America's Recovery Capital Program

An emergency loan program for small businesses which US has announced since Feb but has yet to implement. It essentially provides 100%-guaranteed, interest-free loans to small businesses for them to pay up their previous loans and interests on these loans (which are relatively high and causing many businesses to be struggling with the payments). This eases the financial difficulties of debt-laden but viable businesses especially. Interesting program, which I've been keeping up with:

1. SBA readies emergency biz loans
Agency has 15 days to create guidelines for $255 million emergency lending initiative approved by Congress.
By Stacy Cowley, small business editor
Last Updated: February 19, 2009: 5:30 PM ET

NEW YORK (CNNMoney.com) -- Small businesses owners struggling to keep up with their bills may see some relief from a new $255 million emergency loan program authorized this week as part of the economic recovery bill.
Congress is pushing for the money to start flowing fast: It gave the Small Business Administration just 15 days to issue guidelines for the brand-new program.
Called the Business Stabilization Program, the initiative will offer loans of up to $35,000 that are essentially interest-free. The loans will only be available to companies that already have bank-issued business loans - Congress wants the new loans to be used to make interest payments and pay down principal on existing debt.
The loans can be used to make payments for up to six months, and no repayment on them will be due for a year. Businesses must fully repay their stabilization loan within five years.
The loans won't be coming directly from the SBA. Instead, the agency will offer a 100% guarantee - something it has never done before - to banks that issue the loans. If the business owner defaults, the SBA will pay off the debt.
The SBA will also fully subsidize the interest on the loans for their entire duration, making them low-cost for business owners and largely risk-free for banks.
Entrepreneurs ready to race out and apply for a loan will need to be patient a bit longer, though. Faced with a tight deadline to create an entirely new program, the SBA is still working out the details.
"We want to get everything in the bill in place as quickly as we can," said SBA spokesman Mike Stamler. "We're doing the best we can."
The SBA hasn't started discussions with banks about how the program will work, but lenders expressed cautious optimism that it will help strapped small businesses.
"We have plenty of customers that would be interested in that type of loan," said Michael Downes, chief lending officer of Unity Bancorp (UNTY) in Clinton, N.J. "We just have to guard against throwing good money after bad."
This new programs is one of the ones Congress wants action on the quickest. It gave the SBA less than three weeks to issue emergency regulations for it.
For the stabilization loans, Congress allocated $255 million to fund the program through September 2010. Since that amount covers only the costs and subsides of the program, it can be used to fund several billion in total loan volume; the SBA is still working out the formulas to calculate how far the cash will stretch.
Only banks already certified to participate in the SBA's loan guarantee programs will be eligible to make stabilization loans. But the agency expects the loans themselves to be available to any small business customer at participating banks, regardless of whether or not the customer's existing loan was actually made through the SBA's guarantee program. (To find out whether your bank is an SBA lender, click here and go to the SBA's resource page for your geographic area.)
As the SBA pulls together its guidelines, lenders and business owners are eager to tap the new line of capital.
"One of the reasons that we were proactive in getting involved in the SBA was because we saw the economy beginning to weaken," said One Georgia Bank's Lewis. "Any time the economy weakens, it's going to be the small businesses that will lead the country out of an economic spiral."

2. Emergency biz loans: What qualifies
The SBA's forthcoming loan-relief program can't be used to pay down existing SBA loans -- but past borrowers will still be eligible for help with other debts.
By Stacy Cowley, CNNMoney.com small business editor
Last Updated: March 20, 2009: 4:49 PM ET

NEW YORK (CNNMoney.com) -- The Small Business Administration is still drawing up guidelines for its forthcoming emergency loans program, a stopgap measure intended to shore up small businesses struggling to keep up with payments on existing debt. But the agency this week confirmed an unexpected twist: Businesses with current loans backed by the SBA won't be able to use the new loans to cover payments on their existing SBA debt.
The upcoming program, tentatively dubbed the "America's Recovery Capital" (ARC) loan program, is a measure mandated by last month's stimulus bill. The bill requires the SBA to create a new "business stabilization" program to back loans of up to $35,000 to small businesses "experiencing immediate financial hardship." The loans are intended to be used to make interest and principal payments on a "qualifying small business loan" for up to six months.
In several announcements this week, SBA officials said that SBA-backed loans made before the stimulus bill's passage on Feb. 17 won't be eligible for ARC loan relief. The reason: The American Recovery and Reinvestment Act, the stimulus bill, forbids it. A provision Congress wrote into the bill explicitly prevents the new stabilization loans from being used to pay down SBA-backed loans made before the bill's enactment.
A staffer with the House Small Business Committee said that restriction was mandated by the Congressional Budget Office to comply with pay-as-you-go prohibitions against increasing the federal deficit through new direct-spending measures.
A representative from CBO was not immediately available for comment.
Still, both the House Committee and the SBA emphasized that businesses with existing SBA-backed loans can still apply for the new ARC loans. The only catch is that they'll have to use their new loans to pay down debt other than their SBA loan.
"Private loans made for any legitimate business purpose -- including credit card debts, bank loans and real-estate loans -- would be eligible for the program," the House Committee staffer said. "The Committee is also pushing the SBA to work with borrowers on loan modification and forbearance to provide relief to small business borrowers who have SBA-backed loans."
Talk back: Have you had trouble getting a loan?
The new ARC loans will be offered on extremely compelling terms for both business owners and lenders. The loans will come directly from banks, but the SBA will offer the banks a 100% guarantee on the loans -- something the agency has never done before. If the business owner defaults, the SBA will repay the bank for the full value of the loan.
The SBA will also fully subsidize the interest on the loans, making them essentially cost free for business owners. No payment on the loans will be due for a year, and businesses will have up to 5 years to fully repay them.
The SBA is still creating the guidelines for the new ARC loans program and doesn't yet know when the funds will be available.
"The details have not been worked out yet," SBA spokesman Michael Stamler said earlier this week. "It a very complex undertaking, but we are hurrying as fast as we can, consistent with making sure we have a thoughtful, effective program in place."
Congress allocated $255 million in the stimulus bill to fund the ARC program. That money will be used to pay for the program's loan guarantees and interest subsidies, so the actual lending volume it will support will be higher. The SBA is still working out the formulas to calculate how far the ARC funding will stretch.
It's also still determining what businesses will qualify for aid. The ARC loans will come directly from banks, and in a Web presentation this week, an SBA official said that only "viable" small businesses will be eligible.
That's an important caveat for a program that offers banks complete immunity against loans going bad. The SBA is already trying to cope with soaring default rates for its traditional loan programs, which only ensure banks against losses on a portion of their losses on qualified small business loans.
"A 'viable' small business is a business that has a demonstrated earnings history and proven record for success that may just need a little extra help to get through a short-term downturn," Eric Zarnikow, the SBA's associate administrator for capital access, said during the presentation. "We will be issuing additional guidance to lenders when the ARC program is released."
While many aspects of the program remain nebulous, small business advocates say it can't arrive soon enough.
"This stimulus, while small, will clearly help many existing small business borrowers to weather the storm," said Edward Tuvin, a former SBA lender who is now managing director of factoring firm Creative Capital Associates in Silver Spring, Md."It sounds like a good plan, but where is it, and why is it so difficult to put it into action?" asked Martin, the owner of Nu Wray Inn, a bed & breakfast in Burnsville, N.C.
Martin, who asked not to have his last name used because he's currently consulting part-time for a bank, has been hit hard by rising operating costs at the same time as sales dry up. To buy Nu Wray Inn three years ago, he took out a private bank loan, one not backed by the SBA. That loan is currently at a 10% interest rate, and the bank has turned down Martin's requests for a modification. "I'm taking money from my other job to make those payments. If it wasn't for that, my business would be bankrupt," Martin said. The SBA's ARC program could help his business -- if it gets moving in time."It frustrates me a lot to see banks and auto makers and these other companies getting a quick response, and small business as a whole getting a very slow response," he said. "The inn I run has been operating since 1833. If I go out of business, that's a hardship to my local community. I'm right in the middle of the town square."

