What it means
Legacy assets are assets that banks already held when the crisis began, as opposed to new lending. They included mortgage loans, commercial property loans and securities backed by pools of mortgages.
Their value was uncertain, which made them hard to sell and hard to value. That uncertainty created a stand-off.
Banks believed the assets were worth more than the low prices investors offered, so they refused to sell and took no losses. Investors feared buying too early at a price that might later drop, so they stayed on the sidelines.
The programme tried to end the stand-off by lowering the risk for buyers. The government co-invested and provided financing, and private managers competed to bid, so the prices should come from the market and not from a government formula.
This process of finding a price through competing bids is called price discovery. Two kinds of legacy asset were covered.
Legacy securities were bonds backed by pools of mortgages, and legacy loans were individual loans still on banks' books. Different agencies were involved because the securities and loans needed different financing methods and had different risks.
Understanding the term helps when reading about bank rescues generally. A legacy asset problem arises whenever a bank's old assets fall in value and hold back new lending, and governments have used asset purchases, guarantees or separate bad banks to deal with them.
Each approach moves risk from banks to taxpayers or investors, so the design matters.
In practice
Real-world examples.
Example
A regional bank holds $200,000,000 of commercial property loans that it cannot sell at a price it accepts. A partnership fund offers a bid, and after negotiation the bank sells the loans at a loss to free resources for new lending.
Example
An investment manager looks at mortgage securities from before the crisis. It estimates likely defaults and decides that the price offered by the market is lower than the expected cash flow, which makes the securities worth buying.
Example
A regulator compares two approaches to legacy assets: buying them through partnerships or moving them into a separate bad bank. It weighs the cost to taxpayers, the speed and the transparency of each approach.
Formula
Calculation
Loss on sale = Carrying value - Sale price
Capital freed = Risk-weighted value removed x Required capital ratio
A bank holds legacy loans with a carrying value of $100,000,000 and sells them to a partnership fund at 70 cents on the dollar.
Sale price = $100,000,000 x 0.70 = $70,000,000.
Loss on sale = $100,000,000 - $70,000,000 = $30,000,000. If the loans carried risk-weighted value of $100,000,000 and the bank must hold 10% capital against them, selling frees up $100,000,000 x 0.10 = $10,000,000 of capital, although the $30,000,000 loss reduces its capital first.Case study
Seen in the real world.
Calder Savings is a fictional bank that held $300,000,000 of legacy loans at book value after a property downturn. Management believed they were worth close to that figure, but potential buyers were offering around 60 cents on the dollar.
The bank had two choices: hold the loans and hope for recovery, or sell at a loss and rebuild its capital. In this illustrative case, it held a competitive sale, accepted a 68 cent bid, recorded a loss of $96,000,000 and raised new equity from shareholders. The cleaner balance sheet allowed it to lend again within a year, and the share price, which had been falling for months, began to recover. The chief executive told staff that the sale had been painful but necessary.
The board later noted that holding the assets would have kept the problem alive for years. It also noted that the sale price turned out to be reasonable because the buyers recovered about 75 cents over time. That outcome was slightly better than the bid, which showed how uncertain the original valuations had been.
Watch out
Common mistakes.
- Assuming a legacy asset is worthless, when it is usually worth something but hard to price.
- Thinking the programme was designed to give banks full value for their assets.
- Confusing legacy assets with new lending, which was not covered, since the programme dealt only with assets that banks already held.
Questions
People also ask.
What does legacy mean in this context?
Assets a bank already held before the crisis, as opposed to new loans and investments.
Is PPIPLA different from PPIP?
No, both refer to the same programme, and the longer form simply spells out that it targeted legacy assets.
Why not just let the banks hold the assets?
Because uncertainty about their value kept lenders cautious and made it hard to rebuild confidence in the banking system. Readers of similar schemes should ask who bears the first losses.
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