"Wednesday, February 4, 2009
The Bad Bank Assets Proposal: Even Worse Than You Imagined
Dear God, let's just kiss the US economy goodbye. It may take a few years before the loyalists and permabulls throw in the towel, but the handwriting is on the wall.
The Obama Administration, if the Washington Post's latest report is accurate, is about to embark on a hugely expensive "save the banking industry at all costs" experiment that:
The Obama Administration is as obviously and fully hostage to the interests of the financial services industry as the Bush crowd was. We have no new thinking, no willingness to take measures that are completely defensible (in fact not doing them takes some creative positioning) like wiping out shareholders at obviously dud banks (Citi is top of the list), forcing bondholder haircuts and/or equity swaps, replacing management, writing off and/or restructuring bad loans, and deciding whether and how to reorganize and restructure the company. Instead, the banks are now getting the AIG treatment: every demand is being met, no tough questions asked, no probing of the accounts (or more important, the accounting).
Why is this a bad idea? Let's turn to a study by the IMF of 124 banking crises. Their conclusion:
In case you had any doubts, propping up dud asset values is a form of forbearance. Japan had a different way of going about it, but the philosophy was similar, and the last 15 year illustrates how well that worked.
What we have from Team Obama is a bigger abortion of a :"throw money at bad bank assets" plan that I feared in my worst nightmare. And (when we get to the Post preview), they have the temerity to invoke triage to make what they are doing sound surgical and limited.
Those who remember the origin know that triage means focusing on the middle third of the wounded on the battlefield : leaving the goners to die, leaving those wounded but stable to fend for themselves for the moment (they were in good enough shape to wait to be transported or hold on to be treated later). The middle third, those in immediate danger but who might nevertheless be salvaged, got top priority.
The concept of "triage" recognizes that resources are limited, tough decision need to be made, and some are beyond any hope. But in Team Obama Newspeak, triage means everyone can be saved because resources are presumed to be unlimited:
Yves here. The spin is so thick I have to interject after one sentence. Note how the problem is that the investors don't want to pay enough, not that the assets are in most cases fetid? Back to the article:
Yves here. See how saving the banks in their current form is presumed to be necessary? This is the phony policy constraint that is leading to all the distortions. The savings and loan crisis' Resolution Trust Corporation is touted as a good "bad bank" model (it's far from the only one). But guess what? It got those bad assets from banks that died. That little detail seems to be neglected in modern accounts.
Back to the article:
Yves again. This sounds completely arbitrary, despite the pretense of faux science. Do they want to buy the assets most underwater? The assets most at risk of further price declines? The assets with that are the hardest to value (like lower rated CDO tranches?). It may simply be that the Post reporter doesn't appreciate the issues at work, but I wonder if the extreme vagueness reflects instead failure to come to grips with the real objectives (which means Wall Street will be able to manipulate them) or that they don't want the public to know what is going on (per the persistent stonewalling of efforts to find out what securities the Fed has bought and taken as collateral).
As John Paulson pointed out, a lot of poor quality paper is trading. The idea that it is illiquid is a myth.
The problem is not a lack of price discovery, as the discussion above pretends, it's a lack of investor willingness or ability to take losses. And readers have said if a particular piece of paper doesn't fetch a bid, that's because its real value is not materially above zero. But per above, that's the sort of dreck that Team Obama would buy.
And what, pray tell, is the point of the guarantee? The loss exposure on a guarantee (versus a purchase) at the same nominal price is the same, although the initial cash outlay is considerably different. Ah, but if the paper is guaranteed, then your friendly bank welfare recipient can bring the junk to the Fed and get nice cash back.
So we the taxpayers are going to eat a ton of bank losses that should instead be borne first by stockholders and bondholders This program should be labeled the Pimco bailout plan, since the giant bond fund holds a lot of bank debt. That show what a fiction Obama's populism is. It's mere posturing and empty phrases. Look at where the dough goes, and it is going first and foremost to the big money end of town.
Now I do no labor under the delusion that there are cheap or easy ways out of our financial sinkhole. People are suffering, and we are only partway through the process of contraction and writeoffs. I heard of a suicide today, a jewelry dealer who was $400,000 in debt (also owed a lot of money but unable to collect) who threw himself off 10 West 47th Street (from someone else in the building, this is no urban legend). A tragedy, and a visible one, and there is plenty of less acute but no less real trauma afoot.
