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Bailout Candidates Hashing Out Strategies
Asset Backed Alert, Harrison Scott Publications Inc. (October 10, 2008)

Industry players are increasingly singling out Bank of America, Citigroup, J.P. Morgan and Wells Fargo as candidates to benefit from the U.S. Treasury Department's Troubled Asset Relief Program. The banks might not be seeking to shed their own toxic mortgage investments, however. Instead, the thought is the institutions will use the $700 billion bailout package to disinfect the balance sheets of other operations they are purchasing - by forcing the acquirees to tap the rescue program under their own platforms.

In BofA's case, that would mean sending the government billions of dollars of mortgage-related investments from Merrill Lynch. J.P. Morgan would be seeking to unload unwanted mortgage holdings from Washington Mutual. And Citi or Wells Fargo - or maybe both - might be dumping similar assets from Wachovia.

By moving the damaged assets away from banks they plan to buy, as opposed to working from their own books, the institutions would be pulling off a coup of sorts: benefitting from the financial-system rescue without enduring the government scrutiny that comes with it. For instance, BofA, Citi, J.P. Morgan and Wells Fargo might not be subject to bailout-specific executive-compensation limits or corporate-governance intervention under that scenario.

Such restrictions have been seen as some of the biggest hindrances to use of the package, set up last week under the Emergency Economic Stabilization Act. Likewise, banks accepting bailout money could have to fork over debt or equity to the government, and would be exposed to some level of federal control - possibly for long after the buying side of the initiative expires in two years.

For that reason, the biggest banks are viewed as likely to avoid entering the program directly unless absolutely necessary, or unless the prices the Treasury pays are high enough to justify the consequences. Nonetheless, virtually every shop on Wall Street has been mentioned as a bailout candidate in some capacity over the past few days.

Meanwhile, the possible maneuvers by BofA, Citi, J.P. Morgan and Wells Fargo play into one of the goals of the bailout initiative: to encourage bank mergers by reducing risk and creating profit opportunities. The law "expressly permits financial institutions to make a profit on the sale of assets acquired in a merger or acquisition (such as the Merrill, WaMu and Wachovia transactions) or from an institution in bankruptcy, conservatorship or receivership (such as IndyMac or Lehman Brothers)," according to an Oct. 7 report from law firm Thacher Proffitt.

The assets that the banks are most likely to shift to the government include CDOs and bonds backed by option adjustable-rate mortgages, where borrower defaults have been rampant and values have been plunging. Wachovia and WaMu, for instance, together hold an estimated $175 billion of option ARMs and bonds backed by those products. Some have surmised that BofA and Citi might be compelled to unload similar holdings from their own portfolios, and that Morgan Stanley might also be a candidate for such sales. The counterpoint is that unless the Treasury is paying above-market prices, the banks could just as easily turn to distressed-debt funds that have raised billions of dollars since the credit crunch began last year but have so far put little of that money to work.

At the same time, asset-management firms likely to oversee the Treasury's purchases - such as Pimco, BlackRock or Fidelity Investments - probably will be working to ensure that government purchases come at market values. And banks that have taken paper losses as mortgage-product prices have fallen might not want to realize those declines by parting with the holdings at those currently depressed prices.

That's also the case for some smaller commercial banks that have transferred bonds and loans into hold-to-maturity accounts, where they don't have to record market-value adjustments. For them, selling now would lock in losses.

Another hurdle: Banks big and small have marked some holdings at prices that exceed prevailing secondary-market levels, meaning again that they would take losses by selling now. One trader said banks have assigned values of about 40 cents on the dollar to certain subprime-mortgage bonds they own, even as similar instruments are trading for as little as 5 cents on the dollar. "Very few banks are willing to sell these assets at market prices," he said.

J.P. Morgan researchers wrote in an Oct. 3 report that banks are holding an estimated $300 billion of non-agency mortgage bonds in available-for-sale accounts where assets must be marked to market. On average, those investments were assigned values 10-30 cents higher than going prices, the researchers said.

Companies qualified to sell assets to the government under the bailout package include banks, broker-dealers, mutual funds and investors such as retirement plans and insurers. Unregulated alternative investors, such as hedge funds, don't make the cut. v



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