It made money taking advantage of the wide difference between buying and selling prices in those markets.

TO BE NOTED: From the FT:

"Goldman amasses $164bn war chest

By Greg Farrell and Francesco Guerrera in New York

Published: April 14 2009 18:39 | Last updated: April 14 2009 20:43

Goldman Sachs has amassed a war chest of $164bn in cash and liquid assets that could be used to buy distressed securities and loans as its rivals clear their balance sheets, Goldman’s chief financial officer said on Tuesday.

David Viniar spoke as the bank completed the sale of $5bn in common stock – at $123 per share – which it plans to use to pay back some $10bn from the government’s troubled asset relief programme.

The sale price represented a 5.5 per cent discount to Monday’s close. Goldman’s shares closed down more than 11 per cent at $115.11.

Other banks were weaker too, with Morgan Stanley down 12 per cent as investors speculated it could raise funds when it announced results next week.

Morgan Stanley declined to comment.

Speaking a day after Goldman reported $1.81bn in first-quarter earnings, Mr Viniar said the bank’s liquid assets, which rose more than $50bn in the first quarter, could also be put to defensive use if the crisis worsened.

Goldman’s earnings were helped by a record $6.5bn in revenues in fixed income, commodities and currencies (FICC) activities. It made money taking advantage of the wide difference between buying and selling prices in those markets.

“The environment in the first quarter was such that . . . there were so many opportunities in truly liquid assets that there was no need to use liquidity to buy illiquid assets and there weren’t a lot of good illiquid assets for sale,” Mr Viniar said, adding that strong liquidity made sense “from a defensive and offensive point of view”.

He acknowledged the liquidity position was a drag on profits, but said in the current environment “prudence is the better path”. But he noted activity in the capital markets was gaining momentum, pointing to two dozen equity offerings last week.

In an interview with the Financial Times, Mr Viniar said Goldman wanted to pay back the $10bn in Tarp funds as soon as possible so it could pay bankers, invest abroad and hire foreign workers without generating criticism it was using taxpayer money for such purposes.

However, Mr Viniar told investors that repaying Tarp would still allow Goldman to keep issuing government-guaranteed debt.

“It’s important to run our business the way it ought to be run,” he said. “Not only is it important to be able to compensate deserving executives with bonuses much larger than those currently allowed by regulators, he said, but “we don’t want to have to worry about who we hire with an H-1B visa [for skilled foreign workers]”.

Copyright The Financial Times Limited 2009"

come forth quickly with its subsidy, or make it clear from the beginning that no subsidy was coming

TO BE NOTED: From the NY Times:

"Waiting for the Subsidy

By Casey B. Mulligan

Casey B. Mulligan is an economics professor at the University of Chicago.

Subsidies can have a perverse effect on activity if they are debated too long. The banking sector bailout is one example; the purchase of hybrid automobiles by Chicago cab drivers is another.

Hybrid automobiles can save gas, especially in urban driving conditions when the automobile is moving slowly or idling, where alternative power sources have a bigger advantage. A problem is that the purchase price of hybrid vehicles is often higher, and many are less spacious than the more ubiquitous sport utility vehicles.

A significant fraction of the taxicab fleet may be well suited for hybrids, because many of the miles driven are in urban conditions, and often the vehicles have only one passenger. Thus I have been surprised to notice so few hybrid taxis in Chicago, where less than 1 percent of cabs are hybrids.

by Ray Tsang

[via Apture]

In an admittedly unscientific survey, I watched for Toyota taxis with about 100,000 miles. I assumed that many drivers of Toyotas would be likely to buy a Toyota for their next taxi, and that the Prius — the company’s hybrid model — would get their consideration. I asked the drivers about buying a Prius.

The drivers told me about the Chicago City Council’s debates about transforming the city’s taxi fleet.

The council has debated mandating hybrid purchases. But the rumor among taxi drivers is that in addition, or perhaps instead, the city or another government agency will eventually subsidize the purchase of a hybrid. Drivers have decided that they should not purchase a Prius or another hybrid until the subsidy arrived. Buying one now would mean overpaying.

Regardless of whether it is realistic to expect Chicago to someday subsidize purchases of hybrid taxis, the fact is that some cab drivers are considering the possibility. If taxi drivers consider future subsidies in their industry, then so must bank executives.

Last fall the public learned that banks were not selling many of their legacy mortgages and mortgage-backed securities, despite the impression that ownership of the assets was hindering the banks’ lending. A variety of theories have been put forward to explain this failure, and to suggest what the government might do to fix it.

But the lack of trade in mortgage-backed securities may have something in common with the lack of trade in hybrid Chicago taxicabs. The secondary market for legacy mortgages may have stagnated largely because of the (ultimately correct) anticipation of a huge government subsidy. As I wrote last week, banks were not “unable” to sell their legacy mortgages; they were prudently unwilling to sell because they expected the government to step in eventually and help push the prices of the assets higher.

There would have been two preferable possibilities: for the government to come forth quickly with its subsidy, or make it clear from the beginning that no subsidy was coming. With both Chicago taxis and the secondary market for mortgages, the government did neither. Instead, it only fueled rumors that subsidies were on the way, and froze the same markets it intended to stimulate."

will do so at market-determined (albeit artificially enhanced) prices

TO BE NOTED: From the WSJ:

"By MARTIN FELDSTEIN

The Treasury's new Public-Private Investment Plan should be regarded as a pilot study to see if this approach can remove impaired assets from the nation's banks. If it works, Treasury will have to go back to Congress for substantially more funding to remove enough impaired assets to get the banks lending again.

AP

Increased bank lending is the key to a sustained recovery. Households and businesses that cannot obtain credit are now unable to spend and to invest, dragging down total demand and GDP. The banks are unwilling to lend because they lack confidence in the value of the loans and other assets they already carry on their books, and therefore lack confidence in whether they have enough capital to avoid insolvency. Removing these high-risk assets is a prerequisite to get the lending mechanism in gear again.

The problem of uncertain asset values is particularly acute with respect to residential mortgages. An unprecedented one-third of all such mortgages now exceed the value of the houses that serve as their collateral. Because residential mortgages are generally "nonrecourse" loans (i.e., secured only by the underlying property), homeowners with negative equity have an incentive to default, leaving the banks with net losses. The frequency of defaults is increasing as house prices continue to fall.

The Treasury's primary plan is to induce private investors to buy pools of such high-risk mortgages from the banks. Individual banks will offer pools of mortgages for sale. Private investors -- including pension funds, insurance companies, hedge funds and sovereign wealth funds -- will bid for each mortgage pool in an auction. The total purchase price for each pool will be financed by a combination of the private investor's equity, an equal amount of Treasury equity, and private loans guaranteed by the Federal Deposit Insurance Corporation (FDIC).

Because the FDIC will guarantee six dollars of loans for every dollar of equity, the auction process is expected to produce prices high enough to induce the banks to sell their impaired assets. Because the mortgage loans will be priced in a competitive auction, there will be no windfall profits for the private-equity investors.

The private-equity investors will be responsible for managing the pool of mortgage loans acquired, modifying interest rates, and reducing loan principals in ways that they believe will decrease defaults and increase the value of the loans. If the process produces a gain relative to the initial purchase cost, the private investors and the Treasury will share equally in the profit. If the result is a loss, the private investors and the Treasury can lose up to their entire equity investments. Losses higher than the initial investments would be absorbed by the FDIC as the guarantor of the loans.