But Team Obama is taking the cowardly approach of distributing the costs among the most disenfranchised group in the process, namely the taxpayer, when there far more obvious and logical groups to take the hits. Shareholders and bondholders bought securities KNOWING there was the possibility of loss. A lot of big financial institutions have been on the ropes for over a year. A security holding is not a marriage. When conditions change, prudent investors reassess and adjust course accordingly. If anyone is long a lot of dodgy bank paper now, they have only themselves to blame. Any why are rank and file bankers still exempt from pay cuts when the workers in another failing US industry, autos, expected to take big hits?
This is the most roundabout and probably the most costly way to not solve this problem. Another warning from the IMF paper:
The most amazing bit is the government acts as if it has no leverage. Look how Paulson sent teams in to inspect the accounts of Fannie and Freddie and put them into conservatorship. The reason it is obvious that this program is a crock is that it has ben cooked up in the complete and utter absence of any serious due diligence on the toxic holdings of the big banks.
As we discuss in a separate post, the one punitive element, executive comp restrictions, are mere window-dressing. Welcome to change you can believe in.
More on this topic (What's this?) The Obama Administration, if the Washington Post's latest report is accurate, is about to embark on a hugely expensive "save the banking industry at all costs" experiment that:
1. Has nothing substantive in common with any of the "deemed as successful" financial crisis programs
2. Has key elements that studies of financial crises have recommended against
3. Consumes considerable resources, thus competing with other, in many cases better, uses of fiscal firepower.
The Obama Administration is as obviously and fully hostage to the interests of the financial services industry as the Bush crowd was. We have no new thinking, no willingness to take measures that are completely defensible (in fact not doing them takes some creative positioning) like wiping out shareholders at obviously dud banks (Citi is top of the list), forcing bondholder haircuts and/or equity swaps, replacing management, writing off and/or restructuring bad loans, and deciding whether and how to reorganize and restructure the company. Instead, the banks are now getting the AIG treatment: every demand is being met, no tough questions asked, no probing of the accounts (or more important, the accounting).
Why is this a bad idea? Let's turn to a study by the IMF of 124 banking crises. Their conclusion:
Existing empirical research has shown that providing assistance to banks and their borrowers can be counterproductive, resulting in increased losses to banks, which often abuse forbearance to take unproductive risks at government expense. The typical result of forbearance is a deeper hole in the net worth of banks, crippling tax burdens to finance bank bailouts, and even more severe credit supply contraction and economic decline than would have occurred in the absence of forbearance.
In case you had any doubts, propping up dud asset values is a form of forbearance. Japan had a different way of going about it, but the philosophy was similar, and the last 15 year illustrates how well that worked.
What we have from Team Obama is a bigger abortion of a :"throw money at bad bank assets" plan that I feared in my worst nightmare. And (when we get to the Post preview), they have the temerity to invoke triage to make what they are doing sound surgical and limited.
Those who remember the origin know that triage means focusing on the middle third of the wounded on the battlefield : leaving the goners to die, leaving those wounded but stable to fend for themselves for the moment (they were in good enough shape to wait to be transported or hold on to be treated later). The middle third, those in immediate danger but who might nevertheless be salvaged, got top priority.
The concept of "triage" recognizes that resources are limited, tough decision need to be made, and some are beyond any hope. But in Team Obama Newspeak, triage means everyone can be saved because resources are presumed to be unlimited:
The basic problem confronting the government is that banks hold large quantities of assets that they value on their books for much more than investors are willing to pay...
Yves here. The spin is so thick I have to interject after one sentence. Note how the problem is that the investors don't want to pay enough, not that the assets are in most cases fetid? Back to the article:
Since the early days of the financial crisis, officials have struggled to unwind that knot. If the government buys the assets at prices that banks consider fair, the Treasury would take a huge loss when it ultimately sells the assets for much less. If, instead, the government insists on paying market prices, the banks may not survive their losses.
Yves here. See how saving the banks in their current form is presumed to be necessary? This is the phony policy constraint that is leading to all the distortions. The savings and loan crisis' Resolution Trust Corporation is touted as a good "bad bank" model (it's far from the only one). But guess what? It got those bad assets from banks that died. That little detail seems to be neglected in modern accounts.
Back to the article:
Instead of taking a single approach, the Obama administration plans to divide assets and other loans into three categories, each with its own solution, according to sources familiar with the discussions, speaking on condition of anonymity because the details are not finalized.
The government would buy and hold on to those assets whose falling prices are putting banks under the most pressure. Officials want to limit these purchases because of the vast expense.
The centerpiece of the plan would be a guarantee to limit losses on a second group of troubled assets that can be kept by the banks because they have more stable prices.
And it would allow banks to retain and profit from their healthiest assets.
Beyond these initiatives, the government also is likely to inject more capital into troubled institutions.
