The following guest post was written by Linus Wilson, a finance professor at the University of Louisiana at Lafayette, the media’s go-to guy on calculating the value of transactions between the government and the banks, and an occasional commenter on this blog. Linus also analyzes government-bank transactions at Seeking Alpha.
The U.S. government does few thing better than create debt. After a year of talking about it, the government is going to have the chance to throw their good debt, Treasury bills notes and bonds, after bad, non-performing toxic loans and securities. The Federal Deposit Insurance Corporation (FDIC) and the U.S. Treasury are going their separate ways on their cash for trash schemes at this point. Accountants and investors should be wary of the big prices they see coming from the FDIC’s auctions, but taxpayers should be afraid of the U.S. Treasury’s efforts to re-inflate the securitization bubble.
The FDIC is nearing the century mark of bank failures this year and it has a lot of bad assets to unload. On Tuesday, October 6, 2009, it announced that it sold a $4.5 billion, festering pool of condo loans from the failed lender Corus Bank. The last 10-Q for the failed Chicago lender said that it had $3.3 billion in non-performing loans with heavy concentrations in busted condo markets of Miami and Los Angeles. Yet, zero-coupon, FDIC-guaranteed debt and a billion dollar line of credit led to the price of $2.8 billion. That price of about 60 percent of par seems rich when almost 70 percent of the loans are non-performing. A few weeks earlier the FDIC did its first Legacy Loans Program auction. My paper “Slicing the Toxic Pizza: An Analysis of FDIC’s Legacy Loan Program for Receivership Assets” found that the nearly 6-to-1 government subsidized leverage in the first Legacy Loans Program sale boosted prices by over 20 percent. Yet, the irony is that these subsidies don’t help the FDIC and ultimately taxpayers because the FDIC is offering cheap financing to sell assets it already owns. Any higher prices just offset the subsidized financing if the auctions are competitive. Yet, any marks obtained from these auctions are certainly inflated.
The Legacy Securities Program run by the U.S. Treasury with an initial taxpayer outlay of $30 billion is set to launch soon. More asset managers are closing their investment funds every week. The problem with the Legacy Securities Program is that the government will probably use cheap leverage to finance the sale of trash assets that it does not already own. That means that the taxpayer subsidies are enjoyed by the banks selling the assets. My research shows that the most troubled banks will be reluctant to part with their toxic securities. Yet, the healthy banks will be all too eager to unload those assets at inflated prices. Come Halloween the U.S. Treasury will be handing out the goodies. Unfortunately, taxpayers will be getting none of the treats but all of the cavities.
By Linus Wilson
The Baseline Scenario 
Linus, do you happen to know Joseph Mason, the Hermann Moyse, Jr./Louisiana Bankers Association Endowed Chair of Banking at LSU?
I like the “Pizza slices” paper very much. I think Linus Wilson wrote a good paper.
One random thought that occurred to me when reading Professor Wilson’s paper is this: Is it legally required that these Legacy Loans Program auctions have a guarantor for the assets sold?? And if so, who would provide the guarantees for those assets if the FDIC didn’t do it??
No, the FDIC does have to guarantee the loans. The asset managers could attempt to raise debt from banks or private investors. They would have to pay higher interest rates and have less favorable terms.
Prof. Mason is at LSU which is in Baton Rouge, LA. I work at a different university in Lafayette, LA. Lafayette is the heart of Cajun country which was settled by French speaking Acadians prior to the revolutionary war.
This is all true. But…
Amazing article Prof. Wilson. You really know how to peel a rotten apple. I appreciate that a non-finance PhD, (me) can understand it. I mean, some of the stuff that is written on this addictive site,… sheeech!
Seems like the tectonic plates are shifting again, I can feel the volcanic pressure starting to build underneath me. I have no idea what the explosion is going to look like but I can visualize Pomepeii as a model.
Seems more like Ponzi than Pomepeii to me.
who says ignorance isn’t bliss? I too am addicted to this web site, but after a year of fulmination and teeth gnashing, concerned family members worried about mysterious gibberings at the computer monitor, I am opting for the blue pill dear morpheus “The real housewives of Atlanta”. At least that reality TV is fake, where as actual reality is to fake for me to cope…peace out!