A similar structure will be used to finance the purchase of securities backed by residential mortgages, commercial mortgages and credit-card debt. Private investors will buy those securities from the banks at auction and the Treasury will co-invest an equal amount of equity. The Treasury will then match the equity investment with a nonrecourse loan. The entire amount will then be eligible for additional credit from the Federal Reserve. This process will again give the private investors and the Treasury equal profits or losses, depending on the investors' success in managing the securities. Losses beyond the equity investment would be absorbed first by the Treasury and then by the Fed.

If it succeeds, this plan will remove some $500 billion of impaired mortgages and securities from the banks, will do so at market-determined (albeit artificially enhanced) prices, and will give taxpayers a possibility to gain along with the private investors who manage the assets. It will do all of this without nationalizing any of the major banks.

Although the Treasury's plan is aimed in the right direction, it needs to be substantially expanded in three ways if it is to succeed. First, the Treasury must be prepared to inject capital into the banks that agree to sell mortgages. Without additional capital, the banks may not be willing to sell the mortgages that are causing their lack of confidence.

Here's why. Although mortgages with high loan-to-value ratios have a high probability of imposing substantial losses through default, they are carried on the banks' books at their full nominal value as long as the borrowers are making their monthly payments. Selling these mortgages would require the banks to recognize losses that would reduce their capital, pushing them toward insolvency. To remedy this problem, the Treasury should offer to provide enough replacement capital in the form of either preferred shares or perpetual debt to offset the loss of capital caused by selling the impaired loans.

Second, cleansing the banks' balance sheets will also require much more Treasury money for equity investments and loans. The current plan to remove $500 billion of impaired assets will not be enough to cleanse the banks' balance sheets to a point where they can be confident enough about the remaining assets to resume lending. The banks now own $3 trillion of residential mortgages, $1.5 trillion of corporate real-estate loans, and $1 trillion of consumer debt. While not all of these loans are impaired, the banks will have to sell much more than $500 billion of loans to regain confidence in their solvency.

Third, even if all of the existing impaired assets are removed from a bank's balance sheet, the remaining mortgages that now have positive equity are in danger of sliding into negative equity as house prices continue to fall. That risk can be reduced or eliminated if the government offers "mortgage replacement loans" (along the lines that I suggested on this page, March 7, 2008) equal to 20% of the existing mortgage.

Such loans would have a very low interest rate but the borrower would have to personally be liable for them, and could not discharge the debt in bankruptcy. Because the new mortgage would have a lower principal, it would provide a firewall -- even an additional 20% decline in a house's value would still leave the homeowner with positive equity and no incentive to default.

It's critical that we get the banks lending again and providing the kind of back-up credit lines that facilitate the commercial-paper market. The Treasury plan appears well-designed in principle to do that. If the Treasury shows that it can use the available $500 billion to buy mortgages and asset-backed securities, it will then need to scale up to induce the banks to sell a larger amount of their impaired loans and to prevent a damaging deterioration of healthy mortgages as home prices decline.

Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors."

That type of bond has risen more than 10 cents on the dollar since the plan was announced

TO BE NOTED: From Bloomberg:

"Geithner’s Non-Recourse Gift Keeps on Giving to Gross (Update1)

Share | Email | Print | A A A

By Jody Shenn

April 2 (Bloomberg) -- Treasury Secretary Timothy Geithner’s plan to rid banks and markets of devalued assets may be a boon for Pacific Investment Management Co.’s Bill Gross.

The plan may reward investors with 20 percent annual returns on “really ‘toxic’” mortgages bought at 45 cents on the dollar by allowing them to borrow six times their money with “non-recourse” government-backed debt, New York-based Credit Suisse Group AG analysts Carl Lantz and Dominic Konstam wrote in a March 27 report. That loan would be worth 15 cents to an investor seeking the same return who can’t use borrowed money.

Geithner’s Public-Private Investment Program, or PPIP, promises to boost prices enough to encourage banks, insurers and hedge funds to sell their mortgage holdings, freeing them to make loans while creating a potential windfall for investors. Federal Reserve Chairman Ben S. Bernanke said March 20 that “credit market dysfunction” is countering efforts to fix the economy.

“One of the challenges has been that leverage has really been pulled away from the system and as a result the kinds of returns investors are looking for haven’t really been available,” said Ken Hackel, head of fixed-income strategy at RBS Securities in Greenwich, Connecticut. RBS is one of the 16 primary dealers that are obligated to bid at the Treasury’s auctions of government debt and which trade with the Fed.

Growing Interest

Since Geithner unveiled the plan on March 23, Pacific Investment, or Pimco, which manages the world’s biggest bond fund, and New York-based BlackRock Inc., the largest publicly traded U.S. asset manager, said they may be interested in participating in PPIP. Others include New York-based Apollo Global Management LLC, the private-equity firm run by Leon Black, and Los Angeles-based Colony Capital LLC, which has invested more than $39 billion since it was founded in 1991.

“This is perhaps the first win/win/win policy to be put on the table,” Gross, co-chief investment officer of Newport Beach, California-based Pimco, said in an e-mailed statement last week.

Pimco spokesman Mark Porterfield, Konstam and Lantz didn’t return calls seeking comment.

Geithner’s plan may already be working. Top-rated commercial-mortgage bonds rose 5.6 percent since March 20 to about 79 cents on the dollar on average, according to Merrill Lynch & Co. indexes. The most-senior class of benchmark 2005 securities backed by fixed-rate Alt-A home loans, or those ranked between prime and subprime, increased about 12 percent to 54 cents as of March 31, according to Deutsche Bank AG.

Government Loans

Geithner’s plan encourages investors to buy as much as $1 trillion of real-estate assets by using $75 billion to $100 billion provided by the Treasury and government loans. The goal of the Fed and the Treasury since September has been to cleanse banks of troubled assets.

The Treasury would match the money asset managers raise to join them in public-private funds. The Federal Deposit Insurance Corp. would guarantee borrowing offered to funds buying loans, while the Treasury and Fed would offer financing to mortgage- securities buyers. The Fed loans may be made available to investors that are not part of the public-private funds.

“Institutional investors, especially the largest, want to be able to put more leverage into trades so they can get higher returns for their efforts,” said David Castillo, a senior trader of structured-finance bonds at Further Lane Securities in San Francisco. “On paper the concept is wonderful, though I’m of the opinion most banks still won’t be able to sell.”

$12.8 Trillion

Analysts at JPMorgan Chase & Co., Barclays Plc and Deutsche Bank AG also say they don’t expect banks to sell many loans into the program because accounting rules mean they generally carry the debt at face value. That suggests they would record a loss when selling the assets, eroding their capital.

The credit markets began to seize up in 2007 as losses on subprime mortgages mounted. Since then, the world’s largest financial institutions have taken $1.3 trillion in losses and writedowns, according to Bloomberg data. Gross domestic product shrank 6.3 percent in the fourth quarter, the most since 1982, as banks reined in lending.

The government and Fed have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s, Bloomberg data show.

“Widening credit spreads, more-restrictive lending standards and credit market dysfunction are working against the monetary easing and leading to tighter financial conditions,” Bernanke said March 20, addressing the Independent Community Bankers of America’s national convention in Phoenix.

