The Treasury Department says its latest invention, the Public-Private Investment Program, or PPIP, will relieve banks of their toxic assets and get them lending again — breaking up the logjam that has ground the economy to a halt. Not all experts are sure the plan will work, and some say it’s a rotten deal for taxpayers.
But one thing seems sure — even if the plan does work, it could take quite a while before consumers reap any benefits.
“It’s by no means a done deal in many ways and it will take a bit of time before this has a noticeable effect on the financial markets and the economy,” says Dorsey Farr, Chartered Financial Analyst at French Wolf & Farr, and former chief economist at Wilmington Trust.
“It’s not going to be like flipping a switch where everything is resolved and we’re wondering why we didn’t think of this six months ago. It’s a lot more difficult than that. This is basically the bare bones of an idea of how something might work. Now you have to go out and actually implement it. Coming up with an idea is the easy part; implementing it is the challenge. Waiting to see the impact on the economy will take some time.”
In brief, the PPIP calls for using a combination of public and private money to encourage investors — pension funds, hedge funds, insurance companies, etc. — to buy $500 billion, possibly up to $1 trillion, in toxic assets — euphemistically called “legacy securities” in the plan — from banks.
According to the Treasury Department, banks decide which assets they want to sell and then notify the FDIC, which analyzes the assets and determines the amount of funding it’s willing to guarantee. Leverage is not to exceed a 6-to-1 debt-to-equity ratio. The assets are then auctioned to the private investor who is the highest bidder. The private investor and the Treasury Department each fund 50 percent of the equity requirement, with the FDIC guaranteeing the rest.
Here’s an example from the Treasury Department:
Step 1: A bank has a pool of mortgages with a $100 face value that it wants to sell.
Step 2: The FDIC determines it’s willing to leverage the pool at 6-to-1 debt-to-equity.
Step 3: The FDIC auctions the pool. The highest bid is $84.
Step 4: Of the $84 purchase price, the FDIC guarantees $72 of financing, leaving $12 of equity.
Step 5: The private investor and the Treasury each provide 50 percent of the equity funding, $6 each.
Step 6: The private investor manages the servicing of the pool using asset managers subject to FDIC oversight.
“It’s ironic that they’re using the very tools that have been working against the system — leverage and certain leveraged investors — to help jump-start it,” says Joseph Davis, chief economist at Vanguard.
“I’m more optimistic about the economic prospects of our financial system now than I have been in over a year. That’s not to say I don’t see other issues that need to be addressed. This isn’t the all-clear button. Just the rise in unemployment alone will continue to stress the financial system. But the number of forces they’re bringing to bear on the problem, and in somewhat of a diversified way, is much closer to what I would have hoped they did a year ago.”
Davis says it will take time but that there has to be some optimism that consumer finance companies, car companies and mortgage originators will begin to see that they can obtain short-term funding and will, in turn, increase credit to consumers.
Farr points out that other things the government is doing should have a more immediate impact than this latest plan.
“The Federal Reserve (has begun buying) Treasury bonds; that will have a direct impact on the market; and they’ve started buying mortgage-backed securities. The Fed also has some programs designed to achieve some of the same objectives this new Treasury plan is after. The TALF, or Term Asset-Backed Securities Loan Facility, is designed to make a secondary market for things like auto loans and credit card receivables.”
Investing may be the furthest thing from your mind if you’re struggling to find a job or pay bills. But for those who are attempting to weather this storm by loading up on low-yielding Treasuries, it may be time to consider taking on a bit of risk, even though by all accounts it appears that the economy will take a significant amount of time to return to what most would consider a healthy state.
“The Treasury market is deemed to be a safe haven, but you’re taking on interest rate risk — the risk that rates will rise from today’s very low levels and devalue the bond that you hold (as the price of the bond drops). And you’re taking on inflation risk,” says Farr.
“If you have a 10-year Treasury with a yield of 2.8 percent and inflation is higher than the market anticipates, even by a very small amount, that bond is not going to be the safe haven you expected. If you want to take on credit risk, you could buy investment-grade corporate bonds with yields in the 7-percent range. They make a lot of sense, in particular for retirement accounts. You don’t have the downside risk that (you) would with an equity instrument and you have a nice return. These bonds will be hurt if there’s a sharp rise in interest rates or inflation, but not to the same degree as Treasuries because their yields are high due to the high credit spreads today.”
Of course, there is always the other end of the spectrum. Dan Deighan, a financial planner at Deighan Financial Advisors in Melbourne, Fla., agrees that people holding Treasuries will “get absolutely hammered,” but he doesn’t think corporate bonds are the way to go.
“The challenge with all bonds is that when interest rates go up, bond values go down. And when you look at everything in play right now in our economy, it screams for interest rates to go up. What we’re buying now are hard assets. We’re either buying gold, gold bullion — and clients are taking possession of it — or we’re buying income-generating real estate of a commercial nature.”
Deighan says it will be a very long time before the economy bounces back.
“Seventy percent of our economy is predicated on consumer spending. Everybody was spending all of their equity that was really just on paper. We’ve spent our growth for the next 10 years. It’s gone. We’re going to have to suck it up as individuals, as families, as businesses and as a country. Back to normal isn’t the way it was a year ago.”
If talking with a Certified Financial Planner would help you make some decisions in this tough market, check Bankrate’s database to find one near you.