Monday, February 02, 2009

Hurt So Good Again: The Bad Bank Plus Private Capital - Stifel

Stifel is out with some comments regarding the "Bad Bank" this morning after headlines suggest the government bad bank idea may be put on hold because of difficulty figuring out how to determine asset purchase prices.

- While they recognize this as a major challenge they believe there may be a solution that utilizes the market (and private capital) while still leveraging the government's large and low-cost balance sheet.

- In their recent note titled "Hurt So Good: Why the Bad Bank Works" (January 29) the firm examined how the price investors might be willing to pay for troubled assets could vary based on their costs of capital.

- They showed that for a hypothetical series of expected cash flows a reasonable purchase price could range anywhere from 50 to 95 cents on the dollar depending on financing costs and the rate of return demanded.

- While the government's balance sheet may provide a financially efficient place to warehouse these assets as they mature the difficulty in valuing them creates risk that the government could overpay at taxpayers' expense.

- Stifel believes a possible solution would be to allow private investment managers to essentially rent space on the government balance sheet for purchasing and managing pools of these assets.

- As an example, an asset manager could raise say $10B of private capital to create an investment fund. It would then contract with the government to secure additional debt financing to leverage this supplied capital. Assuming a 9x debt/equity leverage ratio this $10B of private capital then has $100B of purchasing power. • The fund would pay interest on the government debt first and the investor capital would absorb first losses on the purchased assets.

- If a sufficient number of funds participated in such a system then assets could be put out for competitive bid by the banks, ensuring efficient price discovery.

- A competitive process that leverage the government's low cost of capital while private capital absorbs first losses could be an efficient way to clear many of these assets from the banking sector while controlling risk to taxpayers in their view.

Notablecalls: FYI - just wanted to let you know it's out there.

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