Congressional Skepticism

The Treasury’s role in buying securities with private investors raises the risk the government would interfere with the businesses of its partners, said Jim Shallcross, who oversees about $14 billion in bonds as director of portfolio management at McLean, Virginia-based Declaration Management & Research LLC.

Representative Spencer Bachus of Alabama, the top Republican on the House Financial Services Committee, said in an April 1 interview that the distribution of half of the profits to the investor “does bother me.”

“But even beyond that, what bothers me even more is it’s taxpayer money,” Bachus said. “What you are doing is artificially inflating the price of those assets because at the present prices the financial institutions won’t sell them.”

Geithner signaled he’d oppose any attempt to claw back profits from investors participating in the program. Investors and banks “need to have confidence that the rules of the game are going to be clear, consistently applied in the future,” he said in an April 1 Bloomberg Television interview in London.

‘Taxpayer Loses’

Nobel prize-winning economists Paul Krugman, a professor at Princeton University in Princeton, New Jersey, and Joseph Stiglitz, a professor at the Business School of Columbia University in New York, blasted Geithner’s plan for putting the taxpayer on the hook for losses with what they say is little likelihood of success.

“The Geithner plan works only if and when the taxpayer loses big time,” Stiglitz wrote in the New York Times this week. “With the government absorbing the losses, the market doesn’t care if the banks are ‘cheating’ them by selling their lousiest assets, because the government bears the cost.”

Krugman wrote in the Times last month that “Obama is squandering his credibility” with the plan.

Price to Pay

Pimco’s other co-chief investment officer, Mohamed El- Erian, said today that the plan’s economic benefits outweigh its flaws. Those benefits include helping to remove toxic assets from bank balance sheets, reestablishing a functioning market and attracting private capital.

“It is a price that society has to pay because, for doing that, it gets a few things that are important,” El-Erian said in an interview with Bloomberg Radio.

Democratic Representative Carolyn Maloney of New York, who chairs the congressional Joint Economic Committee, said in an April 1 interview that she didn’t have much concern about investors profiting from the program.

“It’s a way to get the assets off the books,” she said.

RTC Example

While the government’s takeovers of failed savings and loans in the late 1980s and early 1990s cost taxpayers and let private investors gain, it succeeded in ending the crisis. The Resolution Trust Corp. recovered almost $400 billion from asset sales, short of their book value of $452 billion, the agency’s executives said on the day it was shut down on 1995. The government cost of the bailout totaled about $90 billion.

“There was a lot of concern that they were selling the assets too quickly and too cheaply,” said Raghuram Rajan, the former chief economist of the International Monetary Fund in Washington who’s now a professor at the University of Chicago. “There was a lot of second guessing, but it worked.”

The odds of Geithner’s programs succeeding would be low if the financing offered was “recourse,” Credit Suisse’s Lantz and Konstam said. That would require the funds to pay back the government funds with their own money if the value of the assets fell below the amount of the loans.

Declining Value

With recourse loans, the type of “toxic” mortgages identified by the Credit Suisse analysts, which have a hypothetical 40 percent annual default probability and only 10 percent expected recoveries, would be worth only 19.7 cents.

The type of loans that may be sold, New York-based Citigroup Inc. analyst Darrell Wheeler said in a March 27 report, include $93 billion of commercial mortgages that are probably carried on the books of banks at 65 cents to 75 cents on the dollar because they were meant to be packaged into bonds.

Unlike Geithner’s plan for loans, the public-private funds for securities will be limited initially to only five managers, such as Pimco and BlackRock, already overseeing $10 billion of the assets targeted. That program will buy securities from holders of toxic assets other than banks.

“There it’s probably going to work -- for five people,” said Dan Castro, chief risk officer at hedge fund Huxley Capital Management in New York. “You’re selecting a very small group of large guys and giving them all the advantages.”

Potential Profits

By providing loans, the government may allow investors to more than double their potential profits.

The most-senior class of a 2007 Goldman Sachs Group Inc. commercial-mortgage bond traded at 69.6 cents on the dollar on March 27, offering a yield of 12 percent, according to report that day from Bank of America Corp. analysts Roger Lehman and Julia Tcherkassova in New York.

If the Fed provides a five-year non-recourse loan and requires an investor to put up only 85 percent of the cost of the securities, then that investor could “walk away” when the loan expires and still have earned 25 percent returns, Lehman and Tcherkassova wrote. That assumes losses on the underlying loans don’t exceed 30 percent.

That type of bond has risen more than 10 cents on the dollar since the plan was announced, according to Wheeler.

The amount of leverage available under the Fed’s program hasn’t been announced. The FDIC program will offer as much as six times the money raised by the private-public funds from individuals and the Treasury.

‘We intend to participate and do our part to serve clients as well as promote economic recovery,’’ Pimco’s Gross said in the e-mail."

encourage banks to auction off tranches of toxic assets without providing subsidies to the purchasers

TO BE NOTED: From the FT:

"Why Geithner’s plan is the taxpayers’ curse

By Peyton Young

Published: April 1 2009 19:07 | Last updated: April 1 2009 19:07

People who outbid others in auctions sometimes pay too much, a phenomenon known as the winner’s curse. Yet the plan outlined last week by Tim Geithner, US Treasury secretary, for pricing the toxic assets clogging up the financial system provides private investors with an unusually strong incentive to overpay: the government is proposing to pick up most of the tab if the assets turn out to be worth much less than was spent on them. Indeed, the more aggressively investors compete in bidding for these assets, the worse off the taxpayers will be. I call this the taxpayers’ curse.

A simple example will illustrate the problem. Suppose that a given bundle of mortgage-backed securities would be worth $20m (€15m, £14m) if you could be sure that all the mortgages will be repaid in full, but they might also turn out to be worthless. No matter how much you pay for them, the US government agrees to absorb any losses beyond approximately 15 per cent, while you get to keep half of any gains. In return, you only have to put up about 7.5 per cent of the purchase price. How much will the assets sell for? That depends on two things: how aggressively others bid and how much uncertainty there is about their ultimate value.

For simplicity, assume the assets could be worth $20m or zero with equal probability. Assume that yours is the winning bid at a price of $10m. Under Mr Geithner’s plan, you put up $750,000 for an equity stake and the government puts up the remaining $9,250,000: a loan for $8,500,000 and $750,000 for an equal share of the equity. There is a 50 per cent chance that you will get your money back in full and make a profit of $5m (in which case the other $5m in profit goes to the Treasury).

Of course, it is equally likely that the assets will turn out to be worthless, but in that case all you lose is your initial payment of $750,000, and the Feds are on the hook for the rest. That works out to an expected profit of $2,125,000 for an investment of $750,000, a return of 283 per cent.

If this seems too good to be true, it is: competition from other bidders will probably drive the bid price much higher. This would be unfortunate, however, because $10m is already the expected value of the asset. For example, a bid price of $14m would still be a bargain, because the investor’s expected profit would be approximately $1m on an initial investment of approximately $1m, which represents a 100 per cent return. Meanwhile, the taxpayers can expect to lose nearly 40 per cent of their money.

This is the singularly perverse feature of the Treasury proposal: the greater the competition among the bidders, the worse off the taxpayers and the more distorted the so-called “market” prices that result. More generally, one can work out the amount of price distortion and the expected returns to the taxpayers as a function of the variance in the realised values of the asset and the expected returns demanded by investors. For example, if there are two equally probable outcomes, one 50 per cent above the mean and the other 50 per cent below the mean, taxpayers can expect to lose money unless private investors make more than 180 per cent in expectation.

