Markets Up on Treasury Plan to Purchase Mortgage Assets, but Pessimism Remains

Stocks rose sharply at Monday's opening, following Treasury Secretary Paul Geithner's announcement of a plan to generate up to $1 trillion in public and private funds to buy up distressed bank assets and related securities to get the economy moving again.

The Dow Industrial Index was up 275 points in the first two hours of trading following the announcement. Bank stocks were among the strong gainers, with Citigroup and Bank of American up 18 and 15 percent, respectively.

Despite the strong vote of confidence from investors, some analysts remained skeptical of the plan, noting that it remains to be seen whether banks will be willing to part with the assets at prices investors will be willing to pay.

Plan seeks to have private investors value assets

The Treasury Department's plan, called the Public Private Investment Program, seeks to attract private investment in distressed mortgage-back loans and related securities by providing substantial matching funds and guarantees from the government. The goal is to encourage private investors to help identify the true value of the assets, with the government as a partner helping to back up the transaction.

The plan would draw on $70 to $100 billion in funds remaining in the Targeted Assets Relief Program (TARP) and private investment to generate $500 billion in funding to buy up troubled assets - with the potential to expand to $1 trillion over time.

Mixed reaction

The plan has drawn a mixed reaction from observers. Jeremy Siegel, a professor at the Wharton School of Business, was quoted by Marketwatch.com as saying the plan would be attractive to investors by providing a call-like option that would provide a floor on potential losses.

"If the asset values go below the purchase price, the Treasury is going to eat that loss, Siegel was quoted as saying. This plan is definitely going to work."

However, Tom Vanderwell, a mortgage loan officer and the author of Straight Talk About Mortgages, expressed reservations about the plan.

"If you look at the surface, it looks like a good thing," Vanderwell said. "However, from what I've been reading and hearing from others, the details are absolutely atrocious."

He noted that the plan calls for the government to heavily subsidize the purchases, meaning taxpayers will be taking on most of the risk. Both private investors and taxpayers stand to benefit if the value of the assets increase. However, the government and taxpayers will absorb the loss if prices drop.

One of the main questions about the plan, he said, is whether banks and investors will be able to agree on a price for the distressed assets. If banks are not willing to accept the price investors are willing to pay, the plan won't work.

FDIC to leverage asset purchases

Though not stating it explicitly, the government appears to be seeking to prop up asset prices by heavily subsidizing their purchase by private investors, thereby making the deal more attractive to banks. Basically, the plan would rely on heavy leveraging through Federal Deposit Insurance Corporation (FDIC) guarantees to encourage private investors to bid on and buy up pools of devalued mortgage loans held by banks. The FDIC would guarantee purchases of pre-approved mortgage assets at a 6-1 ratio, with private investors and the Treasury splitting the rest. In essence, private investors would need to put up only 1/14th of the purchase price.

The plan also calls for the Treasury Department to support the purchase of mortgage-related securities held by other investors by matching such purchases at a one-to-one ratio.

The government is betting that these assets will eventually recover much of their former value, and investors and taxpayers will earn a profit. The downside, however, is that taxpayers will be on the hook for most of the loss if the assets don't recover.

For more details of the plan, see the fact sheet released by the U.S. Treasury Dept. at www.ustreas.gov/press/releases/reports/ppip_fact_sheet.pdf.