3. Audit: Small biz stimulus relief months behind schedule
The hotly awaited America's Recovery Capital emergency loans program is more than a month overdue, but the SBA says it will have guidelines out to banks within weeks.
By Stacy Cowley, CNNMoney.com small business editor
Last Updated: April 16, 2009: 7:23 PM ET

NEW YORK (CNNMoney.com) -- More than a month after President Barack Obama pledged "aggressive action" to help small businesses struggling to survive the recession, key government relief efforts are running behind schedule, an audit report released Thursday points out.
Plans from the Small Business Administration for an emergency lending program authorized in February's stimulus bill are nearly six weeks overdue, and new programs aimed at strengthening the secondary market for SBA loans won't be operational until June, three months after their deadline, according to a report from the Government Accountability Office.
Congress set extremely ambitious timetables for the new programs it laid out in the American Recovery and Reinvestment Act. The bill gave the SBA just 15 days to issue guidelines for a brand-new secondary market guarantee authority and for a "business stabilization" program that will back bank loans of up to $35,000 for small businesses struggling to make payments on existing debt. Congress also asked the GAO to report back in 60 days on the SBA's progress, but so far, there's little progress for the GAO to audit.
The SBA, whose new administrator, Karen Mills, took office less than two weeks ago, has two stimulus provisions up and running. On March 16, it began waiving fees for participation in its lending programs, and it increased to 90% the portion of qualifying small business loans that it will insure for banks against default. Those moves are intended to increase bank lending to small companies by making the loans safer and less expensive.
But the provision most eagerly awaited by small businesses, the new $35,000 stabilization loan program, is still on the drawing board. To explain to GAO the assortment of missed deadlines, SBA officials pointed to the complexity involved in creating entirely new programs very different from those the agency has previously overseen.
"SBA officials said that the array of requirements under [the Recovery Act] and associated rulemaking deadlines have placed a strain on the agency's existing staff and other resources," the GAO wrote in its report. "Similarly, officials from some trade groups representing lenders and broker-dealers expressed concerns that SBA lacked staffing necessary, particularly in the Office of Capital Access, to carry out [the] provisions."
There's hope on the horizon, though: An SBA spokesman says the emergency loans program will be up and running within weeks.
"I don't have a specific date, but it's weeks, not months," SBA Assistant Administrator Jonathan Swain said Thursday. "We know that there's a lot of interest in the program, and that it can be very helpful to a lot of small businesses around the country."
Dubbed "America's Recovery Capital" (ARC), the program will offer banks a 100% guarantee on money lent to "viable" small businesses struggling to make payments on existing debt, including credit cards, commercial mortgages and previous loans. Businesses will be able to borrow up to $35,000 and can use the money to make debt payments for up to six months. The SBA will fully subsidize the interest on the loans, making them essentially cost-free for borrowers.
Those extremely attractive terms have small business owners clamoring for details on how to apply. Mack Sullivan, founder and publisher of Due South Publishing in St. Simons Island, Ga., says he's been to his local SBA and his bank to press for information, but found no one with any knowledge of how the ARC program is progressing.
"The frustration is, where does it stand? When can we expect to learn more? I thought there was a deadline set by Barack Obama," he said. "It's one thing to not meet deadlines, but it's another to just go dark and leave everybody wondering."
Talk back: Could you use an ARC loan?
Founded six years ago, Due South Publishing produces local guide books that are distributed in hotels and tourist hot spots around St. Simons Island. The company is generally cash-flow positive, Sullivan said, but it hasn't been immune from the recession's effects. Sullivan has taken out home-equity loans and borrowed against credit cards to finance his four-person venture.
"A $35,000 loan would allow us to pay off some credit cards, not worry about our credit lines being cut, and ride through this economic downturn for another 12 months," Sullivan said. "As an entrepreneurial small business person, I wouldn't normally find myself waiting for something the government is doing, but these are such extraordinary times."
New business owner Erika Sanchez is also looking for the kind of immediate help the ARC loans are designed to provide. Sanchez and her husband opened a design and printing business, Pronto Graphic Designs, in Dallas in January. Sales have been surprisingly strong: Sanchez already has a client roster of about 40 local businesses and enough work that she'd like to hire an additional designer and expand her office space. Working capital is the obstacle.
"There's more equipment that we need to buy," she said. "We have a lot of work, and it's slowing us down that we don't have the machinery for it."
Congress is pushing for action as fast as possible from the SBA. "The single biggest challenge facing most small businesses right now is access to affordable credit, which is why it is vital that the SBA get these programs up and running immediately," Rep. Nydia Velázquez, D-N.Y., the chairwoman of the House Committee on Small Business, said in response to the GAO report. "With every day that goes by, more small businesses are being forced to close their doors."
The SBA is working "diligently and expeditiously" to implement all of the Recovery Act provisions, SBA Administrator Karen Mills said in a written response to the GAO's report.
"A number of these programs require sophisticated financial modeling and/or legal documentation, and present challenging policy or structural issues, and therefore require additional time to implement," Mills wrote.
While the GAO noted the SBA's blown deadlines, it included no criticism of the agency's efforts or recommendations for improvement.
"In this case we did not see clear criteria for making recommendations," report author William Shear, GAO director of financial markets and community investment, said in an interview after the report's release. For years the GAO has been issuing audits drawing attention to SBA staffing shortfalls and slipshod management of various programs the agency is tasked with overseeing.
"We think our major contribution here was to provide information to Congress and others on what the SBA's challenges are that have affected the agency's inability to meet the schedule Congress set," Shear said.

5 Fund Managers for PPIP

Additional details of the Public-Private Investment Programme. Still going through teething problems in the implementation. Apparently they are looking at 5 fund managers to handle this. Original article in the FT

US shakes up toxic asset rules

By Francesco Guerrera in New York

Published: April 7 2009 03:00 | Last updated: April 7 2009 03:00

Hedge funds and small fund companies could get government loans to buy troubled securities from banks after the US Treasury changed the rules of its $1,000bn toxic assets plan on fears it would only benefit a few large investors.

The move, announced yesterday, came after lobbying by hedge funds and small investors who argued the large funds that helped shape the programme, such as BlackRock and Pimco, would be its main beneficiaries.

The Treasury's decision to amend the plan a fortnight after its creation underlines the difficulties in balancing investors' demand for speedy measures against the need to avoid rushed moves that cause more problems.

The original "public-private investment programme" (PPIP) stated that only funds with at least $10bn of mortgage-backed assets under management could become one of the five managers in charge of buying troubled securities from banks.

But in guidance, the Treasury said it was considering "opening the programme to smaller fund managers [with less than $10bn of eligible assets under management]", after it had selected the first batch of fund managers.

Hedge fund managers said the changes could enable smaller groups to take advantage of the cheap leverage being offered by the Treasury to entice investors to buy troubled securities from banks. "Treasury seems to have realised the original plan would have benefited a handful of 'mega-funds'," said one.

The authorities said they could appoint more than five fund managers in the first round and extended the application period from April 10 to April 24.

Selected fund managers will have three months to raise $500m from investors - a condition to receive government loans. The Treasury relaxed eligibility rules for the first set of fund managers.

The authorities said failure to meet one of the five original criteria, such as having headquarters in the US and having a record of managing bad assets, did not automatically disqualify an applicant. That could pave the way for foreign fund managers.

The Treasury stood firm on one of the plan's more controversial points - the ability of banks to participate as buyers of toxic assets. The loophole - reported in the Financial Times - sparked protests that banks would add to their stockpile of bad assets with cheap taxpayers' funds.

The Treasury was seeking applications from a range of institutions and would consider their "overall financial health" before approving proposals.

Good bank, Bad Bank

Here is the original article by Bulow and Klemperer

Reorganising the banks: Focus on the liabilities, not the assets

Jeremy Bulow Paul Klemperer 21 March 2009

Fixing the banks is an absolute priority in G7 nations. Doing this by buying toxic assets is costly, inefficient, and risky. Governments should focus on which liabilities, rather than which assets, they need to support. This column proposes creating “bridge” banks as a way of re-establishing a healthy banking system.

Summary of the argument

1. We cannot efficiently value or transfer “toxic” assets - so a good plan cannot depend upon this.

2. The UK’s Special Resolution Regime, or one similar to that of the US FDIC, can cleanly split off the key banking functions into a new "bridge" bank, leaving liabilities behind in an "old” bank, thus also removing creditors’ bargaining power.