Some might argue that this is the price we must pay to get the financial system back on its feet but, in my view, it is much too steep. The problem is not merely the size of the bill, which could run into the hundreds of billions of dollars. The real difficulty is that the scheme perpetuates the very practices that got us into this jam in the first place. Over the last several decades, Wall Street wizards have developed products that most people cannot understand, including quite a few players in the financial markets themselves. The result has been mispricing and excessive risk-taking throughout the financial system.

It is truly dismaying that the Obama administration, which publicly champions greater transparency, should put forward a proposal whose main object is to subsidise the banks without appearing to do so. Instead of making the prices of toxic assets more transparent, it is likely to inject a new level of price distortion and uncertainty into the markets, while putting taxpayers at great risk. It may also allow banks to claim that assets remaining on their books after the auction should be priced at the same inflated level as the assets sold off.

A more straightforward plan would be strongly to encourage banks to auction off tranches of toxic assets without providing subsidies to the purchasers. This would involve fewer gimmicks and produce prices that more nearly reflect the assets’ true economic value. If these auctions do not generate enough activity to clean up the banks’ balance sheets, the government will have to seize control of insolvent institutions temporarily and sell off their bad assets over a period of time, as happened in the wake of the S&L debacle of the 1980s.

The writer is James Meade professor of economics at the University of Oxford and a senior fellow at the Brookings Institution"

Mr. Miller says the choices are either to “nationalize or overpay for the assets…” I vote nationalize…

TO BE NOTED: From Shopyield:

Nationalize or overpay for assets

Analysis and discussion with Paul Miller of FBR Capital Markets (Bloomberg News)… Mr. Miller says… the whole loans are on the bank’s books at 97-98 cents on the dollar and it’s likely they are worth 70-80 cents… so there will be minimal incentive for the banks to sell at a loss…

Mr. Miller says the choices are either to “nationalize or overpay for the assets…” I vote nationalize…

the price discount imposed by difficulty obtaining financing – in these ­markets may not be as big as policymakers hope

TO BE NOTED: From the FT:

"Caution urged as toxic assets fail to rally

By Krishna Guha in Washington and Aline van Duyn in New York

Published: March 25 2009 18:55 | Last updated: March 26 2009 01:23

Amid the general euphoria over Tim Geithner’s plan to tackle toxic assets there is one note of caution: while bank stocks have rallied strongly on the plan, the underlying toxic assets have not.

The ABX index, which tracks subprime mortgage-backed securities, has barely lifted from its record lows. The leveraged loan LCDX index has gained a little but is still sharply down on the year. Top-rated commercial mortgage-backed securities have rallied but are only back to mid-February levels, while lower-rated tranches have rallied much less.

It is possible that the lack of movement reflects a lack of trading in some of these markets. Problems accessing finance may be preventing investors from anticipating the impact of the government plan to finance ­purchases of such assets by bidding up the price of these assets until the actual ­government cash arrives to fund such trades.

Equity investors may also be most enthusiastic about the effect of the plan on loan portfolios that are not traded. Or, they may be taking broader comfort from the administration’s apparent commitment to support big banks as going concerns come what may.

But the plan’s modest impact on toxic asset prices nonetheless raises questions as to the sustainability of the rally in bank stocks. It is a reminder that even this plan, which most experts believe is well crafted, may not work.

In particular, it suggests that the liquidity risk premium – the price discount imposed by difficulty obtaining financing – in these ­markets may not be as big as policymakers hope, implying that prices may not rise very much when government financing comes on stream, leaving banks with still large capital holes.

The bigger these capital holes – and the greater the uncertainty over the value of the remaining assets on bank balance sheets – the less plausible it is that they can be filled with private capital and the more likely it is that the government will have to provide that capital instead.

Experts highlight three reasons why the credit markets have not responded as vigorously to the Geithner plan as has the equity market.

First, the history of failed rescue plans has left credit markets wary of responding to any government plans until there are clear signs that they will be implemented.

“Credit investors are likely to watch the effectiveness of the scheme before taking a more positive view on the markets and drive spreads tighter,” said a research note from Dresdner Kleinwort.

Second, credit market investors are not convinced that the low prices on risky mortgage-related assets are necessarily too low.

Specifically, the government’s assumption that by injecting liquidity into the markets, prices will rise may not prove correct, not least because prices on the underlying collateral – property – continue to fall.

“The assumption underlying the plan to take loans off banks’ balance sheets is that current prices are not reflective of the underlying collateral, but rather the low prices are due to a lack of liquidity,” said Greg Peters, head of global fixed income and economics research at Morgan Stanley.

“This is not necessarily true and this will mean there will remain a huge gap between the bid and offer prices on loans, even if investors have access to non-recourse loans.”

Third, the buying power of distressed mortgage assets available from the plan is small relative to the scale of the potential problem.

Analysts at Barclays Capital estimate that the programme will allow buying of as much as $700bn (€515bn, £482bn) of toxic “legacy” loan assets and about $400bn for legacy securities. For residential mortgage-backed and commercial mortgage-backed securities, the programme is worth about a third of their $1,100bn market value.

But in the case of US bank holdings of residential and commercial mortgage loans – an estimated $4,300bn – it is only 16 per cent of all loans.

Copyright The Financial Times Limited 2009"

Bernstein’s Bruno Paulson reckons the modest reaction in the ‘toxic’ markets could be down to uncertainties as to whether then plan will actually driv

TO BE NOTED: From Shopyield:

"The Great Toxic Asset Giveaway?

Bloomberg video of Curtis Arledge of Blackrock talking about the Geithner plan… Blackrock can be presumed to be one of the five favored investment managers that Treasury would choose to be in the program…