Yves again. This sounds completely arbitrary, despite the pretense of faux science. Do they want to buy the assets most underwater? The assets most at risk of further price declines? The assets with that are the hardest to value (like lower rated CDO tranches?). It may simply be that the Post reporter doesn't appreciate the issues at work, but I wonder if the extreme vagueness reflects instead failure to come to grips with the real objectives (which means Wall Street will be able to manipulate them) or that they don't want the public to know what is going on (per the persistent stonewalling of efforts to find out what securities the Fed has bought and taken as collateral).
As John Paulson pointed out, a lot of poor quality paper is trading. The idea that it is illiquid is a myth.
The problem is not a lack of price discovery, as the discussion above pretends, it's a lack of investor willingness or ability to take losses. And readers have said if a particular piece of paper doesn't fetch a bid, that's because its real value is not materially above zero. But per above, that's the sort of dreck that Team Obama would buy.
And what, pray tell, is the point of the guarantee? The loss exposure on a guarantee (versus a purchase) at the same nominal price is the same, although the initial cash outlay is considerably different. Ah, but if the paper is guaranteed, then your friendly bank welfare recipient can bring the junk to the Fed and get nice cash back.
So we the taxpayers are going to eat a ton of bank losses that should instead be borne first by stockholders and bondholders This program should be labeled the Pimco bailout plan, since the giant bond fund holds a lot of bank debt. That show what a fiction Obama's populism is. It's mere posturing and empty phrases. Look at where the dough goes, and it is going first and foremost to the big money end of town.
Now I do no labor under the delusion that there are cheap or easy ways out of our financial sinkhole. People are suffering, and we are only partway through the process of contraction and writeoffs. I heard of a suicide today, a jewelry dealer who was $400,000 in debt (also owed a lot of money but unable to collect) who threw himself off 10 West 47th Street (from someone else in the building, this is no urban legend). A tragedy, and a visible one, and there is plenty of less acute but no less real trauma afoot.
But Team Obama is taking the cowardly approach of distributing the costs among the most disenfranchised group in the process, namely the taxpayer, when there far more obvious and logical groups to take the hits. Shareholders and bondholders bought securities KNOWING there was the possibility of loss. A lot of big financial institutions have been on the ropes for over a year. A security holding is not a marriage. When conditions change, prudent investors reassess and adjust course accordingly. If anyone is long a lot of dodgy bank paper now, they have only themselves to blame. Any why are rank and file bankers still exempt from pay cuts when the workers in another failing US industry, autos, expected to take big hits?
This is the most roundabout and probably the most costly way to not solve this problem. Another warning from the IMF paper:
All too often, central banks privilege stability over cost in the heat of the containment phase: if so, they may too liberally extend loans to an illiquid bank which is almost certain to prove insolvent anyway. Also, closure of a nonviable bank is often delayed for too long, even when there are clear signs of insolvency (Lindgren, 2003). Since bank closures face many obstacles, there is a tendency to rely instead on blanket government guarantees which, if the government’s fiscal and political position makes them credible, can work albeit at the cost of placing the burden on the budget, typically squeezing future provision of needed public services.
The most amazing bit is the government acts as if it has no leverage. Look how Paulson sent teams in to inspect the accounts of Fannie and Freddie and put them into conservatorship. The reason it is obvious that this program is a crock is that it has ben cooked up in the complete and utter absence of any serious due diligence on the toxic holdings of the big banks.
As we discuss in a separate post, the one punitive element, executive comp restrictions, are mere window-dressing. Welcome to change you can believe in.
Obama’s New Stimulus Plan May Be the Needle That Pops the Treasury-Bond Bubble (Money Morning, 1/28/09)
Democrats Have Conceded They Do Not Have Stimulus Package Votes (Zero Hedge, 2/4/09)
Posts
"This program should be labeled the Pimco bailout plan, since the giant bond fund holds a lot of bank debt."
The purchasing of Toxic Assets by the government has been the advice of William Gross since September:
http://www.washingtonpost.com/wp-dyn/content/article/2008/09/23/AR2008092302322.html?hpid=opinionsbox1
"And so, instead of mild medication and rest, it became apparent that quadruple bypass surgery is necessary. The extreme measures are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from "troubled financial institutions" to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent. Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that.