3. Creditors left behind in the old bank can be fairly compensated by giving them the equity in the new bank.

4. We can pick and choose which creditors we wish to “top up” beyond this level, but should not indiscriminately make all creditors completely whole as in recent bailouts.

5. Coordinating actions with other countries will reduce any risks.

As we pour good money after bad in trying to save the banks, far too much time and attention has been focused on attempting to value or transfer or shore up the so-called “toxic” assets. This is natural enough, since they arguably caused the crisis, but it’s also wrong. Here’s why.

Flaws of the current approach

First, the toxic assets are very difficult to value. Many are held by only one or two owners so there is no real market even in good times. And even if a hedge fund buyer and a bank seller both thought that an asset was worth 50, the bank might demand 80 in the hopes of receiving that price in the next government bailout. Furthermore, the banks may be the “natural” owners of these assets. Say a bank makes a construction loan. Even if the loan sours, the bank may be the most knowledgeable party to hold and possibly renegotiate the loan.

Second, purchasing or guaranteeing “toxic” assets creates other problems too. Putting aside the obvious inequity of paying bank creditors a “risk premium” for having invested in failed businesses, how can we ever again rely on market signals to allocate capital efficiently among banks if their capital structures are effectively guaranteed by the government? And under schemes like the recent Citigroup, RBS and Lloyds bailouts, banks’ incentives to manage the “insured” assets are drastically reduced, as the government bears up to 90% of any marginal losses.

Lastly and perhaps most important, the obvious fiscal risks associated with the huge incremental costs of current policies may undermine confidence far more than paying off creditors in full may temporarily boost it, however superficially attractive the latter approach may seem.

Re-establishing a healthy banking system is crucial, but doing so through the purchase of toxic assets is costly, inefficient, and risky.

How to reorganise the banks

How then can we make banks healthy without separating the “bad assets”? The answer is, instead, to separate the “bad liabilities”.^*

Take Citigroup, for example. At the end of 2008 the bank had roughly $1.8 trillion in liabilities on its consolidated balance sheet, of which less than $800 billion were deposits.

Say Citi’s assets were worth $1.5 trillion. A new (“bridge”) bank that included all the assets plus say $1 trillion of the old bank’s most senior liabilities would still be comfortably well capitalised, even if the asset values were overestimated. The original bank would be left with all the equity in the new bank, worth $500 billion, and the remaining $800 billion in liabilities.

The original bank would still be insolvent, but that would not prevent the healthy new bank from operating efficiently and making good loans. If a risky original bank's marginal cost of funds is, say, 10% it will not be profitable for it to make new riskless loans at 7%, even if the market riskless rate is zero. By contrast, because the new bank is well capitalised, it can borrow on sensible terms if it has a profitable investment to fund.¹

Giving the old bank an equity stake in the new bank is the best way to compensate the holders of old bank’s liabilities to the full liquidation value -- but not more than that value -- of their claims. It may also facilitate the reorganisation of the old bank if, as is likely, it goes into bankruptcy, since creating marketable equity in the new bank resolves the difficulty of valuing the old bank's assets, and avoids any need to sell the new bank on to a third-party – a transaction from which the government might be unlikely to get full value.²

The reorganisation could be managed under a regime like the UK’s Special Resolution Regime (SRR) or similar to that of the US Federal Deposit Insurance Corporation (FDIC)³ (there may be other possibilities too). The government’s role ends when the old bank has sold its shares or allocated them amongst its creditors.

Who loses?

Paying all creditors at least their liquidation claims is probably a pre-requisite for maintaining market confidence. It is anyway mandated by the Fifth Amendment in the US and by Human Rights legislation in Europe, and it is enshrined as the “no creditor worse off” principle in the recently-enacted UK Banking Act. So both the FDIC and the SRR assure the non-guaranteed creditors of the banks that they will be paid at least as much as they would receive under a liquidation of the institution, but not that they will get back every penny they are owed.⁴

Under a liquidation the junior creditors would suffer losses of $300 billion in our example (and the old bank’s shareholders would be wiped out), unless there were further government subsidies. A key virtue of isolating the junior liabilities rather than the troubled assets is that while the government may then choose to subsidise some of the junior creditors’ losses, it can more easily get off its current path towards subsidising them 100%.

For example, in the U.S. system the order of priority for debts is the following: (1) administrative expense of liquidation; (2) secured claims up to the value of collateral; (3) domestic deposits (both insured and uninsured); (4) foreign deposits and other general creditor claims; (5) subordinated creditor claims; and (6) equity investors. Recently issued subordinated debt has been guaranteed by the government, which would therefore take any loss on those securities in a reorganisation. (The UK prioritisation is a little different; in particular, it does not make domestic deposits senior to foreign deposits or other general creditors).

For a large bank like Citi or Bank of America the first three categories would be placed in the new bank, and so would be fully protected. Foreign depositors should probably also be made whole. As when the Icelandic banks defaulted, countries will try to “ring fence” the operations within their borders if their deposits are not paid. Furthermore, not paying foreign deposits would lead to tit-for-tat behavior and might increase systemic risk. Making these depositors whole, and protecting domestic depositors in a jurisdiction like the UK that does not have depositor preference, may give them more than their liquidation values, so the government would have to either infuse the new bank with enough capital that the claims of the remaining creditors would be worth as much as in a no-intervention insolvency, or make a cash payment directly to the old bank. (The infusion to the new bank makes its equity more valuable and therefore raises the value of the claims of the “original bank” creditors in insolvency. The amount of the equity infusion or cash payment is easily calculable if the new bank’s stock is traded, as explained in this note.⁵)

However, other general creditors (other than those with a government guarantee) including non-guaranteed bondholders and owners of credit default swaps that are not fully collateralised need not be paid in full. The government may, if it wishes, choose to pay these creditors more than they would receive in liquidation. (It can even buy their claims from the old bank at full value and place them in the new bank.) But because the old bank’s creditors’ leverage would be reduced to their financial claims, and they would not have the threat of bankrupting the new healthy bank were they not paid in full, this need only be done when not doing so would contribute to systemic risk.

If there is still concern that the new bank is undercapitalised, the government can infuse more equity, but in contrast to the current situation the infusion would no longer have to be large enough to pay off the junior creditors.

Finally, coordinating actions with other countries would resolve the concern that some have expressed that if one country alone fails to bail out a category of creditors, its institutions will find it hard to raise funding in the future. International coordination may also make it politically much easier to favour some groups of systemically-important creditors (especially foreign ones) over others.

For some banks, particularly those whose liabilities are almost entirely deposits, this approach may save little money relative to the current bailouts. And, of course, if it is systemically important to make every creditor completely whole, then there is no saving at all. But if the authorities do not believe that any bank creditors can be asked to lose a penny then they should say so. We can then stop worrying about things like whether, if the government buys (or “insures”) the troubled assets from the banks the government pays fair price or an extra couple of hundred billion, since in this case any overpayment simply reduces the amount the government will ultimately have to pay to make good all the creditors, by an equal amount.

If governments feel that they need to absorb more of the risk in the system, they should consider whether providing subsidies to bank creditors is the most effective use of their funds.

Conclusion

A plan that isolates the bad liabilities rather than the bad assets of the banks, and pays the owners of those claims everything they legally deserve in liquidation but does not fully immunise them from losses, will achieve three major objectives.

• It will help unfreeze the credit markets by creating healthy banks able to lend.
• It will assure that depositors are paid in full, and all creditors are paid at least their entitlement.
• It will make the bailout cheaper for the government, increasing its flexibility.

Finally, as an additional benefit, paying creditors based on market values rather than government guarantees reduces moral hazard in bank finance, and increases the prospect of better monitoring by sophisticated private creditors in determining the future allocation of capital across financial institutions.

There will be a lot more we will need to do to solve the financial crisis -- let's not make the bank bailouts more expensive than absolutely necessary.

---

* While presented in the form of a plan, what follows is intended to raise questions that deserve answers, rather than make definitive recommendations; some of this might require other legal means than those suggested here.

---

1. Why do undercapitalised banks have difficulty funding good, relatively safe loans?

First, because any new capital raised is effectively bailing out the senior creditors. If any capital raise has to come primarily from junior creditors, as is likely since the supply of depositors’ funds is relatively fixed, the senior creditors benefit because there will be more collateral available to secure their claims. If the new funds are used for any new zero net present value investment, then any gain of the senior creditors must be matched by an equal loss for the junior creditors – regardless of the riskiness of the new investment. So an undercapitalised bank will need a higher return on even the riskiest investments, if the funding must come from issuing more equity or junior debt.

