Bank Writeoffs May Rise, Bond Spreads Fall on TARP

By Jody Shenn and Caroline Salas
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Oct. 6 (Bloomberg) -- The U.S. Treasury's $700 billion plan to rescue the nation's banks from the subprime mortgage debacle may help bonds rebound from losses of at least 90 percent while contributing to writedowns at financial institutions.

The Troubled Asset Relief Program, or TARP, signed into law by President George W. Bush Oct. 3, allows banks to sell toxic assets above current prices, driving down yields on some bonds relative to benchmarks, said Eugene Flood, chief executive officer at Smith Breeden Associates Inc., which manages $27 billion in fixed-income assets. Spreads may retrace a quarter of their widening since the credit crisis began, Flood said.

Yields on so-called super-senior commercial mortgage securities widened to a record 4.05 percentage points over swap rates last week, up from 0.22 percentage point at the start of 2007. Based on Flood's estimate, they may drop to about 3 percentage points in the next few weeks.

The $2 trillion market for bonds tied to home loans that don't have the backing of Fannie Mae, Freddie Mac or Ginnie Mae has ``been priced down now at fire-sale prices because everyone's afraid to jump in,'' said Timothy Policinski, managing director at Cincinnati-based Fort Washington Investment Advisors Inc., which manages $22 billion in fixed-income.

Credit-Market Losses

While the plan will let financial companies sell toxic securities to the Treasury, banks may have to recognize bigger losses than the $586 billion recorded since the start of 2007 because the assets haven't been written down enough, according to JP Morgan Securities Inc. Losses may reach $1.7 trillion, Christopher Flanagan, a New York-based analyst at the firm, estimated in an Oct. 3 report to clients.

Mounting losses and doubts that Congress would give U.S. Treasury Secretary Henry Paulson power to purchase mortgage- backed securities and other troubled assets with taxpayer money caused global credit markets to lose 5.16 percent of their value in September on average, Jack Malvey, a strategist at Barclays Capital in New York, said in a report to clients dated Oct. 6. Last month's losses were worse than in any single year, he said.

The seizure that began in August 2007 deepened as the London interbank offered rate, or Libor, that banks charge each other for three-month loans in euros increased to a record 5.33 percent last week, according to the British Bankers' Association. The corresponding rate for dollars climbed to 4.33 percent, the highest since January.

Fallout in Europe

Damage from the credit crunch accelerated last month as Lehman Brothers Holdings Inc. and Washington Mutual Inc. collapsed, the U.S. government took control of Fannie Mae, Freddie Mac and American International Group Inc., and Merrill Lynch & Co. and Wachovia Corp. were sold.

European stocks fell today as the credit crisis deepened in the region and after European leaders meeting in Paris this weekend pledged to bail out their own nations' banks, while stopping short of a coordinated rescue.

Germany agreed to a 50 billion-euro ($68 billion) rescue package for commercial property lender Hypo Real Estate Holding AG after its stock slumped 89 percent this year. BNP Paribas SA, France's biggest bank, will take control of Fortis's units in Belgium after a government rescue of the Brussels and Amsterdam- based company failed. In Iceland, the government is reportedly arranging a 10 billion-euro injection into its banking system.

Yields on U.S. securities rated AAA and composed of subprime or home-equity loans were near a record of 7.57 percentage points more than Treasuries last week, from 0.53 percentage point at the beginning of last year, according to Lehman Brothers index data.

Investment Grade

The yield premium, or spread, for investment-grade corporate bonds in the U.S. widened to a record 4.91 percentage points on Oct. 3, from 2.03 percentage points at the start of the year, according to the Merrill Lynch Corporate Master Index.

Paulson's plan may spark a recovery. Yield premiums may retrace about a quarter of their increases relative to benchmark rates since markets collapsed, according to Flood at Chapel Hill, North Carolina-based Smith Breeden.

