocks.ExplainedOnline.Net on November 20th, 2008 4:08 pm

    [...] Original post by Heard It In A Bar [...]

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    [...] Original post by Heard It In A Bar [...]

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    [...] Original post by Heard It In A Bar [...]

  4. An Open Letter to Hank Paulson: Uncertainty & the Banks, What to do now · Stocks-Trading.ExplainedOnline.Net on November 20th, 2008 4:54 pm

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