From the FT Alphaville blog…

~~~~ “The structured credit markets did show some positive reaction, with AAA sub-prime up a point and AAA CMBS index up three points (about 5% in both cases), but this still leaves prices massively down YTD with sub-prime still down on prior month compares (CMBS is roughly at end February levels).

Barring a continued revival over the next week, the Q1 marks could be uncomfortable given the YTD performance. The sub-prime and CMBS indices shown in Exhibit 1 below are an average of the Markit AAA ABX (subprime) and AAA CMBX (CMBS) vintages/series respectively.

Bernstein’s Bruno Paulson reckons the modest reaction in the ‘toxic’ markets could be down to uncertainties as to whether then plan will actually drive up prices.

And his reasoning;

The two issues are whether there will be buyers and whether there will be sellers. The government leverage should help buyers’ potential returns boosting the prices offered, as should the current depressed prices versus fundamentals. However the political environment may discourage investors, given the twin threat of ‘cram-downs’ on lending balances and arbitrary expropriation of profits.

On the seller side, institutions which do not mark-to-market through capital (either because they are marking to model or because the securities are tucked away as ‘Available for Sale’) have no incentive to realise losses, particularly if they (probably reasonably) think the ultimate losses will be lower than that implied in the prices. Even those who mark stuff to market may prefer to let someone else do the selling to raise prices, thus realising the gain without losing the future upside. Paradoxically, the belief that the securities are undervalued relative to fundamentals may constrain the number of transactions….” ~~~~

This was written by cate. "

administration officials keep saying that there’s no subsidy involved

TO BE NOTED: From Paul Krugman:

"Geithner plan arithmetic

Leave on one side the question of whether the Geither plan is a good idea or not. One thing is clearly false in the way it’s being presented: administration officials keep saying that there’s no subsidy involved, that investors would share in the downside. That’s just wrong. Why? Because of the non-recourse loans, which reportedly will finance 85 percent of the asset purchases.

Let me offer a numerical example. Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100.

But suppose that I can buy this asset with a nonrecourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset?

The answer is, slightly over 130. Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.

Notice that the government equity stake doesn’t matter — the calculation is the same whether private investors put up all or only part of the equity. It’s the loan that provides the subsidy.

And in this example it’s a large subsidy — 30 percent.

The only way to argue that the subsidy is small is to claim that there’s very little chance that assets purchased under the scheme will lose as much as 15 percent of their purchase price. Given what’s happened over the past 2 years, is that a reasonable assertion?

Update: Another way to say this is that by financing a large part of the purchase with a non-recourse loan, the government is in effect giving investors a put option to sweeten the deal."

It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay.

TO BE NOTED: From Robert's Stochastic Thoughts:

"Sunday, March 22, 2009

Robert Waldmann

I think the reason the CDO market is frozen is that CDO owners are not willing to sell at the market clearing price, because they would then have to mark their remaining holdings to market. This is one hypothesis.

(after the jump I will re-review others and explain why I find them unconvincing)

I'd say that people are convinced that something else must be going on, because of an earlier example of market freezing. I say frozen markets are a sign that people care a lot about the latest price and will not sell an asset at a price higher than their perception of its hold to maturity value, because they don't want the transaction to be recorded in the market to which they mark.

So, why would broker-dealers have done such a thing say the last time markets froze ?
That would be during the Long Term Capital Management meltdown/Freeze up metaphor mixer.

Why lo and behold, it is alleged that markets froze because all broker dealers were manipulating the mark to market value in this book I read "Inventing Money. subtitle includes "long term capital management" or "LTCM""

The assets were long maturity calls on European stock indices. LTCM was massively short these options. The market price of the options became absurdly huge and trading volume fell to roughly zero. LTCM collapsed. Now given the absense of actual trading, the price to which they were marked was the list price as listed by broker/dealers. All major broker dealers were LTCM counter parties. LTCM had REPO accounts so if the mark to market value LTCM's holdings at a bank fell to zero, the bank could seize the holdings including a short position on a grossly overpriced option.

So long as all broker/dealers refused to sell the options for less and no one wanted to buy them for that absurd price, they could seize a valuable LTCM position.

It was rumored that broker/dealers were secretly trading the options at lower prices.
So, it is alleged, that the market freeze up then was pure fraud.

I just know what I read in this book. I don't know if it is true. However, I think the allegation makes it unwise to use the case to prove that market's freeze up for reasons other than dishonesty about the true value of assets.



Here I argue against three other explanations of the current freeze.

Another would be adverse selection. Only the worst of the CDOs are for sale so the market price is the price of the worst of the worst. This can happen if sellers know more about the value of assets than buyers (check) and buyers have to bid on assets and let sellers accept some of the bids and reject others (huh). The second condition doesn't hold. As I've argued repeatedly below, if I had the money I could offer to buy x% of a bank's CDO book at a y% discount but only if they sold me equal proportions of the book. Adverse selection problem largely solved.

Another would be that everyone is panicked (except Geithner, Paulson and Summers). or that everyone has to deleverage. This would really have to be everyone. With frozen markets willingness to buy even a small amount of the assets at a high price would be enough that the latest market price wouldn't be the latest fire sale price.

Another would be that everyone has to deleverage. Again *everyone*.

posted by Robert permalink and comments10:53 PM

Commenting on Drum again in one day

Drum argues that the US public will have to eat the toxic assets in any case and that Bank shares are basically worthless so who cares.

Now, it's true that if we nationalize we'd wipe out the shareholders of the bad banks. But although that's the right thing to do, it's also pretty small potatoes since stock prices have dropped so far that shareholders in bad banks have virtually no equity left at this point. (Sweden didn't even bother trying to wipe out shareholders when they nationalized Nordbanken in 1992, for example. They just bought out the minority shareholders at the highly depressed market price.) What's more, a lot of those shareholders are mutual funds and pension funds anyway. The amount of bankster wealth that would be wiped out in a nationalization is probably pretty small.

Look the aim is not to keep the banks going with worthless shares forever OK.
Shares are worth nothing now, but, if the Geithner plan works, they will be worth a lot. So will shares in nationalized banks. But if we nationalize the value shares which are actually worth something will go into the Treasury. Geithner's plan is not to keep zombie banks staggering around forever. If shareholders are not wiped out and if the plan works as promised, they will end up with a huge amount of money given to them out of your tax dollars.

Also, I know this is so totally 2 days ago, but remember that little dust up about AIG bonuses ? The issue is not the shareholders; they lost long ago. It is the managers. Will they be able to pay themselves £11 million a year (and claim it is $1 million ?). Will they be masters of the universe or subordinates of the subordinates of Geithner ?

CEO compensation is a tiny amount of money, even in banking. Total compensation over $250,000/yr for all employees is not. That's the money Atrios is after.

Managers at banks don't want banks to be nationalized. Geithner is willing to give hedge fund managers tens of billions of US dollars to protect the sacred power of the Bank managers who messed up.
posted by Robert permalink and comments10:42 PM

Commenting on Drum

update: Oh wow. Drum linked to this post. A Political animal stampede. I want to stress that, while I tend to use a confident tone, I really don't know anything about finance.

kevin Drum discusses Valuing the Toxic Waste

After all, if markets can overvalue assets on the way up — and obviously they can — then they can also undervalue them on the way down. There's a pretty good chance that the toxic waste in question really is worth more than the market is currently willing to pay for it.

It is hard for markets to freeze at a price far from subjective effective hold to maturity value. It is easy for markets to flow (opposite of freeze) at such prices.
The current situation is not just that many people are willing to buy Toxic Waste at a huge discount and some owners are willing to sell it. It is also necessary that no one is willing to pay a higher price for toxic waste which happens not be available in a fire sale. Someone should be willing to buy at least a little bit of an asset at say 90% of that persons expectation of its hold to maturity present value. That would be enough to give a market price which isn't absurdly low.