Second, shareholders in a risky bank are biased against safe investments. Say that a bank that wished to borrow 80 pounds had to promise to return 100 – reflecting a 20% chance of not paying – even when the riskless interest rate is zero. Say that it could make a riskless investment with these funds that would pay off 90 – well above the riskless market rate (of zero). The sum of these two transactions would be a bad deal for the shareholders because they will receive 10 pounds less if the bank is able to pay all its obligations in full, and nothing otherwise. In addition, the probability that they will wind up with nothing will increase, because the risky assets the bank already holds will need a 10 pounds higher payoff to pay off the bank’s debts in full.

2. We have put all the assets, including the "toxic" assets, into the new bank, because this avoids the need to value or trade them (except to the extent that the market will estimate the value when putting a price on the new bank’s equity). A possible danger--depending in part upon regulatory rules--is that the new bank might nevertheless feel under pressure to sell these assets to improve its regulatory capital position. In that case, the "bad assets" might be better left behind in the old bank if the old bank’s liquidation procedures did not create even greater pressures to sell rather than to run to maturity or renegotiate, etc., as appropriate. (A plan that credibly focuses the government’s bailout efforts on liabilities rather than assets should reduce the difficulties of trading the troubled assets, but it may still be inefficient to trade them.)

3. An important difficulty in the US is that the FDIC procedures cannot be applied at the bank holding company level (where some large US banks hold significant assets and liabilities) rather than at the bank level, and subsidies may also be required at the holding company level to curtail system risk. It is easy to imagine a situation where the operating banks are themselves insolvent and perhaps appropriate for a “bridge” bank reorganisation, while at the same time the holding company would be required to go through Chapter 11 of the bankruptcy code in the US. In this case the US government might perhaps provide Debtor in Possession financing to the holding company as it resolved its affairs.

4. In fact, the SRR guarantees only that creditors will get back what would have been their liquidation values in the absence of prior government assistance. So the benefits they gained from the recent government schemes to insure their assets could be discounted from their liquidation values to compute their guaranteed minima. Whether the benefits that some groups of creditors gained from earlier bailouts, including the Lloyds/HBOS merger, can also be "taken back" by the government is beyond our legal expertise.

5. Say for example, that a bank had liabilities in the amounts of L1 and L2, both equal priority, but the government wished to elevate the seniority of L1 by making it a debt of the new bank. If the new bank, with this liability, establishes an equity value of E and a debt value of L1, the value of the L2 claim becomes E, whereas its previous value as an equal priority claim was ((E+L1) times L2/(L1+L2)), so the amount of a fair cash payment to the old bank is the difference between these values, which equals (L2-E) times L1/(L1+L2). (This reflects the facts that the excess of liabilities over assets is (L2-E), and the owners of L1 originally bore share L1/(L1+L2) of these losses).

Good Bank Bad Bank

Here's an explanation of the good bank- bad bank solution. Just note, that the main problem this tries to solve are banks with so much toxic assets (these can be bad loan portfolios with high NPL rates) that they can't continue lending.

A capital idea to get the banks to start lending again

By Tim Harford

Published: April 4 2009 02:13 | Last updated: April 4 2009 02:13

I’ve been weighing up a very elegant treatment for the banking crisis that has been buzzing around the economics blogs – so elegant, in fact, that it took me several days to convince myself that it wasn’t just a logical sleight of hand, the kind of subtle fallacy that mathematicians use to “demonstrate” that 1+1=1.

One way to understand the banking crisis is that the banks cannot raise new money and lend it to people who could use it. This is not because there is no money, or no deserving investment projects. It is because the banks, whose assets are worth less than they hoped, are now weighed down by their existing promises to repay depositors and other creditors. They cannot raise fresh money because nobody wants to lend money to a near-bankrupt bank.

So far, governments have been trying to raise or at least stabilise the value of bank assets, but an alternative is to reduce the burden of their liabilities.

The elegant approach I’ve been examining has been developed by long-time collaborators Jeremy Bulow and Paul Klemperer. They suggest splitting crippled banks such as Citigroup or RBS into a good “bridge” bank and a bad “rump” bank. The bridge bank gets all the assets, even the so-called “toxic” assets. These are not truly toxic, simply worth less than everyone hoped. The bridge bank also inherits sacred liabilities such as deposits. The rump bank gets no assets, only the debts the old bank used to owe to creditors.

With a leap and a bound, the bridge bank is well-capitalised and capable of raising new funds to lend out to good projects. Depositors feel secure and the economy acquires a functioning bank. The rump bank, of course, is a basket case, so one might think that the shareholders and creditors in the rump bank have suffered expropriation. They have not: Bulow and Klemperer propose giving all the equity in the bridge bank to the rump bank – this is full and fair compensation. The rump bank may well go bankrupt and the creditors will have to see what they can salvage – which will include shares in the bridge bank. But the bankruptcy process will not damage the bridge bank, nor prevent it from raising new money and making fresh loans.

The plan may not work, for a number of reasons. The most serious objection is that everything is now systemic, and that allowing creditors to lose a percentage of their claims – despite the fact that they lent money to the banks without any government guarantee – may cause further bankruptcies. Even so, the Bulow-Klemperer plan allows the government to pour further money into the banks in a more transparent way: to the bridge bank if the concern is to ensure well-capitalised banks; to the rump bank’s creditors if the concern is to prevent a chain reaction of bankruptcies. Transparency, of course, may be the last thing governments want, given the possible sums involved.

If you are still blinking at the idea that one can produce a healthy bridge bank like a rabbit from a troubled-bank top hat, without injecting new funds and without resorting to expropriation, you should be. But it is true. The confusing thing about the financial crisis is that the physical economy is in the same shape as ever, but it can be paralysed if investment money cannot flow from those who have it to those who can use it. A tangle of – unpayable? – claims against the banks is, like some modern-day Jarndyce and Jarndyce case, stemming that flow. Bulow and Klemperer try to set the tangle to one side to be resolved while the banks continue their business. Put like that, the idea does not seem like such a conjuring trick.

Ireland Sets Up A 'Bad Bank' As First Eurozone Country: Will Others Follow Suit?

Irish bank debt plan a first for Europe

By John Murray Brown
Published: April 7 2009 20:39 Last updated: April 7 2009 20:39

Brian Lenihan, Ireland’s finance minister, described it as a bold and radical measure. But the plan for the state to assume the bad debts of the country’s main commercial banks was attacked by the main opposition party as a "big time bomb" for the Irish taxpayer.

The Irish plan, the most striking part of Tuesday’s emergency budget, involves a government-controlled agency taking property assets and loans to developers off the banks’ books in return for government bonds. Mr Lenihan said the agency would take over loans with a book value of €80bn-€90bn ($59bn-$67bn, £54bn-£61bn), although actual value is much lower.

Ministers expect banks, which have benefited from a blanket government guarantee since last autumn, to co-operate with the plan though the government is willing to pass legislation to enforce the transfer if necessary. The government already has 25 per cent of Bank of Ireland and is finalising a plan to take a similar stake in Allied Irish Banks.

The transfer may force banks to recognise additional losses, although the government said it was prepared to recapitalise those institutions in return for ordinary shares if necessary.

The "bad bank" proposal makes Ireland the first European country to offer to take toxic assets off the balance sheets of lenders that are still privately owned. Similar structures have been examined in other countries such as the UK, but were abandoned because it would be too difficult to value the assets properly.

The Irish plan is simpler than schemes adopted by other European governments because the main problem for Irish banks is bad loans caused by a speculative property boom, rather than holdings of complex debt securities.

However, Mr Lenihan is likely to face considerable public anger over the plan. Aware of the public perception that it represents another bank bail-out, he emphasised "this is not something the banks especially want because we’re insisting on the banks taking their losses up-front for the sake of the economy".

The governing Fianna Fáil party has in the past been accused by opposition parties of favouring the building industry, many of whom are big political donors. But Mr Lenihan said those who borrowed money would have to repay their loans in full, and warned "there will be a hardening of the approach to these borrowers".

