The private-public partnership scheme announced by Treasury Secretary Tim Geithner this morning would seem to offer the big hedge fund and institutional investors allowed to invest in it a great deal.
They can borrow at low cost from the government up to 97 per cent of the money used to buy assets from banks. If the values go up, they can pay off the loans and profit from the upside. If the values keep dropping, they can walk away from their debt.
But will that deal stick?
In the aftermath of the AIG bonus debacle, investors must be a bit nervous about getting involved in a deal with Treasury. We’re sure that Geithner has already lined up PIMCO and other big buyers for the assets but the political backlash over the AIG investments may limit participation.
Here are the two risks that Geithner cannot control or reduce for investors:
- If assets lose value. If a year or two from now it becomes obvious that investors paid too much for the troubled assets and they are now facing loses, many will be tempted to cut their losses by defaulting on the FDIC debt and the Treasury department. That’s how the program was designed to work: taxpayers get stuck with the bill of everything but the tiny percentage of money put up by the private investor.
How will politicians react to this? There will be anger at the taxpayer losses. Some of this will be directed at the Obama administration officials who set the program. But some will no doubt come to rest on the private partners who chose to pay the elevated prices. Special taxes could be levied against “hedge funds that recklessly overpaid for assets knowing their own risks were limited.”
Hedge fund pay structures could make that anger even more intense. Say Citadel bids on assets priced at 50 per cent of par. Those assets wind up being worth just 20% on the dollar. Citadel cuts its losses and stops paying on the non-recourse debt, handing the junk assets back to the government. The lenders collect their piece of the loans from the FDIC. But if Citadel is otherwise having a good year, it may pay hundreds of millions in bonuses to employees. How do you think lawmakers are going to react to a hedge fund that cost the taxpayers hundreds of millions in losses but paid hundreds of millions in bonuses to employees.
- If the assets gain value. Now flip it on its head. Two years from now it seems that the private-public partnerships were a great value. The investors who put up just 3% of the principal–the rest was government guaranteed debt and the Treasury equity contribution–now stand to make a killing. They can pay off the debt, and the Treasury’s only upside will be its own small equity contribution.
How will politicians react to this? It may be that politicians will be grateful that there was any upside in the investments and happy the banking system was saved by the program. But there is a serious risk that politicians, particularly those running for office against incumbents who created or supported this plan, will call for the government to recoup the gains through taxation. “Taxpayer funded deals that enriched hedge fund fat facts,” could well be the next populist target.
In short, whatever the technical merits of the plan, there remains serious political risks that neither Geithner nor Obama can control.