In effect, the Treasury will have the fate of the American taxpayer in its hands. The Resolution Trust Corp., created in the late 1980s to deal with the savings and loan crisis, dealt with previously purchased real estate, which was flushed into government hands with a "best efforts" future liquidation. Today, the purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below "par" or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth. Politicians afraid of parallels to legislation that enabled the Iraq war are raising concerns about a rush to judgment, but the need for speed is clear. In this case, there really are weapons of mass destruction -- financial derivatives -- that threaten to destroy our system from within. Move quickly, Washington, with appropriate safeguards. "
Also in Sept., Gross said he would buy Toxic Assets for the government for free:
http://www.nytimes.com/2008/10/04/business/economy/04plan.html?hp=&pagewanted=all
"Mr. Ryan is a former director of the Office of Thrift Supervision, where he played a key role in the savings and loan cleanup. Still, some investors are troubled by the government’s heavy reliance on private firms. They said it would be difficult to prevent firms from steering capital in ways that favor their private customers.
Inevitably, large asset management firms own, or are tied to banks that own, some of the same securities the government is seeking to sell. Pimco, for example, is owned by Allianz, one of Germany’s largest insurance companies. Merrill Lynch owns a stake in BlackRock.
“I can’t even fathom how I would manage that,” Mr. Siegel said. “How would I manage one side, where I’m seeking to maximize profit, and the other side, where I’m looking out for the social good?”
The law stipulates that the government must prevent conflicts of interest in the hiring of firms, the decision of which assets to buy, the management of those assets and even the jobs held by employees after they leave the program. But it leaves the details to the Treasury.
The Treasury plans to publish guidelines for hiring the asset management firms in the next day or two, officials said. Some experts say that the department simply needs to gird itself for protests.
“You’re never going to get past conflicts of interest, so you take your lumps,” said Peter J. Wallison, who was general counsel of the Treasury during the Reagan administration.
The bailout legislation itself highlights the contradictory goals that the Treasury will face when it goes on its buying spree. Among the goals it is supposed to consider are “protecting taxpayers,” “preventing disruption to financial markets” and “the need to help families keep their homes.”
What's he buying?
http://www.forbes.com/2009/01/05/intelligent-investing-pimco-gross-bonds-stocks-Jan6.html?feed=rss_news
"What should investors do?
We're buying bank preferred stocks -- JP Morgan Chase (nyse: JPM - news - people ), Bank of America (nyse: BAC - news - people ) and Wells Fargo (nyse: WFC - news - people ). The government is in the market [through its Troubled Asset Relief Program] to the tune of $150 billion. Its interest rate is 5%. With its equity warrants, that effectively boosts the yield to 6%. We can buy--the public can buy--[similar] preferred shares for yields of 12% or 13%.
How safe are these securities? There's no government guarantee.
In for a nickel, in for a dime. Or in this case, in for $150 billion, in for $300 billion… It's close to a guarantee. [The government] is assuming the survival of these companies…
…The banking industry has been nationalized. People don't realize that. There are so many programs. It's hard to keep up."
As I read this, he's saying that the government has guaranteed the bank's losses, but will not actually nationalize.
Here's the major point from Gross:
"For now, our Ponzi-style economy and its policy remedies encourage bond investors to mimic Uncle Sam and its global compatriots. Buy what they buy, but get there first."
Pretty clear. There's nothing about his strategy that's not public. However, since he won big on GMAC, I've noticed a major distancing of himself from the government and even boards ( GM ).
From Paul Kedrosky:
http://paul.kedrosky.com/archives/2009/01/29/bill_gross_pick_1.html
"Having said his strategy is to stay under the Treasury/Fed umbrella, PIMCO fund manager is now cheerily suggesting that the umbrella be re-positioned a little to give him better rain protection. He wants Treasury/Fed to start buying the bonds that he owns:
Policymakers should not focus entirely on one-off bailouts of large real estate developers, municipalities, or even credit card issuers like they have with Citi, BofA, and AIG. Rather, they should recognize that supporting critical asset prices such as municipal bonds, CMBS, and even investment grade corporate bonds is a necessary step towards eventual economic revival.
[via PIMCO]
Pick me!, as it were."
I read this a bit differently. Gross was saying "We're not in the inside and have no special power over you, so please pick us".
Since Gross is a very smart man, I have been arguing the opposite from what he advises. Not because I don't respect him. On the contrary, I do. But his plan is going to be the plan that favors keeping the big players in place. Since Gross says that we've already nationalized and we haven't, the best bet has always been to nationalize. That's what the banks fear, and what the banks fear is what the taxpayer should want.
By the way, I'm advocating as short a period of government running these banks as possible. Otherwise, we'll end up losing more money. It's not clear to me how these banks are going to do going forward, and we don't want to be invested in them. They might do well, but we don't need to be on the hook if they don't.
Don the libertarian Democrat