He acknowledged that the issuance of bonds would result in a "significant" increase in national debt levels, but "the cost of servicing this debt will be offset, as far as practical, from income accruing from the assets of the new agency." Any shortfall would be met by a levy on the banks’ assets.

Richard Bruton, Fine Gael finance spokesman, said it was an enormous gamble. "We don’t know what price the taxpayer will have to pay. We don’t know if the working out of this leaves a huge deficit. Will the bankers pay up?"

He pointed out the value of assets being assumed by the new agency was "equivalent to more than 50 per cent of GDP, the equivalent of 12 years of income tax".

In an interview with Irish radio, Mr Lenihan conceded it might be 10 years before the full cost would be clear.

Looks like not all is rosy on the p2p lending landscape. Primarily it seems that the primary cause is the high default rate.


===============
BusinessWeek, 3 Apr 09

Peer-to-Peer Lending Pain

Once seen as the future of financing for entrepreneurs, the social-networking approach has suffered from high defaults

By Amy Barrett

It has been a year of setbacks for peer-to-peer lenders such as Prosper, Lending Club, and Zopa, which use the Web to connect those who need a loan with individuals willing to act as lenders. Once positioned to become an alternative financing spigot for entrepreneurs, the nascent industry has been hit by regulatory issues, a slow economy, and a slew of defaults.

The biggest player, Prosper, stopped making new loans in October. It will resume after it completes its registration with the Securities & Exchange Commission. That has left the field to smaller rivals such as Lending Club, which completed its filing last fall. Zopa, a British company, pulled out of the U.S. market in November after deciding that its business model, which relied on credit unions, simply wasn't attractive. As Prosper prepares to reopen this spring, one question looms: Can the industry attract enough lenders to be a viable source of funding for entrepreneurs?

The uncertainty is quite a turnaround from the initial hype surrounding peer-to-peer lending. Much of the early attention was on the sites' social networking aspects. Borrowers seeking loans of up to $25,000 could post profiles of themselves and their financial situations. Lenders, meanwhile, were ordinary people seeking better returns than those offered by other investments and supposedly could be swayed by personal appeals. Prosper set interest rates using auctions, while Lending Club bases rates on a borrower's financials.

Now lenders such as Greg Bequette of Livermore, Calif., are backing away. Two years ago, Bequette, who works in finance at Lawrence Livermore National Laboratory, had lent $800,000 to 173 borrowers through Prosper. Because of high defaults, he figures his return rate is -22%. So he isn't planning to make new loans. "I don't think peer-to-peer lending will take off the way people thought," says Bequette, who was once the site's biggest lender. Lender Dennis Rogers, a machinist from Mystic, Conn., has made $1,000 available to about 20 borrowers since 2006 and so far has dealt with one default and two late payers. He says the economy now makes the whole proposition too risky. "I could lend to A+ [credit-rated] people, and they could lose their job," he says. "I probably have a better chance of getting my money back at a casino."

THEY GO BAD FAST

The charge-off rates, or the percentage of loans written off as uncollectible, for loans made through the sites suggest that Bequette and Rogers are not isolated examples. Prosper, which launched in 2006, has facilitated $178 million in loans, of which 16.5% have been charged off because they're more than 120 days past due. For loans made before 2008, the charge-off rate is over 20%. By comparison, the charge-off rate for commercial and industrial loans made by banks was just 1.6% in the fourth quarter of 2008. The rate for personal loans (including auto and student loans) was 2.8%, according to the Federal Deposit Insurance Corp.'s most recent data. Credit-card charge-offs were at 6.2%. A spokesperson for Prosper declined to comment, saying the company is in a quiet period relating to its SEC filing.

Many Prosper loans have gone bad relatively quickly, before lenders have collected many payments. Eric Petroelje, a Prosper lender who uses a feed from Prosper's database to track loan performance, says about half of all loans that have gone bad did so within eight months.

The figures are less bleak for Lending Club, which has had tougher credit requirements since its May 2007 launch. About 8.5% of its loans made before 2008 are in default. However, the company's founder and CEO, Renaud Laplanche, says that many of its defaulted borrowers do resume payment, and that the company's charge-off rate for loans made before 2008 is only about 3.5%. Laplanche says Lending Club's more conservative requirements and lower default rates will continue to attract lenders and help make peer-to-peer lending "mainstream." And while only $2.6 million in loans were funded on the site in January, compared with a peak of $5 million in both March and April of last year, Laplanche expects to reach the $5 million mark again by April of this year.

Not surprisingly, individuals who still lend through the sites increasingly are seeking out the safest borrowers. In October 2008, Lending Club raised the minimum FICO score (a measure of creditworthiness) for borrowers by 20 points, to 660, and lowered the maximum debt-to-income ratio to 25% from 30%. As of last fall, before Prosper stopped lending, the percentage of its borrowers funded in September rated as "prime" was 45%, up from 30% a year earlier. Less than 15% of would-be borrowers get funded at either Lending Club or Prosper. If peer-to-peer lending does make a comeback, it's likely to serve only those with sterling credit who are shopping for better rates—and not the majority of entrepreneurs.

Nationalisation of Banks

Another good piece here arguing for nationalisation by Matthew Richardson http://www.voxeu.org/index.php?q=node/3143

Treasury Secretary Timothy Geithner’s financial plan calls for stress tests at the large complex financial institutions (LCFIs). These tests are due to start this week. They will involve estimates on the eventual losses due to default on a wide variety of assets.

Economic analysts have already performed such a test at the aggregate level. The results were not pretty. For example, Goldman Sachs looked at the US banking sector’s holdings of the current “toxic” pool of assets, such as option ARM residential mortgages, subprime residential mortgages, Alt-A residential mortgages, credit card debt, second liens/home equity loans, consumer auto loans, and commercial real estate. Expected losses come in at around $900 billion. These losses give the banking sector very little wiggle room. Therefore, there is the real possibility that some LCFIs are bankrupt – the face value of their liabilities exceeds the current value of their assets.

Insolvent financial institutions

If a bank is insolvent, there are three general ways to attack the problem.

The first is unbridled free-market capitalism. I am sympathetic to this view. I wish we somehow could figure out a way to let the market work and let these institutions fend for themselves. Shareholders, creditors and counterparties knew the risks they were getting into. After all, why is some debt secured, why do we have collateralised lending, why do riskier assets deserve larger haircuts, etc? But when Lehman Brothers went down, we looked into the abyss. This would be the equivalent of nuclear armageddon for the financial system.

The second option is to provide government aid to the insolvent bank – to in effect throw good money after bad. This is sanctioning private profit-taking with socialised risk. Since October of this past year, the government has followed this strategy. Let the banks plod along, throwing money here and there to keep them afloat, at usually way below-market prices at a high cost to taxpayers.

It is not a totally crazy solution. There may well be a positive externality to spending taxpayer money to save a few so we can save the entire system. For economists specialising in the field of banking, however, this approach has a familiar ring to it. In Japan’s lost decade of the 1990s, its banks kept loaning funds to bankrupt firms so as not to writedown their own losses, which resulted in the government supporting zombie banks supporting zombie firms.

As an example, consider the poster child for the “freebie” programmes, the Temporary Liquidity Guarantee Program, started in late November of 2008. For a cost of 0.75%, it allows banks to issue bonds backed by the government, essentially risk-free. The banks have accessed this market 97 times for $190 billion!

The biggest pig at the trough was Bank of America, which accessed it 11 times for $35.5 billion. Close behind were JP Morgan ($30 billion), GE Capital ($27 billion), Citigroup ($24 billion), Morgan Stanley ($19 billion), Goldman Sachs ($19 billion) and Wells Fargo ($6 billion). A not so surprising correlation with their respective writedowns (including merged entities): Bank of America $96 billion, JP Morgan $75 billion, Citigroup $88 billion, Morgan Stanley $22 billion, Goldman Sachs $7, billion and Wells Fargo $115 billion.

In terms of helping us exit the financial crisis, this programme has many problems. It charges each institution the same amount, so it hardly separates the solvent from the insolvent institutions. It charges a fee that is grossly below what these institutions could issue in the marketplace given their current balance sheets, distorting the system. Wasn’t that the Fannie Mae and Freddie Mac problem? And it is unlikely to cleanse the system of toxic assets, because it allows banks to continue business while out of money and hope that toxic asset prices increase. In effect, the access to this capital allows them to continue to make their original bets.