In contrast back during the bubble one could sell short a huge amount of toxic waste at its huge price without affecting that price. People were willing to buy a huge amount at that price. Current owners are just not selling huge amounts of toxic waste at huge discounts (the market is frozen remember). That's the difference. It really has to be that no one wants it except at a huge discount and that really means no one not fewer people than want to sell it at a higher price (so long as they won't sell it at the huge discount because they would have to mark down the identical assets that they still own).

a lazy shorthand that a lot of us have fallen into: namely the notion that the value of mortgage-backed securities is certain to keep plummeting because home prices themselves still have another 20-30% to fall. But these securities aren't backed by the value of the homes they represent. They're backed by mortgage payments. Home prices could fall by half, but the value of the securities wouldn't drop by a dime if homeowners kept making their monthly payments. Their value only drops if default rates go up.

So what causes default rates to rise? Falling home prices are certainly a factor, since it's more tempting to mail in the keys when your loan is way underwater. Rising unemployment is an even bigger factor: if you lose your job, you're more likely to stop paying the mortgage. And the crappy lending practices at the height of the bubble produced a surplus of buyers who have always been more likely to default than average.

I comment

You understate the effect of home prices on the value of mortgage based assets for two reasons. First the value of the assets is not just based on default rates, it is also based on cents on the dollar recovered through foreclosure. That clearly falls when home prices fall. Also, if a homeowners have positive equity I'd guess that even if they have say zero income, they can fend off foreclosure by taking out a second mortgage to pay the first (even if this debt is junior it is covered by the equity in the home). So default rates are higher for under the water mortgages for a reason different from mailing in the keys.

Obviously, then, there's tremendous uncertainty about future default rates. But the market appears to be valuing most mortgage-backed securities these days at something like 30 cents on the dollar. That's crazy. When you factor in recovery rates, it assumes that over three-quarters of all homeowners will default on their loans. That might be true of the absolute worst of the toxic waste, and it's certainly true of the equity tranches of even the better stuff, but on average? No way. 30 cents on the dollar simply doesn't represent a reasonable long-term value for most of this stuff.

But everyone is scared, and when there are no buyers prices get unreasonable.

Your argument rests entirely on the figure 30% which does sound low. In fact, it seems that it would be low even if we could be absolutely sure that all mortgage debtors will never make another payment. Recovery after foreclosure should be worth more than 30% of face value on average.

You assume that the figure 30% applies to all mortgages or, at least, to all securitized mortgages. Whatever gave you that idea ? What if the figure comes from mezzanine tranches of CDOs of by liars loan only MBSs ? There are some assets which no one will buy for more than 30% of face value. They are called toxic sludge. Are they representative mortgages ? I think that's unlikely.

A key point is that there are patient, brave deep pocketed investors still out there. Warren Buffet is one and he controls enough money that there doesn't have to be another one. If the current market price is so absurdly low, why isn't he buying? If he is worried about adverse selection and counterparties with more information picking lemons to sell him and keeping the cherries, then why not offer to buy say 1% of a banks total MBS and CDO of MBS book ?

I think the fact that this isn't happening shows that the prices banks demand for their toxic sludge are higher than justified by a sober patient valuation by an agent with a huge capacity to bear risk.

To get a market price of 30 cents on the dollar it has to be that no one is willing to buy even a small amount of the asset for more. Banks would be delighted to sell a little of an asset for a high price so they could mark the rest to that high price.

The claim that everyone is scared must be literally true. Everyone. Warren Buffet has to be terrified of maybe losing a billion while probably making many billions.
How likely is that ?
posted by Robert permalink and comments10:37 PM

Attempted DeLong smackdown meets It's a Dirty Rotten Job But Someone's Got to Do It.

Brad DeLong attempts to defend the Geithner plan. I consider this a good sign for the USA and a bad sign for Berkeley economics department economic history teaching. He is brilliant as always and almost convincing. I post some of his argument and all of my comment

Q: What is the Geithner Plan?

A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.

[snip]

Q: Why isn't this just a massive giveaway to yet another set of financiers?

A: The private managers put in $30 billion, but the Treasury puts in $150 billion--and so has 5/6 of the equity. When the private managers make $1, the Treasury makes $5. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year; the Treasury is only paying 0% of the capital value and 17% of the profits every year.

We own the FDIC too so we are bearing 97% of the downside risk. Hedge fund investors can't end up with less than zero if the manager ends up with zero. This makes the analogy clearly false.

Second, the fact that hedge fund investors do it does not mean that it isn't essentially giving lots of money to already rich people in exchange for a chance to bear a lot of risk. You do not, in general, assume that investors are rational. You can't turn the efficient markets hypothesis on and off at will.

Finally, no one is willing to invest in someone's second hedge fund (well maybe someone is but it is dumb). If I have one hedge fund that is generating me income of 10 million a year and another one where I have limited risk, I might just take huge gambles with the second, to, you know, maximize the value of my option. If all my income comes from one fund, I won't be so casual about it becoming worthless. I think that hedge fund managers typically keep a lot of their wealth in their one fund too. The one example I know of LTCM was like that except for one manager who put more than all of his wealth in LTCM by borrowing to super duper leverage.

Investors can tell how much fund managers have taken out. I don't know anyone who invests in a hedge fund, but, I suspect, that if the manager takes a lot of money out of it, they switch funds.

The fact is that the Geithner deal will have highly positive expected returns for the private partners even if the expected returns on the investment are negative. Loss limited to 3% of the investment and gain equal to 17% of the gain is an extremely valuable Geithner put. This means that, if the private partners really are experts and know what assets are worth in expected value, they will pay more and the US government will have large expected losses.

If Geithner didn't want the USA to lose money, he could design the program so that hedge fund managers put of 3% of the capital and get, say, a 4% share. That way they would be willing to buy assets at 4/3 of their expected hold to maturity value *if* they were risk neutral, less since they are risk averse. This way I'd guess that they are willing to pay double their estimate of the expected hold to maturity value, because of the value of the Geithner put.

I admit that my guess has nothing to do with any calculation of the value of the option. I'm guessing that Geithner wants to buy toxic sludge at twice its hold to maturity value, because that is the only price at which banks are solvent -- that he wants to give banks the value of their toxic sludge but wants to pretend that he didn't do it on purpose. I am using the current market price as my estimate of the hold to maturity value. OK so I'm switching the efficient markets hypothesis off and on, but its the only estimate we have. I'd say there is a lot of wealth in the world and selling pressure can't keep assets undervalued for months.

The fact that CDOs are not being bought and sold doesn't mean that there is no one able to buy them because everyone is deleveraging. It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay. Current owners won't sell at the current market price, because they are not marking to the current market price not because they can't find buyers at the current market price.

Oh and adverse selection my ass. If I had a billion dollars, I could go to Goldman Sachs and say I want to buy 0.1% of your CDO proportional to your current portfolio. If you want to sell me some of them and not all of them, you can go to Geithner -- he's the one who wants to give you money. Doesn't seem to be happening does it ?

update: pulled back from comments

"The fact that CDOs are not being bought and sold doesn't mean that there is no one able to buy them because everyone is deleveraging. It has more to do with the fact that they are on balance sheets at values much higher than anyone is willing to pay. Current owners won't sell at the current market price, because they are not marking to the current market price not because they can't find buyers at the current market price."

You offer zero evidence for this proposition. You spend an enormous time on this blog arguing that markets are not efficient, but here insist on using the "market" price as a reasonable estimate of the net present value of the assets, even though there is no liquid market in these assets. You can offer hypotheses about why that is, but what we know is that the market doesn't exist right now. The vast majority of the "prices" that are being used for markdowns are fire-sale prices. It's absurd to think that the prices that distressed institutions are willing to sell at are real prices.

