Geithner's Toxic-Loan Plan Could Be Toxic for Banks

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The Treasury Department's program to buy toxic loans could cost banks as much as $210 billion. That's the losses the financial firms will book from selling poorly performing loans as part of the government's recently announced Public-Private Investment Plan. What's more, if a recently proposed accounting rule change is not made, PPIP's bottom line effect on the banks could be more than triple that.

The losses would deal a blow to financial firms already struggling from rising delinquencies, and could force some troubled firms such as Bank of America, Citigroup and Wells Fargo to go back to the government for another round of financing. That could create another problem: There's just $135 billion left in the Treasury Department's Troubled Asset Relief Program, so an increasingly cantankerous Congress could balk at being called on to pony up more funding for the program. (Read "Separating Toxic Assets From Legacy Assets")

Some observers say the multi-hundred billion dollar losses, along with the possibility that government will be tapped out when it comes to financial rescues, raise the question as to whether some of the big banks will choose to, or be able to, participate in the Treasury's PPIP program.

"The government's plan is a nice thought, but it is just not going to work," says Paul Miller, who follows banks stocks at FBR Capital Markets. "None of these banks have the capital necessary to recognize these losses."

So far, much of the public reaction to the Treasury Department's plan to dislodge risky loans and poorly performing bonds from banks has been positive. After the plan was announced two weeks ago, the stock market produced one of its biggest rallies in months. At its core, the plan promises to offer cheap loans to investors to purchase bank loans on which borrowers are behind or at risk of default. The plan would put needed cash into the hands of the banks. And on the surface it looks like it could produce sizeable returns for investors, as well as a smaller profit for the government.

But largely overlooked is what the bailout would really cost the banks. Yes, banks would get cash for loans they can't sell without government assistance. But these same banks would also be forced to book a large accounting loss on the sale of the loans, further eroding common equity—a key measure watched by stockholders.

How big a loss the PPIP would create is still the question, and few analysts are willing to put a number on that the figure. Goldman Sachs estimates that on average banks value mortgage loans on their books at $0.91 on the dollar. That means they agree those loans are worth 9% less than their original value. The market, though, thinks many of those loans are worth much less. Some highly rated mortgage bonds based on subprime loans recently traded for as little as $0.26.

Here's where things start to get interesting: A lower price translates into a high potential return for an investor. When the loans were made, an investor who bought them at "par," or the dollar value of the loan, could expect a return of around 7%. That's a more than acceptable rate of return if you believe you will get paid back. But now that defaults are rising on home loans, investors are demanding higher returns to compensate them for the risk that a mortgage will end up delinquent or in foreclosure. A price of $0.26 implies that investor are looking to get paid at least 40% to take on the risk of an existing mortgage loans these days. (Read "Why Berlin Says U.S. 'Bad Bank' Plan is Bad")

Of course, the hope of the Treasury's PPIP program is that with cheap loans from the government investors will be willing to pay more. Why would they do that? Like lower prices, leverage boosts returns. So an investor buying an asset in part with loans should be willing to pay more than someone who has to buy that same asset with just their own cash. Based on's analysis, an investor, using the 6-to-1 leverage the government is providing, can pay as much as $0.70 per dollar lent, and still expect to get the same return as an unlevered investor.

The problem is that $0.70 is still less than the $0.91 average banks are holding loans on their books. The Treasury Department has said that PPIP program could buy up to $1 trillion in "legacy" banks loans and other debt. That suggests banks could lose up to $210 billion on those sales alone (see chart below). Citigroup, for example, has about $200 billion in residential U.S. real estate loans. Goldman estimates that Citigroup values those loans on its books at about $0.94. If it were to sell half of its mortgage loans, Citigroup would lose an estimated $23 billion, about 15% of the total capital the banks had back at the end of 2008.

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