The final way of addressing insolvency is nationalisation. Over the past week, there has been debate about whether nationalisation is the right word. According to a standard dictionary definition, nationalisation is the act of transferring ownership from the private sector to the public sector. Although this is literally what we are discussing for certain banks, almost everyone agrees that the type of nationalisation that would take place would be a temporary one. Thus, if everything went as planned, a better analogy would be of the government acting as a trustee in a receivership of the bank.

That said, I do think a term like nationalisation is the appropriate description. It is a misnomer to think, as a number of pundits have suggested, that we have experience at nationalising banks through the FDIC. For example, the latest bank (and 39th of the current crisis) to be closed by regulators is the Silver Falls Bank of Silverton, Oregon. It has three branches and assets of approximately $131 million.

Silver Falls Bank is no Citigroup or Bank of America. The complexity, size and systemic nature of these institutions deserve deep analysis.

The basic argument for nationalisation is that we need an organisation to simultaneously facilitate the reorganisation of the large complex financial institutions and be a trustworthy counterparty to all current and ongoing transactions. The only one with the balance sheet right now is Uncle Sam. But make no mistake about it. With nationalisation of a LCFI, the government is the owner and the ultimate residual claimant. Once we take down the LCFI, we have crossed the Rubicon. The die is cast and there is no turning back.
It is therefore important to do it right. Nationalisation has its pros and cons.

The good bank, bad bank model

In order to have a healthy economy, we need a healthy financial system, and a healthy financial system requires that we cleanse the system of bad assets. Otherwise, creditworthy firms and institutions will not have access to needed capital, prolonging the economic downturn.

Such cleansing would be the primary benefit of nationalising some financial institutions. In receivership, it is much easier to separate a bank’s good assets and bad assets – to divest the firm from its toxic assets and troubled loans. This is because insolvent institutions will never take this action. If they did, it would by construction force them under.

How would it work? The healthy assets and most of the bank’s operations would go to the good bank, as would the deposits. Some of these deposits are insured; others (e.g., businesses and foreign holdings) are not. But the good bank would likely be so well capitalised that there would be no threat of a bank run. The net equity, i.e., assets minus deposits, would be a claim held by the other existing creditors of the bank, namely shareholders, preferred shareholders, short-term debtholders, and long-term debtholders.
The goal would be to reprivatise the good bank as soon as possible. After all, the point of the exercise is to create healthy financial institutions that can start lending again to creditworthy institutions. In almost every successful resolution of financial crises in other countries, this was the path.

Of course, the tricky part of nationalisation is the handling of the bad assets. The bad assets would be broken into two types – those that need to be managed, such as defaulted loans in which the bank would own the underlying asset, and those that could be held, such as the AAA- and subordinated tranches of asset-backed securities. With respect to the former, the government could hire outside distressed investors or create partnerships with outside investors as was done with the Resolution Trust Corporation in the 1980s savings and loan crisis.

Along with the equity of the good bank, these assets would be owned by the existing creditors. The proceeds over time would accrue to the various creditors according to the priority of the claims. Most likely, the existing equity and preferred shares would be wiped out, and the debt would effectively have been swapped into equity in the new structure. Under this scenario, it is quite possible, even likely, that taxpayers would end up paying nothing. This is because, for the large complex financial institutions, these creditors cover well over half the liabilities.

Does such a solution risk systemic bank runs?

The problem with the above solution is that it shifts all the risk of the insolvent institution onto the creditors of the LCFI. While this is fair to the extent the creditors were accruing the profits in normal times, it may lead to the “Lehman Brothers problem” – it risks runs throughout the system.

Why did Lehman Brothers cause systemic risk?

Was it the counterparty risk, e.g., fear of being on the other side of interest rate swap, credit default swap, or repo transactions? This fear was well founded. Ask any hedge fund whose hypothecated securities disappeared in Lehman’s UK prime brokerage operations. It is pretty clear that the government would have to stand behind any counterparty transaction and publicly commit to this rule. Since most of these are margined and collateralised, however, many of the assets would show up in the good bank.

Or was it the short-term debt? The run on money market funds was directly attributable to the Reserve Primary Fund’s holdings of a large amount of short-term Lehman commercial paper. One would presume the same thing would happen here as the short-term debt of all questionable LCFIs would come under pressure. It is highly likely that the government might have to step in.

Compared to the standard large complex financial institution, Lehman had very little long-term debt. To understand whether a collapse in the institution’s long-term debt value is systemic, one would have to analyse the concentration of this debt throughout the system. If it is widely held, it is unlikely to have systemic consequences. Of course, it would have profound effects on future financing of these firms.

If the government has to cover the creditors, or at least some of them, what has been gained?

On the positive side, the system will have cleansed itself of the assets.

Moreover, to minimise the cost to taxpayers, it is not clear that the government will have to step in. If the government is completely transparent to the market who is solvent and who isn’t, and the reasons why this is, then the type of uncertainty that surrounded Lehman’s failure may be mitigated. The runs on the equity and debt of banks in September and October 2008 may have occurred because there was no clear message from the regulator.

That said, actions speak louder than words, and, in a dynamic setting where conditions change rapidly, solvent firms can become insolvent very quickly. While the government needs to do a thorough stress analysis, consistent across all the major banks, to find out the trouble spots, the only definitive way it can prevent a bank run on solvent institutions is to backstop all the creditors of these institutions. Maybe the government can provide a haircut, guaranteeing X% of the debt. In any event, in this case, the creditors of the insolvent institutions would not have to be protected.

Advantage: Nationalisation solves the toxic asset problem

It has been argued that trying to implement nationalisation will be near impossible because we won’t be able to price the hard-to-value “toxic” assets. It is actually the opposite. The current problem is that banks don‘t want to sell the assets at the price the market is willing to pay for them. If we were banks, we wouldn’t want to sell them either. As long as the government is providing free money, why not continue to hold out? Hope is eternal.

But let’s be real. The banks bought illiquid assets with credit risk using borrowed short-term liquid funds. For taking these types of risk, the banks earned a hefty spread. And, in normal times, they raked it in. But there is no free lunch in capital markets. In rare bad times, illiquid, defaultable assets are going to be greatly impaired. There is no mulligan here. It will be easier to resolve this within a receivership.

To make the point using a real economy analogy, this past Christmas, Saks Fifth Avenue sold their designer lines at a 70% discount. Designer labels and boutique shops on Madison Avenue were up in arms. How could they sell $500 Manolo Blahnik shoes for $150? In this economy, they are $150 shoes.
Moreover, receivership allows one to separate out the assets without having to price them.

Disadvantage: How to manage a nationalised bank?

Does the government have the ability to run a large complex financial institution? In a recent conversation, Myron Scholes told me he was also in favour of nationalisation – as long as it lasts just 10 minutes.

These institutions have literally tens of thousands of transactions on their books –, who is going to manage a LCFI while it is a government institution, good bank or bad bank? Certainly, no one envisions Barney Frank or Christopher Dodd as the Chief Investment Officers of these firms, but there are many concerns. The government can go and hire professionals as they have done with Fannie Mae, Freddie Mac, and AIG. But much of the value of a Wall Street firm is in its vast array of intangible, human capital. This labour is incentive-driven. How much franchise value will be lost during the nationalisation process?

Let’s assume this gets sorted out and the government mirrors employment practices at other firms. But then, with the government’s protection in receivership, what is to prevent the LCFI from making too many, risky loans? They will have a competitive advantage over solvent, albeit less-supported banks. This issue has recently come up with other government-supported institutions. Indeed, the argument has been made that AIG and Northern Rock, to name just two institutions, have undercut their competition by offering overly cheap insurance and mortgages, respectively.

Advantage: Nationalisation addresses the moral hazard problem

There is something unseemly about managed funds buying up the debt of financial institutions under the assumption that these firms are “too big to fail”. In theory, these funds should be the ones imposing market discipline on the behaviour of financial firms, not pushing them to becoming bigger and more unwieldy.

It has been said by many that this is not the time for thinking about moral hazard. I disagree. If we bailout the creditors, then effectively we have guaranteed the debt of all future financial institutions. We have implicitly socialised our private financial system.

