Almost a year since the idea was first raised by policymakers as a solution to the credit crisis, the Federal Deposit Insurance Corp. went forward Friday with a plan to auction off toxic assets from a failed bank.
But the pilot program raised questions about whether it could ever apply, as originally envisioned, to open and operating institutions and if it will have much impact on the market.
Though the agency made few details public, sources said the test sale would involve just over $1 billion of assets from the $4.9 billion-asset Franklin Bank in Houston, which collapsed in November. The agency said it would make leverage available to investors that bid on the assets.
Observers said the pilot test could broaden the pool of investors seeking toxic assets, and prove how the financing model can lighten the FDIC's balance sheet. But it was unclear if the plan would boost asset prices to the point where open institutions would want to participate.
The sale could "show there's a market and people are willing to buy. The unknown quantity is: … Are people willing to sell?" said Lawrence Kaplan, an attorney at Paul, Hastings, Janofsky & Walker LLP.
John Douglas, a former FDIC general counsel and now a partner at Davis, Polk & Wardwell, agreed that the effect of the program will depend on how high a price the FDIC gets for the Franklin assets.
"If it turns out that it attracts a lot of attention and interest and proves that it can get good pricing, I think the FDIC's hope is that maybe bankers will look at it and say, 'If that's the kind of price you're getting for your stuff, maybe I'd be interested in participating in this for some of my assets,' " Douglas said.
Under the plan, the FDIC and other investors would share control of a limited liability company that holds the assets. Investors could bid on a piece of the LLC under two scenarios. They could either propose to own 20% of the entity — which would increase to as high as 60% if the assets perform — or they could receive financing and split ownership 50-50 with the FDIC.
Under the second option, the FDIC would provide the bulk of the financing, lending $4 or $6 for every $1 of equity in the LLC. For example, if a winning bidder chose the 6-to-1 option on a portfolio priced at $700 million, the bidder and the FDIC would each contribute $50 million for a total of $100 million in equity. The LLC would issue a bond to the FDIC for the remaining $600 million.
The agency would guarantee the debt and could possibly choose to sell it on the secondary market, according to senior FDIC officials who declined to speak publicly.
Although the test sale is the long-awaited first step in the plan to create a market for toxic loans, in practice it appears very similar to deals struck by the FDIC already. The agency has created six LLC partnerships to resolve failed bank assets during the recent crisis, and the FDIC-run Resolution Trust Corp. launched joint ventures that provided financing to purchase failed assets during the savings and loan crisis.
The RTC facilitated cheaper interest rates for financing rather than offering the debt itself, because the private debt markets performed better then than they do now, said Tom Horton, who ran the RTC's national sales center. "They were proven to be good tools to move a significant amount of complex assets to the right kind of investors," said Horton, now an executive director with Ernst & Young. "It's probably a pretty good deal for the FDIC to move its receivership assets first and foremost."
But the government has never attempted to use the same model to help operating banks sell their troubled loans, which was the original purpose of the Treasury Department's Public-Private Investment Program. That program, the second under which the government tried to help create a market for troubled assets, was divided into two parts: an auction and financing process run by the FDIC for whole loans, and a Treasury-run effort to buy up banks' illiquid asset-backed securities. Though the Treasury said it is still moving ahead with its plan, the FDIC's program hit a wall earlier this year after bankers were unconvinced it would give them high enough prices to convince them to participate.
The agency said the test sale will help determine how the whole-loan program — known as the Legacy Loans Program — can be improved to find out if it is viable for open institutions. "The FDIC will analyze the results of this sale to see how the LLP can best further the removal of troubled assets from bank balance sheets, and in turn spur lending to further support the credit needs of the economy," the agency said Friday.
Some observers agreed there was a potential for the asset sale to jump-start the market, and the FDIC at the very least can show whether the financing vehicle works. According to agency officials, the model could also be used for other receiverships.
"If the banks see that a high enough price was being reached … then this will be a great help with the PPIP going forward," said Lawrence J. Wolk, a former assistant general counsel at both the RTC and the FDIC, and now a partner at Holland & Knight. "If it doesn't work, either there will be ways it can be fine-tuned, … or at least they have found out if it will or won't be successful without a cost to the taxpayer."
Industry representatives remain skeptical. "Will this enhance the ability of the FDIC to move the stuff it has? There's a real shot at that. That's what they're really testing," said Wayne Abernathy, the American Bankers Association's executive director for financial institutions policy. "The ancillary hope is to see if it affects the appetite of the market for the assets of operating banks. I think that's more wish than anything."
Abernathy reiterated a point made by many in the industry: that since banks have already written down assets so low, and the housing market is beginning to show some signs of recovery, they may not need a government plan for toxic loans.
"Most banks on the one hand have been spooked by any kind of government program and all the strings that come with it," he said. "Second, most operating banks have pretty much devalued any assets they'd think of moving into these programs anyway, and they're looking at a market that has more upside than downside. That means hanging on to their assets and waiting for the right price."
Kaplan said it was still unclear how open banks participating in the PPIP could avoid a steep capital hit if they sold assets to a government-run plan at a loss.
"The challenge in the Legacy Loans Program dealt with the capital hole that would occur when open banks sell their assets," he said. "If people are seeing assets worth $100 bidding for $95, that might be something that's worth it. But if investors are looking for truly bottom feeders, that's going to scare banks off."