Winners likely will include financial companies that were already required by accounting regulations to write down assets, such as New York-based Goldman Sachs Group Inc., Morgan Stanley and funds run by Blackrock Inc., as well as Pacific Investment Management Co. of Newport Beach, California.

Markdowns

Goldman Sachs marked down its holdings of bonds backed by Alt-A mortgages to 50 cents on the dollar on average on Aug. 31, to $3.6 billion, Chief Financial Officer David Viniar said in a conference call last month. Alt-A loans, which rank between subprime and prime, were made to borrowers with better credit who provided no proof of income, bought property for investment or took out so-called option adjustable-rate mortgages.

The companies may now be able to sell the securities to the U.S. government for a higher price than at which they carry them on their books, or increase the value of the debt as the Treasury buys the assets.

Some bonds backed by home loans not guaranteed by government-sponsored agencies such as Fannie Mae and Freddie Mac have fallen to less than 10 cents on the dollar, Fort Washington's Policinski said.

Mortgage bonds with top AAA ratings are being offered at about 60 cents to 70 cents on the dollar, though buyers have ``little'' knowledge of their true worth, according to Paul Gifford, a vice president and senior fixed-income manager at 1st Source Investment Advisors in South Bend, Indiana.

Negotiating Prices

``Hopefully with the price discovery from the Treasury we'll see if that's a correct view or not,'' said Gifford, who manages $1 billion of bonds.

The bailout will allow the Treasury to negotiate the prices paid for some bank assets or purchase them in auctions and reverse auctions. The agency will also set up an insurance fund for mortgage securities. Banks won't be allowed to sell securities to the Treasury for more than what they paid, unless the bonds were bought from another company already in bankruptcy or conservatorship.

The first attempt to hold an auction to buy troubled assets from financial firms will take at least four weeks to set up, a department official said. Paulson is likely to name Neel Kashkari, assistant secretary for international economics and development, to oversee the program, the Wall Street Journal reported.

The Treasury may even initially decide to buy $50 billion of securities directly, without holding an auction, Smith Breeden's Flood said.

Federal Reserve Chairman Ben S. Bernanke told lawmakers last month that the government would likely pay above current ``fire-sale'' values, while still seeking discounts to shield taxpayers. The sales will force some financial institutions to book losses they've been able to avoid until now.

`Balancing Act'

Whether the bonds sustain the gains depends on whether the crisis is ``spreading beyond our shores if not to the broader economy, rather than being isolated to financial firms,'' said Scott Kirby, head of structured products at Ameriprise Financial Inc.'s RiverSource Investments LLC.

The Treasury also needs to find a balance in how much it's willing to pay, said Kirby, who oversees about $20 billion from Minneapolis.

``If they set the prices too low, you will not necessarily have the participation you're hoping for,'' Kirby said. ``There's a balancing act that will be sorted out in coming weeks.''

Choosing Firms

The Treasury will choose five to 10 investment firms to help it buy troubled securities. BlackRock, Pimco and Legg Mason Inc. of Baltimore informally advised the U.S. in the days leading up to the passage of the plan and want to manage some of the assets before selling them, according to people familiar with the matter, who asked not to be identified because the discussions were private.

Bobbie Collins, a spokeswoman for BlackRock, declined to comment, as did Legg Mason's Mary Athridge and Pimco's Mark Porterfield.

If the Resolution Trust Corp., which helped the U.S. liquidate assets of failed savings-and-loans, is any guide, lawmakers will push the Treasury to recoup taxpayer money by quickly selling securities purchased from banks, said Peter Monroe, the former president of the RTC's oversight board.

``A lot of investors may find that if they purchase distressed assets from the Treasury Department they'll be able to buy them at great prices and come out winners,'' said James Barth, a finance professor at Auburn University in Auburn, Alabama and a senior Fellow at the Milken Institute, who has written a book on the savings and loan crisis. ``The U.S. government is not known for its savviness when it comes to financial matters.''

To contact the reporters on this story: Jody Shenn in New York at jshenn@bloomberg.net; Caroline Salas in New York at csalas1@bloomberg.net