It is certainly true that we can institute future regulatory reform to try to quell the behaviour of large complex financial institutions. But this will be complex and difficult to implement against the implicit guarantee of “too big to fail”.

Thus, nationalisation resolves the biggest regulatory issue down the road, namely the “too big to fail” problem of banks that are systemically important. In one fell swoop, because the senior unsecured debtholders of a bank will lose when it is nationalised, market discipline comes back to the whole financial sector.

So the large solvent banks will have to change their behaviour as well, leading, most likely, to their own privately and more efficiently run spin-offs and deconsolidation. The reform of systemic risk in the financial system may be easier than we think.

Concluding remark

We are definitely caught between a rock and a hard place. But the question is – what can we do if a major bank is insolvent? Sometimes the best way to repair a severely dilapidated house is to knock it down and rebuild it. Ironically, the best hope of maintaining a private banking system may be to nationalise some of its banks. Yes, it is risky. It could go wrong. But it is the surest path to avoid a “lost decade” like Japan.

Epilogue: Sweden¹

Sweden has been cited frequently as a model of “nationalisation”. While this is probably an exaggeration, the Swedish approach is in many ways a model in terms of the principles it puts forth to handle a financial crisis. Putting aside the obvious fact that Sweden’s economy is much smaller and its financial institutions much less complex, it is a useful exercise to describe some basic facts.

The distribution of assets within the Swedish and US banking system were similar. For example, while Sweden had 500 or so banks, 90% of the assets were concentrated in just six. In the US, while there are over 7,500 institutions, and the majority of assets are concentrated in the top 15 or so.

Sweden’s credit and real estate boom in the late 1980s closely mirrors the recent US boom prior to the crisis. There was even a similar shadow banking system that developed during these periods – in Sweden, unregulated companies financed their operations via commercial paper; in the US, unregulated special purpose vehicles used asset-backed commercial paper. When the bubbles began to burst, there were also sudden collapses in these markets as a few of these companies and special purpose vehicles began to fail.² Ultimately, the funding came back to the banks, causing them to have large exposure to the real estate market.

As conditions eroded in 1991, the Swedish government forced banks to writedown their losses and required them to raise more capital or to be restructured by the government. Of the six largest banks, three – Forsta Sparbanken, Nordbanken and Gota Bank – failed the test. One received funding and the other two, Nordbanken and Gota bank, ended up being nationalised.

These latter two banks had their assets separated into good banks and bad banks. The good banks ended up merging a year later and were sold off to the private sector. The poorly performing loans were placed in the bad banks, respectively named Securum and Retrieva. These banks were managed by asset management companies who were hired to divest the assets of these banks in an orderly manner. (It took around four years.)

The main lessons from Sweden for the current crisis are:

1. Decisive action in terms of evaluating the solvency of the financial institutions.
2. Some form of “nationalisation” of the insolvent firms.
3. Separation of these insolvent firms into good and bad ones with the idea of reprivatising them.
4. The management of the process was delegated to professionals, as opposed to government regulators.

While complexity may affect the application of these principles to the current crisis, it does not nullify them.

---

1 Many of the facts here are taken from Tanju Yorulmazer’s “Lessons from the Resolution of the Swedish Financial Crisis.”
2 In Sweden, in September 1990, a finance company called Nyckeln went bankrupt, while in the current crisis, in early August 2007, three ABCP funds run by BNP Paribas halted redemptions, leading to a run on the system.

Geithner's Public-Private Investment Programme

From BT today

"Under the public-private investment programme announced by US Treasury Secretary Timothy Geithner on Monday, the government will pump money into joint-venture investment funds with private investors to buy up to US$500 billion worth of soured mortgage debt and other troubled assets from banks. The special-purpose funds will be privately managed, but subject to close watch by US regulators.

The government is offering to provide half the seed capital for these investment vehicles, drawing US$100 billion from its war chest under the Troubled Assets Relief Program. It expects private-sector investors such as Pimco, BlackRock and hedge funds to provide the other half of the equity capital.

The government will then offer loans to the special-purpose funds or guarantee debt securities that they issue, to finance their purchase of the toxic assets. Through this leverage, the government estimates the programme could be expanded to buy US$1 trillion worth of hard-to-value assets from banks.

Banks holding such assets, which include billions of dollars of debt securities backed by pools of mortgages and other loans, are reluctant to dump them at the distressed prices that private investors would pay without government support, forcing massive writedowns. Meanwhile, fears that the value of the underlying collateral will collapse further as the US economy worsens have put off potential buyers. Equity investors, worried that the banks will ultimately shoulder the losses, have driven the share prices of many banks to record lows.

By sharing the risk of losses through its co-investment, the government hopes that it will be able to attract private capital, especially from pension funds, insurance companies and other long-term investors back into the market.

'It could be just what we need' to start the world's biggest economy on the slow road to recovery, said David Cohen, director of Asian economic forecasting at Action Economics in Singapore. 'After all, what has been the major hurdle to allow the economic recovery to get started was the fear that the banking system was still frozen and would not be able to finance the recovery with the necessary credit flows.'

But the plan also came under fire from other economists, including Nobel laureate Paul Krugman, who argued that the government support is effectively a subsidy to encourage private investors to buy banks' unwanted assets for more than they are worth, using money from the public purse.

The latest proposal, wrote Mr Krugman in The New York Times, 'would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt'.

Here is Krugman's Op-Ed Piece criticising the Public-Private Investment Programme. Clear here that Krugman's recommends nationalisation of the banks.

Over the weekend The Times and other newspapers reported leaked details about the Obama administration’s bank rescue plan, which is to be officially released this week. If the reports are correct, Tim Geithner, the Treasury secretary, has persuaded President Obama to recycle Bush administration policy — specifically, the “cash for trash” plan proposed, then abandoned, six months ago by then-Treasury Secretary Henry Paulson.

This is more than disappointing. In fact, it fills me with a sense of despair.

After all, we’ve just been through the firestorm over the A.I.G. bonuses, during which administration officials claimed that they knew nothing, couldn’t do anything, and anyway it was someone else’s fault. Meanwhile, the administration has failed to quell the public’s doubts about what banks are doing with taxpayer money.

And now Mr. Obama has apparently settled on a financial plan that, in essence, assumes that banks are fundamentally sound and that bankers know what they’re doing.

It’s as if the president were determined to confirm the growing perception that he and his economic team are out of touch, that their economic vision is clouded by excessively close ties to Wall Street. And by the time Mr. Obama realizes that he needs to change course, his political capital may be gone.

Let’s talk for a moment about the economics of the situation.

Right now, our economy is being dragged down by our dysfunctional financial system, which has been crippled by huge losses on mortgage-backed securities and other assets.

As economic historians can tell you, this is an old story, not that different from dozens of similar crises over the centuries. And there’s a time-honored procedure for dealing with the aftermath of widespread financial failure. It goes like this: the government secures confidence in the system by guaranteeing many (though not necessarily all) bank debts. At the same time, it takes temporary control of truly insolvent banks, in order to clean up their books.

That’s what Sweden did in the early 1990s. It’s also what we ourselves did after the savings and loan debacle of the Reagan years. And there’s no reason we can’t do the same thing now.

But the Obama administration, like the Bush administration, apparently wants an easier way out. The common element to the Paulson and Geithner plans is the insistence that the bad assets on banks’ books are really worth much, much more than anyone is currently willing to pay for them. In fact, their true value is so high that if they were properly priced, banks wouldn’t be in trouble.

And so the plan is to use taxpayer funds to drive the prices of bad assets up to “fair” levels. Mr. Paulson proposed having the government buy the assets directly. Mr. Geithner instead proposes a complicated scheme in which the government lends money to private investors, who then use the money to buy the stuff. The idea, says Mr. Obama’s top economic adviser, is to use “the expertise of the market” to set the value of toxic assets.

But the Geithner scheme would offer a one-way bet: if asset values go up, the investors profit, but if they go down, the investors can walk away from their debt. So this isn’t really about letting markets work. It’s just an indirect, disguised way to subsidize purchases of bad assets.

The likely cost to taxpayers aside, there’s something strange going on here. By my count, this is the third time Obama administration officials have floated a scheme that is essentially a rehash of the Paulson plan, each time adding a new set of bells and whistles and claiming that they’re doing something completely different. This is starting to look obsessive.

