TARP recipient buys toxic assets once claimed unable to sell

Tom Karol Occasional Political Commentator
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It’s almost too bizarre to believe, but banks that received taxpayer money because they had toxic assets on their books have actually been buying more toxic assets from other banks, to sell back to the very government that provided them assistance.

To understand how this happened, it helps to oversimplify the financial market meltdown, where a lot of banks made many and large stupid loans. Because these were large and stupid loans, the banks then faced collapse. The banks were stuck with hundreds of billions of stupid loans, debts of no immediate value, mortgage-backed securities, and other toxic assets, which collectively can be called “bad debts.”  These bad debts are so bad that the banks could not sell them to anyone else.

The U.S. government then stepped in and offered to buy the bad debts from the balance sheets of troubled banks, to manage these debts and sell them for the best price it can. The Public-Private Investment Program (PIPP) was introduced in March 2009, to help struggling banks by reviving the market for bad debts. In PIPP, the government hires asset managers to raise money from investors and, with loads of additional taxpayers money, buy as much as $1 trillion in bad debts, which supposedly will give the banks money for lending. Since PIPP exists to buy bad debts, suddenly there was a demand for bad debts.

It has recently been reported that some banks have purchased bad debts from other banks thinking that the government would pay more for them when PIPP began.

While the government-sponsored investors were busy raising cash for the program, some of the banks that made the bad loans in the first place were actually buying other bad loans in hope of selling them to the government at a higher price. Astoundingly, banks that were bailed out by government TARP support–such as Bank of America, Citigroup, Goldman Sachs and Morgan Stanley–and which were expected to reduce their holding of bad loans, reportedly had trading desks buying bad loans from other banks ahead of the government program, for their own profit.

Bad loans, which were as low as 35 cents on the dollar in March, were purchased by speculators during 2009 only because PIPP had committed to buy them. The rally was fueled in part by traders jumping in before PPIP funds could get off the ground and prices have almost doubled. Higher prices for these bad debts have eroded potential profits of PPIP funds and increased the risk of losses, making it more likely that taxpayers will lose big in the program.

Clearly, PIPP should not be used to reward these speculators–particularly banks who caused the problems in the first place. Congress and the administration can take simple action to prevent this. Since PIPP should not pay a higher price for bad debts that were purchased simply to resell to the government, Congress and the administration should ensure that PIPP only purchases loans that were on the books of the seller before March 2009.  Bad debts acquired after March 2009 were most likely trying to front run PIPP and should be excluded from the program. These bad debts are now off the books of the troubled banks, which is the aim of the program.

This could actually be a win for the taxpayers.  Let’s say these speculators bought $100 million of this bad debt, assuming they could sell it to PIPP for more.  That $100 million is now off the banks’ books – problem solved. The banks have cash and less bad debt. There is no reason to buy these debts now and PIPP should be precluded from buying these particular bad debts. This saves taxpayers the $100 million and any mark-up the speculators counted on.  Hopefully these trading desks take a loss, and perhaps the traders will think twice next time about trying to use a support program to soak the American taxpayers.

Thomas J. Karol is presently the President and Chief Operating officer of the Washington D.C. based Sovereign Investment Council, a 501 (c) (6) a trade association for sovereign investor, their advisors and U.S. issuers interested in sovereign investment.