I'm glad you called this an "attempted smackdown," because it certainly doesn't succeed.

1:35 PM
Delete
Blogger Robert said...

I admitted to the inconsistency in my turning the efficient markets hypothesis on and off (and after accusing Brad of doing that).

On the substantive contested claim it is just not true that *everyone* is deleveraging. This is a fact, and I have evidence. Warren Buffet, for example, decided to pick up more exposure to Goldman Sachs. I don't need another example.

Brad's analysis is aggregate (he is a macroeconomist).

Now it has been alleged that no one is buying CDOs because the seller knows more about the CDO than the buyer so there is an adverse selection problem and there is an equilibrium of no trading except for fire sales.

I think this argument is based on an absurd assumption that all sales must be via market orders on double auction markets. There is no need for me to allow the seller to pick the lemons to sell me and keep the cherries. If I had the money, I could offer to buy 1% of a banks CDO book for, say 60% of face value. That is demand an equal fraction of all of their CDO's.

No one has done this. Banks are very eager to deleverage. Warren Buffet is buying -- something -- but not a part of any banks current CDO book. I think my explanation, for which you claim I present no evidence, is the only explanation which fits that fact, which I call evidence.
posted by Robert permalink and comments5:11 AM"

Dear God, the Administration really thinks the public is full of idiots.

From Naked Capitalism:

"Private Public Partnership Details Emerging

The New York Times seems to have the inside skinny on the emerging private public partnership abortion program. And it appears to be consistent with (low) expectations: a lot of bells and whistles to finesse the fact that the government will wind up paying well above market for crappy paper.

Key points:

The three-pronged approach is perhaps the most central component of President Obama’s plan to rescue the nation’s banking system from the money-losing assets weighing down bank balance sheets, crippling their ability to make new loans and deepening the recession....

The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell.

Yves here. If the money committed to this program is less than the book value of the assets the banks want to unload (or the banks are worried about that possibility), the banks have an incentive to try to ditch their worst dreck first.

In addition, it has been said in comments more than once that the banks own some paper that is truly worthless. This program won't solve that problem. Back to the piece:

In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money.

Yves here. Hiring asset managers to do what? Some investors get 85% support (more as is revealed later), others get dollar for dollar? This makes no sense unless very different roles are envisaged (but how will the price for assets given to the asset managers be determined? Or are these for the off balance sheet entities that should be but are still not yet consolidated, like the trillion dollar problem hanging around at Citi?) Back to the article:

In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Secure Lending Facility, a joint venture with the Federal Reserve.

Yves again. While the first TALF deal got off well, Tyler Durden points out its capacity is 2.7 times pre-credit mania annual issuance levels, which means the $1 trillion considerably overstates its near term impact. And credit demand by all accounts is far from robust. Cheap credit is not enticing in an environment of weak to falling asset prices and job uncertainty. To the Times again:

Although the details of the F.D.I.C. part were still being completed on Friday, it is expected that the government will provide the overwhelming bulk of the money — possibly more than 95 percent — through loans or direct investments of taxpayer money.

The hope is that such a generous taxpayer subsidy will attract private investors into the market and accelerate the recovery of the country’s banks.

The key protection for taxpayers, according to people briefed on the plan, is that the private investors will bid in auctions against each other for the assets. As a result, administration officials contend, the government will be buying the troubled loans of the banks at a deep discount to their original face value.

Because the government can hold those mortgages as long as it wants, officials are betting the government will be repaid and that taxpayers may even earn a profit if the market value of the loans climbs in the years to come.

To entice private investors like hedge funds and private equity firms to take part, the F.D.I.C. will provide nonrecourse loans — that is, loans that are secured only by the value of the mortgage assets being bought — worth up to 85 percent of the value of a portfolio of troubled assets.

The remaining 15 percent will come from the government and the private investors. The Treasury would put up as much as 80 percent of that, while private investors would put up as little as 20 percent of the money, according to industry officials. Private investors, then, would be contributing as little as 3 percent of the equity, and the government as much as 97 percent.

Yves here, If this isn't Newspeak, I don't know what is. Since when is someone who puts 3% of total funds and gets 20% of the equity a "partner"?

And notice the hint of skepticism from the Times regarding the Administration's supposition that the bidding will result in fair prices. Huh? First, the banks, as in normal auctions, will presumably set a reserve price equal to the value of the assets on their books. If the price does not meet the reserve (and the level of the reserve is not disclosed to the bidders), there is no sale; in this case, the bank would keep the toxic instruments.

Having the banks realize a price at least equal to the value they hold it at on their books is a boundary condition. If the banks sell the assets as a lower level, it will result in a loss, which is a direct hit to equity. The whole point of this exercise is to get rid of the bad paper without further impairing the banks.

So presumably, the point of a competitive process (assuming enough parties show up to produce that result at any particular auction) is to elicit a high enough price that it might reach the bank's reserve, which would be the value on the bank's books now.

And notice the utter dishonesty: a competitive bidding process will protect taxpayers. Huh? A competitive bidding process will elicit a higher price which is BAD for taxpayers!

Dear God, the Administration really thinks the public is full of idiots. But there are so many components to the program, and a lot of moving parts in each, they no doubt expect everyone's eyes to glaze over.

Later in the article, there is language that intimates that the banks will put up assets and take what they get. However, the failure to mention a reserve (a standard feature in auctions) does not mean one does not exist. Or the alternative may be, since bidding will almost certainly be anonymous, is to let the banks submit a bid, which would serve as a reserve. That is the common procedure. when at foreclosure auctions, the bank puts in a bid equal to the mortgage value (so either a foreclosure buyer takes the bank out or the bank winds up owning the property).

Regardless, the equity comes from TARP, and Elizabeth Warren of the Congressional Oversight Panel is no slouch. What will happen when she asks for reports of how the actions have gone (for instance, how many failed because the reserve was not met?) The mechanics will become more apparent to the public over time and may yet come back to haunt Team Obama.

More on this topic (What's this?)

Two Largest Corporate Credit Unions Seized (Option ARMageddon, 3/20/09)

FDIC Closes Three More Banks (Zero Hedge, 3/20/09)

$1 Trillion "Run On Britain" Disclosed (Zero Hedge, 3/9/09)

Read more on Banking at Wikinvest

Posted by Yves Smith at 2:25 AM"

Me:

Don said...

Paul Krugman says this:

"Why was I so quick to condemn the Geithner plan? Because it’s not new; it’s just another version of an idea that keeps coming up and keeps being refuted. It’s basically a thinly disguised version of the same plan Henry Paulson announced way back in September. To understand the issue, let me offer some background."

Here's the first I remember about this plan. It's William Gross in the WaPo on Sept. 27th:

"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.

The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic. Democratic Party earmarks mandating forbearance on home mortgage foreclosures will be critical as well. If this program is successful, however, it is obvious that the free market and Wild West capitalism of recent decades will be forever changed. Future economic textbooks are likely to teach that while capitalism is the most dynamic and productive system ever conceived, it is most efficient over the long term when there is another delicate balance -- between private incentive and government oversight."

Interestingly, even the price of the TAs is the same. The overall plan is to have someone buy the TAs at a discount, borrow cheaply from the government, and sell the TAs down the line for a profit.

There were various schemes offered for the government to do this. Why didn't anything come of them? This is harsh, but I believe it's because there's a widespread belief that the government is either incompetent or a sucker, and would vastly overpay for these TAs no matter the plan. Every other reason boils down to this in my view.

I suggested that the only way for the government to do this was to lie, hire Gross and John Paulson secretly, and have them buy up the TAs under their own names for the government. Needless to say, this is not politically feasible.

