NOT AN ANALYST

New “TARP Tax” on Banks The Administration has proposed a “Financial Responsibility Fee” that would be levied on banks and other financial institutions with assets exceeding 50 billion. The goal would be to recover the losses and costs associated with the TARP program.

Fee to be based on liabilities The fee would be 15 bps based on the “covered liabilities”, which are assets minus Tier 1 capital, FDIC-insured deposits and insurance liabilities covered by state regulated funds. The logic is that Tier 2 and Tier 3 liabilities serve as a proxy for risk trading activity and that firms engaged in such activities should bear additional costs.

Support The proposal will strike a positive tone from a populist perspective and be politically popular. The Democratic leadership in the House has indicated support for the proposal and it’s too early to speculate where the Senate might stand.

In details The fee would go into effect on June 30 2010 and would last for 10 years. The fee collected would contribute to the overall reduction of the budget deficit. I believe that is the bottom line, the Administration will need to decrease the horrifying budget deficit by increasing taxes to someone, and financial institutions look like the perfect candidate.

Flaws and uncertainties About 50 institutions could be subject to the new tax, including US subsidiaries of foreign firms. The Administration has not yet decided if off-balance sheet liabilities would be eligible to be taxed. So here is what needs to be clarified: If the tax is on only domestic liabilities, then a financial institution could avoid the tax by allocating the liabilities to its foreign subsidiaries or to a foreign SPV (Special Purpose Vehicle).  An SPV is an off-balance-sheet liability that is usually created by the parent company for the purpose of selling asset backed securities and securitization purposes. If the tax is on consolidated liabilities, then the Administration has no authority to tax the consolidated liabilities of foreign institutions operating within the US, which means that foreign institutions can avoid the tax while their US competitors cannot. 

The reality While the behavior of many major financial institutions or their leaders was unjustifiable, the proposed tax is both designed incorrectly, irrelevant and it makes little economic sense.  Moreover, the spin that the tax is intended to recoup the losses banks caused to the TARP is misleading, because the primary sources of those losses to date have been Freddie and Fannie and the automobile companies that are exempted from the tax. There is no justification from the taxpayers’ perspective of excluding them from responsibilities for losses, as well. I guess it would make little sense for the Administration to tax itself. Finally, it should be noted that government support to financial institutions extends far beyond just the TARP. Subsidies have come in the form of access to low-cost funds, through borrowing at subsidized rates utilizing Federal Reserve special programs, from merger assistance, from FDIC deposit and debt guarantees, and from the implicit subsidy inherent in too-big-to fail.

Recent turmoil In the past few weeks, there have been a number of reports from different individuals trying to value GGP and unfold how much equity will be created through reorganization. There are a lot of uncertainties over how much GGP is worth and we might see a valuation battle between the creditors and the owners. It’s clear that the Committees representing each side have different views: the Unsecured Creditors will want a lower valuation so they can have a higher equity stake and the shareholders will want a higher valuation so they can retain a higher residual stake.

For those who have not been following the GGP bankruptcy story, I will offer a brief synopsis:

• As of January 25, the restructuring of 74 secured mortgage loans aggregating approximately 9.4 billion has been completed. As a result, 180 GGP subsidiary debtors owning 96 properties are no longer in bankruptcy.
• The restructuring of the remaining 16 loans aggregating approximately 2.1 billion was approved by the Bankruptcy Court in December 2009 and January 2010 and is expected to be completed in the next few weeks.
• GGP has recently engaged UBS Investment Bank to assist the Company with exit strategies and Miller Buckfire & Co., LLC as a financial advisor and investment banker.

Now it all boils down to a restructuring plan for the remaining 2,590 mm in Bank Debt and 4,000 mm in Unsecured Debt. Valuation is rarely litigated in court; usually the Creditors and Equity Committee will submit a plan of reorganization which implies a valuation of the Debtor they both agreed upon. But in the case of GGP, there might be large discrepancies between Creditors and Owner, and we might see a valuation battle between the two. The Company is contractually obligated to de-lever its balance sheet based on the loan extension agreements with the Secured Mortgage Loans. Also, the fact that all the 6,590 mm remaining liabilities could be potentially reinstated at par and still have substantial equity left, it doesn’t mean that the Bankruptcy Court will allow it, as the Judge has to make sure that the Debtor will be able to survive as a going concern through another financial downturn.

Key ingredients Let’s look at some key elements that will play a pivotal role in the valuation process:

Ownership: There is a strong bias towards generating a high equity value. The Company is held by insiders, the Bucksbaum family has a 25% ownership and William Ackman, which is Director and a member of the Board, has a 20% ownership.

Equity Committee: An honorable member is Luis A. Bucksbaum, ex-CEO of the Company, which will push for a high valuation, given the large equity interest by his family.

UBS compensation: The Investment Bank charges several fees, but the discretionary fee that caught my attention. There is a completion fee comprised of the greater of 17,500 mm and 0.33% on any amount by which the equity recovery exceeds 1,000 mm. UBS will be indifferent between the two if the residual equity is 5,300 mm or 16.6 dollars a share. This is an incentive for UBS to maximize shareholders’ value.

A Valuation Expert: If the creditors and owner cannot agree on a valuation, the Court will consider the opinion of a third party independent and credible expert. This could be good news for GGP as the positive report from William Ackman, which value the Debtor between 42 and 24 dollars a share, is highly valued and recognized by other institutions and Hedge Funds.

Hovde Capital: The Hedge Fund that highly criticized Pershing Square Capital valuation and rates the Company at 5 dollars a share will have no weight in Court. The Hedge Fund is not a member of any committee, doesn’t own any equity or debt and it’s not a valuation expert.

De-leveraging How will de-leveraging be achieved? Two of the Rouse Bonds were due in 2009, and the Company will probably repay them at par plus post petition accrued interest. The 1,990 mm Term Loan under the 2006 Credit Facility will be refinanced with an Exit Facility and the 590 mm Revolver will be repaid in full. Eurohypo AG is the only creditor under the 2006 Facility and it’s a member of the Creditor Committee. How will the Debtor come up with the cash to pay off the bonds and Revolver ? With proceeds from equity issuance. If the three remaining Rouse bonds and the GGP LP notes, amounting to 1,650 mm and 1,550 mm respectively, are converted into new common, leverage will significantly decrease and equity will increase by 3,200 mm. That would mean that shareholders will face substantial dilution, probably around 40%. Let’s assume that the residual equity is valued at 5,000 mm, an addition 3,200 mm in equity will mean a 39% dilution for shareholders.