But the real problem with this plan is that it won’t work. Yes, troubled assets may be somewhat undervalued. But the fact is that financial executives literally bet their banks on the belief that there was no housing bubble, and the related belief that unprecedented levels of household debt were no problem. They lost that bet. And no amount of financial hocus-pocus — for that is what the Geithner plan amounts to — will change that fact.

You might say, why not try the plan and see what happens? One answer is that time is wasting: every month that we fail to come to grips with the economic crisis another 600,000 jobs are lost.

Even more important, however, is the way Mr. Obama is squandering his credibility. If this plan fails — as it almost surely will — it’s unlikely that he’ll be able to persuade Congress to come up with more funds to do what he should have done in the first place.

All is not lost: the public wants Mr. Obama to succeed, which means that he can still rescue his bank rescue plan. But time is running out.

Another idea by one in one of the comments, John G...

"First, admit that the zombies are in fact dead and that they aren't coming back.

Second, come up with legislation to allow for their orderly termination through a government run receivership (not a bankruptcy) following the FDIC model for insolvent banks, extended to the holding companies.

Third, sell the assets off to existing banks and/or create new, smaller, banks to buy the assets. Distribute the customers (depositors) to these instiutions.

Finally, there will be some assets so toxic that nobody would take them, and there will be some liabilities that nobody will assume at a reasonable price. The government will have to retain these and deal with them over time.

The whole package could be financed by an issuance of 30 year bonds at what are historically low interest rates.

Who loses - the current bank management (who will lose their salaries, bonus payments, perks, and golden parachutes), the bond holders of the institutions (who will have to take a haircut, if not getting scalped), and the Wall Street crowd who saw a risk free opportunity to profit. Who profits - the American people."

Malaysian Budget Financing Measures

Putting together the financing initiatives found in the Malaysian Mini Budget which was just rolled out:

First a brief summary
* RM60 billion for stimulus budget, almost 9% of the GDP, to be implemented in 2009 to 2010.

• RM15 billion is fiscal injection,
  
• RM25 billion guarantee funds
• RM10 billion equity investments
• RM7 billion private finance initiative (PFI) and off-budget projects, as well as
  
• RM3 billion in tax incentives.

Working Capital Gaurantee Scheme ($5bn)
The Credit Guarantee Corporation under Bank Negara Malaysia provides Skim Jaminan Usahawan Kecil to fund working capital of SMEs, with shareholder equity of less than RM3 million.To assist medium-sized companies access to working capital to finance operation during downturn. The maximum loan amount will be RM10 million with a maximum repayment period of five years. 80:20 default risk sharing. Eligibility raised to Malaysian companies with shareholders funds of less than RM20 million eligible (subsidiaries not eligible).

Industry Restructuring Loan Guarantee Scheme ($5bn)
The slower economic environment provides us with the opportunity to improve the economic structure of the nation and shift rapidly towards increased productivity and higher value-added activities, as well as promote greater use of green technology.

To accelerate this shift, the Government will set up an Industry Restructuring Guarantee Fund Scheme to provide loans increase productivity and value-added activities, as well as the application of green technology. Scheme for companies with shareholder equity less than RM20 million, the Government will provide a guarantee based on the ratio of 80:20, with Government guarantee of 80%, and the remaining 20% by financial institutions. For companies with shareholder equity of RM20 million or more, the guarantee ratio will be 50:50.

The maximum loan is RM50 million to be repaid within a period of 10 years.

Facilitating Access to Capital Market (Up to $15bn)
"Under the current market conditions, even companies with investment grade ratings are unable to access the capital market, particularly the bond market.

To assist and facilitate these companies access the bond market, the Government will establish a Financial Guarantee Institution to provide credit enhancement to companies that intend to raise funds from the bond market. This measure will also further develop the domestic bond market.

Bank Negara Malaysia will assist in the setting up of this institution. This government-owned company will have an initial paid-up capital of RM1 billion, which will subsequently be raised to RM2 billion. It is expected that bonds totalling RM15 billion will be raised under this facility."

Najib's speech is found here

US Attempt to Support Small Business Loans

Okay, this is really tricky... and it took me sometime to digest this press release to better understand how the US govt is trying to help loans to the Small Businesses. However, let me give this a shot. What I found most useful was this white paper from the US treasury.

Importance of Securitization Markets
This is important to understand why US doesn't go through the banks (i.e. offer risk sharing on defaults of loans given out by banks like the UK) to address the credit crunch to small businesses. Over the past two decades in the US, what banks have used to raise funds for loans to small businesses is to create Asset-Backed Securities (ABS) through collateralising these loans and then selling them to investors.

To do this, a bank sells their pool of loans (or the loans they intend to give out) to a Special Purpose Vehicle (some other created legal entity). The SPV then splices them up based on different risk levels and then sells it to different investors.

The reason why this has been so popular, that it broadens the investor base and as a result brings funds in more easily and cheaply. This is as compared to our system where, banks fund such borrowings either from deposits from their consumers, or through raising money from the capital market.

Credit Crunch has dislocated ABS market
Federal Reserve data shows that around 1/4 of all non-mortgage consumer credit (here could include car loans, college tuition as well as small busines loans) have been funded out of ABSes. As a result of the severe dislocation of these markets, new issuance has come to a virtual halt in Oct 2008.

TALF Plan of Attack
TALF's plan of attack is to lend money to potential investors of these ABS so as to catalyze the flow of funds into the banks to allow them to lend. The Federal Reserve Bank of New York will lend up to $200bn to holders of eligible ABS. Investors will be charged an interest rate which includes risk premium for these loans and will have to put up the respective collateral (the asset behind the securities themselves) for such government funding. Depending on the risk of the loans, investors may have to put up higher level of collateral then the loan given out ("haircuts") For instance, if the haircut is 10%, then to receive a $90 loan, investor must give $100 in collateral. $20bn has been set aside for possible defaults (10% rate assumed)


http://blogs.wsj.com/privateequity/2009/03/04/pes-glass-is-talf-full/
PE’s Glass Is TALF Full

By Shasha Dai

Now that the details of the government’s TALF plan have been unveiled, private equity firms find themselves intrigued.

TALF - short for Term Asset-Backed Securities Loan Facility – will provide three-year loans at relatively low interest rates to private investors, who will in turn buy securities backed by newly- or recently-issued consumer debt like car loans, student loans and credit card receivables. The program aims to re-open the securitization market so that banks will start lending to consumers again.

Several private equity firms have already expressed interest in participating. Blackstone Group Chairman Stephen Schwarzman told papers including The Wall Street Journal that his firm is considering investing in securities using TALF funding. The Journal also reports that hedge funds Millennium Capital Management, Cerberus Capital Management and Fortress Investment Group are considering participating.

Other firms with expertise investing in debt include Oaktree Capital Management LLC, Apollo Management LP, Ares Management LLC and Bain Capital. Officials at those firms either declined comment or said they haven’t made a decision yet.

Those firms that do go after this program may face some pushback from their LPs. Investing in consumer loan-backed securities is new to most PE firms – Blackstone, for instance, hasn’t been involved in this area in the past. A similar issue recently arose for some firms, including New Mountain Capital and BC Partners, when they decided to move into debt investing and had to seek LP approval.

“The first issue is what they tell their LPs,” said Steven Kaplan, a professor at University of Chicago Graduate School of Business. “For some, this is off-strategy, and some LPs will not like it.”

But whether or not buyout firms decide to tangle directly with TALF, they should still benefit tangentially from the program. TALF’s intended unlocking of consumer credit should help portfolio companies in related industries, such as auto finance companies or for-profit colleges, by increasing demand for their services.

However, TALF probably won’t have much direct impact on the lending markets buyout firms most want unlocked - those for their own portfolio companies - since it doesn’t address things like high-yield bonds. TALF only finances purchases of AAA-rated securities, or those backed by the most secure debt.

“It won’t help PE firms (directly), as financing for PE transactions comes from high-yield bonds and institutional loans,” said a senior loan officer at a large bank who asked not be named.

But it’s a beginning.

“This is a little bit of experimentation,” said Mitchell Hollin, a partner at growth equity investor LLR Partners. “The securitization market is a long way from coming back.”

Will look at the following website detailing US govt's credit assistance plans in a following post. http://www.financialstability.gov/