So, in my view, the government is meant to be played in many investor's minds, and history has reinforced that view to them. That's why the Swedish Plan was the only way to go. The government needed to show that it would be ruthless in protecting the taxpayer's interests in winding down this crisis. Once this ruthlessness was not shown, we were bound to end up in a mess, with hybrids in which the government and investors danced a costly tango.

In theory, some of these TAs could be profitably purchased. But no one really believes that the government would make the hard choices necessary to do this. We're paying more precisely because the market expects us to.

Don the libertarian Democrat

By the way, thanks to Yves for allowing us to post our thoughts, giving it our best shot. Krugman's blog rejects many comments.

March 21, 2009 2:15 PM

the government will wind up paying well above market for crappy paper

From Naked Capitalism:

"Private Public Partnership Details Emerging

The New York Times seems to have the inside skinny on the emerging private public partnership abortion program. And it appears to be consistent with (low) expectations: a lot of bells and whistles to finesse the fact that the government will wind up paying well above market for crappy paper.

Key points:

The three-pronged approach is perhaps the most central component of President Obama’s plan to rescue the nation’s banking system from the money-losing assets weighing down bank balance sheets, crippling their ability to make new loans and deepening the recession....

The plan to be announced next week involves three separate approaches. In one, the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money that those partnerships will need to buy up troubled assets that banks want to sell.

Yves here. If the money committed to this program is less than the book value of the assets the banks want to unload (or the banks are worried about that possibility), the banks have an incentive to try to ditch their worst dreck first.

In addition, it has been said in comments more than once that the banks own some paper that is truly worthless. This program won't solve that problem. Back to the piece:

In the second, the Treasury will hire four or five investment management firms, matching the private money that each of the firms puts up on a dollar-for-dollar basis with government money.

Yves here. Hiring asset managers to do what? Some investors get 85% support (more as is revealed later), others get dollar for dollar? This makes no sense unless very different roles are envisaged (but how will the price for assets given to the asset managers be determined? Or are these for the off balance sheet entities that should be but are still not yet consolidated, like the trillion dollar problem hanging around at Citi?) Back to the article:

In the third piece, the Treasury plans to expand lending through the Term Asset-Backed Secure Lending Facility, a joint venture with the Federal Reserve.

Yves again. While the first TALF deal got off well, Tyler Durden points out its capacity is 2.7 times pre-credit mania annual issuance levels, which means the $1 trillion considerably overstates its near term impact. And credit demand by all accounts is far from robust. Cheap credit is not enticing in an environment of weak to falling asset prices and job uncertainty. To the Times again:

Although the details of the F.D.I.C. part were still being completed on Friday, it is expected that the government will provide the overwhelming bulk of the money — possibly more than 95 percent — through loans or direct investments of taxpayer money.

The hope is that such a generous taxpayer subsidy will attract private investors into the market and accelerate the recovery of the country’s banks.

The key protection for taxpayers, according to people briefed on the plan, is that the private investors will bid in auctions against each other for the assets. As a result, administration officials contend, the government will be buying the troubled loans of the banks at a deep discount to their original face value.

Because the government can hold those mortgages as long as it wants, officials are betting the government will be repaid and that taxpayers may even earn a profit if the market value of the loans climbs in the years to come.

To entice private investors like hedge funds and private equity firms to take part, the F.D.I.C. will provide nonrecourse loans — that is, loans that are secured only by the value of the mortgage assets being bought — worth up to 85 percent of the value of a portfolio of troubled assets.

The remaining 15 percent will come from the government and the private investors. The Treasury would put up as much as 80 percent of that, while private investors would put up as little as 20 percent of the money, according to industry officials. Private investors, then, would be contributing as little as 3 percent of the equity, and the government as much as 97 percent.

Yves here, If this isn't Newspeak, I don't know what is. Since when is someone who puts 3% of total funds and gets 20% of the equity a "partner"?

And notice the hint of skepticism from the Times regarding the Administration's supposition that the bidding will result in fair prices. Huh? First, the banks, as in normal auctions, will presumably set a reserve price equal to the value of the assets on their books. If the price does not meet the reserve (and the level of the reserve is not disclosed to the bidders), there is no sale; in this case, the bank would keep the toxic instruments.

Having the banks realize a price at least equal to the value they hold it at on their books is a boundary condition. If the banks sell the assets as a lower level, it will result in a loss, which is a direct hit to equity. The whole point of this exercise is to get rid of the bad paper without further impairing the banks.

So presumably, the point of a competitive process (assuming enough parties show up to produce that result at any particular auction) is to elicit a high enough price that it might reach the bank's reserve, which would be the value on the bank's books now.

And notice the utter dishonesty: a competitive bidding process will protect taxpayers. Huh? A competitive bidding process will elicit a higher price which is BAD for taxpayers!

Dear God, the Administration really thinks the public is full of idiots. But there are so many components to the program, and a lot of moving parts in each, they no doubt expect everyone's eyes to glaze over.

Later in the article, there is language that intimates that the banks will put up assets and take what they get. However, the failure to mention a reserve (a standard feature in auctions) does not mean one does not exist. Or the alternative may be, since bidding will almost certainly be anonymous, is to let the banks submit a bid, which would serve as a reserve. That is the common procedure. when at foreclosure auctions, the bank puts in a bid equal to the mortgage value (so either a foreclosure buyer takes the bank out or the bank winds up owning the property).

Regardless, the equity comes from TARP, and Elizabeth Warren of the Congressional Oversight Panel is no slouch. What will happen when she asks for reports of how the actions have gone (for instance, how many failed because the reserve was not met?) The mechanics will become more apparent to the public over time and may yet come back to haunt Team Obama.

More on this topic (What's this?)

Two Largest Corporate Credit Unions Seized (Option ARMageddon, 3/20/09)

FDIC Closes Three More Banks (Zero Hedge, 3/20/09)

$1 Trillion "Run On Britain" Disclosed (Zero Hedge, 3/9/09)

Read more on Banking at Wikinvest

Posted by Yves Smith at 2:25 AM"

Me:

Don said...

"Risk-taking institutional investors, like hedge funds and private equity funds, have refused to pay more than about 30 cents on the dollar for many bundles of mortgages, even if most of the borrowers are still current. But banks holding those mortgages, not wanting to book huge losses on their holdings, have often refused to sell for less than 60 cents on the dollar.( NB DON )

The result has been a paralyzing impasse. Banks, unwilling to sell their loans at fire-sale prices, have had less capital available to make new loans. Mortgage investors, unable to leverage their investments with borrowed money, have been unwilling to pay more than fire-sale prices.

To break that impasse, the government’s crucial subsidy is meant to provide investors with the kind of low-cost financing that has been utterly unavailable in today’s credit markets."

This is all such a tangled web now that there's no easy answer. For instance, by keeping hope of the government helping to buy the TAs alive, the government has kept the price up and given the owners of the TAs an incentive to hold on to them. The government has also advanced money to some of these owners, also allowing them to hold out. This has created the possibility that it could take years to clear the TAs off the books, also giving the owners an incentive to keep them instead of selling them.

Having now created a raft of incentives for owners of TAs to take a hard stance on them, the government now needs an incentive to counter these incentives. It's decided to give that incentive to the buyers, many of which will be Hedge Funds. They would be the likely investors to buy this crap anyway, but we will be subsidizing them.

However, it is important to see that the government has gotten itself into a bind. I'm not defending them, since I believe that all of this could have been avoided, but I want everyone to understand that the government has nowhere else to go given their previous actions. Also, remember, they claim that they can't seize the large banks.

There are other alternatives, but, given their presuppositions, they're pretty much stuck with this plan.

Don the libertarian Democrat

March 21, 2009 11:30 AM