Are Citi and BofA gaming the Geithner Plan already?

Here we are just days out from the announcement by Treasury Secretary Tim Geithner that the Obama Administration will be buying up so-called toxic assets as originally planned by Henry Paulson during the Bush Administration.  The initial reaction has been one of euphoria as most asset markets responded positively to the news.

Now that the dust has settled somewhat, another reaction is taking place behind the scenes and it looks an awful lot like banks — specifically Citigroup and Bank of America — are gaming the system (hat tip Yves, Tom and Barry).  Note my highlighting:

As Treasury Secretary Tim Geithner orchestrated a plan to help the nation’s largest banks purge themselves of toxic mortgage assets, Citigroup and Bank of America have been aggressively scooping up those same securities in the secondary market, sources told The Post.

Both Citi and BofA each have received $45 billion in federal rescue cash meant to help prop up the economy and jumpstart the housing market.

But the banks’ purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults.

One Wall Street trader told The Post that what’s been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

The secondary market represents a key cog in the mortgage market, and serves as a platform where mortgage originators can offload mortgages in bulk that have been converted into bonds.

Yields on such securities can be as high as 22 percent, one trader noted.

BofA said its purchases of secondary-mortgage paper are part of its plans to breathe life back into the moribund securitization market.

“Our purchases in [mortgage-backed securities] increase liquidity in the mortgage market allowing people to buy a home,” said BofA spokesman Scott Silvestri.

A Citi spokesman declined to comment, though people familiar with the bank say it argues the same point.

You can read the rest of the Post article to see the full details. Of course, I am sceptical here. But, for the sake of argument, let’s assume Citi and BofA are telling us the truth as to their true motivations.

One must still ask the question: why are BofA and Citi, two of the weaker large banks in the U.S., aggressively buying up the same toxic assets which have already caused them huge writedowns? Here’s another one for you: if Citi and BofA are so bullish on these Mortgage-backed securities, why weren’t they buying them aggressively two weeks ago or last month? What’s changed between then and now?

I’ll tell you what has changed: the Geithner Plan. See, the U.S. government has pledged to purchase these toxic assets from banks like Bank of America and Citigroup. That means Citi and BofA know full well that they aren’t going to be holding these assets for long. So why are they buying? A couple of reasons:

1. The Geithner Plan effectively pledges to insure the purchases of these assets against downside risk.  This implicit put option means the sale price will be higher than a free-market transaction.  In essence, this is a transfer of money from taxpayers to both the selling and investing organizations.  Therefore, it behooves sellers to sell more assets.
2. The auction process is non-binding meaning the selling organizations do not have to sell if they don’t like the price offered.  In effect, this means the sellers have yet another option: the right but not the obligation to sell at a specific price.  This is the definition of a put option.  That means sellers are going to transact only if the sale does not force them to writedown the assets too much. Of course, they have received this option free of charge.  

Now, if you were Citi or BofA, wouldn’t you be looking to get the most out of this process as well? Their actions are wholly predictable. Nevertheless, their actions demonstrate the problems with this plan i.e. that we are about to see a massive transfer of money from taxpayers to banks. The interesting thing about all of this is that most Americans won’t necessarily know that these implicit options are embedded in the transaction structure unless they are familiar with derivatives.

My take on this is similar to Barry’s: Citi and BofA’s actions demonstrate yet again why the government must take control of the organization and get rid of existing management. Neither the Bush Administration nor the Obama Administration has been willing to do so.

For more on embedded options in the Geithner plan see Steve Waldman’s piece, Degrees of recourse.

UPDATE 1150AM ET: The Economist has this to say:

These assets can’t be comparable to ones for which the Geithner plan is designed, because that plan is designed for assets for which no secondary market exists. If a secondary market does exist, then presumably there’s no need to discover prices—we can just look at them—and there’s no question about which banks are solvent. I don’t see how Bank of America can go out and by a bunch of MBS on the market, then turn around and auction them based on the idea that they don’t know what they’re worth.

Right? What am I missing?

Source
Citi, BofA buying back laundered loans at lower rates – NY Post