The US Financial Stablity Plan

Shares in US enjoyed a breather early this week when US Treasury Secretary Tim Geithner announced his new plan to rid banks of toxic assets. In my opinion, this
Public-Private Investment Program (PPIP) will require the US government to print more money which may result in devaluation of the US currency as well as hyper inflation in years to come. However, they are in desperation to do something or else the whole US economy will collapse earlier than we will like to see. Perhaps I can share a bit, based on my limited knowledge, why this move is better than not doing anything at all.

The need to boost liquidity

Imagine bank A had lend out billions in mortgage loans over the years. In the past 1 year, there was lots of defaults and the bank are not able to collect the cash as expected. The bank have to take-over the houses where the loans defaulted. The bank is now holding on to plenty of assets but no cash. The worst is that there are no market for these assets and nobody know how much these assets are worth?

Notewithstanding that the banks, with their initial expected cashflow, issued bonds and securities which resulted in high level of debts and end up with little money to finance a normal commercial operation in the private sectors. To make things worst, all banks are doubtful of each other and refuse to lend money as usual. They are reluctant to raise that extra capital needed to take advantage of business opportunities and are affecting the whole economy.

Creating market value for toxic assets

As mentioned earlier, the banks are holding on to plenty of such toxic assets and are not able to value them due to lack of buyers. Without government intervention, buyers will forever wait till and see until a market price for these assets are more firm. However, such a day may never comes... The government is now trying to create an interest to the private sector. This interest will help find a market value for these toxic assets.

Making the investment attractive

To make this investment attractive, the government and private investors will both take a 50-50% share in the equity capital. The government capital will come from the Troubled Asset Relief Program (TARP), with the amount expected to be between US$75 and US$100 billion.

There will be a 6-1 leverage ratio for the private investor and the leveraged amount do not comes from their own pocket. In other words, the private sector only stands to lose its capital, not the leveraged portion.

How it works?

a) Assume the purchase price is agreed at $84

b) With 6-1 leverage, the FDIC would provide guarantees for $72 of financing, leaving $12 of equity.

c) Out of this $12, Treasury would invest $6, with the private investor contributing $6

d) If the price later fell to $60, the private investor will only lose $6 and the taxpayers lose $18.

Can this plan revive the economy?

The plan will start in May. It waits to be seen how spontaneous the market can be created. There is no guarantee that banks will be willing to release their assets at depressed prices when opportunites in the private sectors are not forecoming. The plan will fails if too little interest or sales are made when the whole thing start. However, if the plan is successful, it will generate a lot of cash and liquidity for the banks and the economy may start flowing again.

Well. I really don't know what will happen but I do hope things will start turning around soon. This may solve the short term US credit crisis but not the long term debt crisis that may come next.