April 3, 2009

The Obama-Geithner Plan: Bad Business

I repost the following here in its entirety because the Naked Capitalism folks understand it better than I, and people need to get an understanding. The Obama plan for the financial system is not a good one.

From the good folks at Naked Capitalism, breaking down the major problems with Team Obama's Treasury plan to rescue the financial system.

Let us go back to some basic principles:

1. Despite bank and Administration smoke-blowing to the contrary, the problem with the so-called toxic assets on bank balance sheets is NOT that they cannot be priced, but that banks do not like the prices on offer from willing buyers. We have read anecdotes suggesting that the gap is as big as bank valuation 90-95 cents on the dollar versus market prices of 30 cents, but the typical example is bank holding price of 80 cents versus market of 30 cents.

So let us repeat, the purpose of this program is NOT price discovery, and any claim along those lines is a lie. The purpose is to keep the banks from recognizing losses that already exist, by reversing them via unloading the paper at a fictitious high price and dumping the loss on the taxpayer.

The more straightforward way to do this would be to require the banks to take the loss (one could lower the haircut a tad if there really was an economic justification for thinking the market value of 30 really was an undershoot, but a gap of 80 versus 30 says pretty clearly that further writedowns are inevitable). And those banks that wind up bankrupt get put into receivership, with the first losses coming from shareholders and bondholders.

2. The public private investment partnership program is thus a very costly way to camouflage overpayment for bad bank assets in lieu of writedowns and some combination of relief (say for impaired banks that still look viable) and receivership. The extra costs come about because for whatever amount of capital is provided by private sources, there must be an expected positive return. And given the risks involved, that return requirement is pretty high. Thus if the bank won't sell for less than 80, and Uncle Sam is trying to get private capital involved to improve the optics, and private investors provide $6, it is fallacious to think that the taxypayer is somehow $6 ahead. The investor needs to expect $6 plus his return requirement. Say it's 15% per annum given the risk of the deal. He's need that investment to be worth $9 in three years (assuming no interim income). If his investment expected to return that much (and how can it be, if the market price for the same paper is $30), there has to be an additional element of subsidy to induce him to participate (maybe he can dump the paper on the TALF? Maybe a friendly bank that has reason to play ball will provide a non-recourse loan for his piece of $9?)

The broader point is that private investors have higher return expectations than Uncle Sam, who is generally happy to get out whole (meaning you tell the public you took no loss, but it would be nice if the government recovered its cost of funding). Merely providing them with non-recourse debt is not sufficient if their investment is still expected to produce a loss. And given their high return expectations, it is more costly to subsidize their participation rather than have the government bear the full cost.

We now see the absurdity of this program and the Treasury's position. the program is by design a gimmie to the banks, who can dump their dodgy paper on to Uncle Sam. In fact, they are now pretty ham-handedly trying to game the system. And rather than condemning their actions, the Treasury is lamely trying to defend them.

From the Financial Times:
US banks that have received government aid, including Citigroup, Goldman Sachs, Morgan Stanley and JPMorgan Chase, are considering buying toxic assets to be sold by rivals under the Treasury’s $1,000bn (£680bn) plan to revive the financial system.

The plans proved controversial, with critics charging that the government’s public-private partnership - which provide generous loans to investors - are intended to help banks sell, rather than acquire, troubled securities and loans.

Spencer Bachus, the top Republican on the House financial services committee, vowed after being told of the plans by the FT to introduce legislation to stop financial institutions ”gaming the system to reap taxpayer-subsidised windfalls”.

Mr Bachus added it would mark ”a new level of absurdity” if financial institutions were ”colluding to swap assets at inflated prices using taxpayers’ dollars.”

Participating in the plan as a buyer could be complicated for Citi, which has suffered billions of dollars in writedowns on mortgage-backed assets and is about to cede a 36 per cent stake to the government.....

And attract new investments from private investors, limiting the need for the further government funds.

Many experts think it is essential to take these assets from leveraged institutions such as banks that are responsible for the lion’s share of lending, into the hands of unleveraged financial institutions such as traditional asset managers, where they will have much less impact on the flow of credit to the economy.

Banks have three options if they want to buy toxic assets: apply to become one of four or five fund managers that will purchase troubled securities; bid for packages of bad loans; or buy into funds set up by others. The government plan does not allow banks to buy their own assets, but there is no ban on the purchase of securities and loans sold by others.

“It’s an open programme designed to get markets going,” a Treasury official said. But he added: “It is between a bank and their supervisor whether they are healthy enough to acquire assets,” raising the possibility regulators may prevent weak banks from becoming buyers.

Yves here, That isn't just lame, it is out and out dishonest. The Treasury can and bloody well ought to rein in this kind of thing, but instead it will fob its duty to make sure the program works as promised (ie gets bad assets off the balance sheets of banks that NOW own them, as opposed to those who decide to load up on them for fun and profit). But no, they pretend this isn't a problem of due to their negligence. More important, it show very clearly that their first and only loyalties are to the banking industry. The public is a mere goose to be plucked. Back to the story:
Wall Street executives argue that banks’ asset purchases would help achieve the second main goal of the plan: to establish prices and kick-start the market for illiquid assets.

Yves here. This too is a baldfaced lie. John Paulson (among others) maintain that there are active markets for these assets. The "oh we need price discovery" is a con job.Back to the story:
But public opinion may not tolerate the idea of banks selling each other their bad assets. Critics say that would leave the same amount of toxic assets in the system as before, but with the government now liable for most of the losses through its provision of non-recourse loans.

Administration officials reject the criticism because banking is part of a financial system, in which the owners of bank equity - such as pension funds - are the same entities that will be investing in toxic assets anyway. Seen this way, the plan simply helps to rearrange the location of these assets in the system in a way that is more transparent and acceptable to markets.

Yves again. Oh my God, do they believe the garbage they shovel out? First, the idea that "the same entities" own bank stock as debt is an utter canard. Pimco, one of the biggest holders of bank debt, is a bond shop! It doesn't own any bank equity. Ditto for particular pension funds. To imply that all investors are indiscriminate indexers and on top of that, equally exposed to bank debt and equity is idiotic.

Similarly, the notion that equity and debt are fungible, flies in the face of all corporate finance theory. The way to "rearrange" things in this situation is to go pup the capital structure, wipe equity holders out, and swap debt for equity. The idea of rearranging assets in a capricious way (only a very few players are participating in this scheme) and claiming it is somehow superior is rubbish. This is all about shoring up the value of bank bonds that ought to be written down in a very major way.

Third, the very biggest lie is that this is merely "rearranging" the counters within the moneyed classes. This is massive dumping of losses from the investing class onto taxpayers, many of whom have little in the way of retirement savings. The costs the average taxpayer is absorbing is well in excess of what his bank related investments.

The dishonesty of this crowd is just breathtaking. The Bushies were blatantly high handed, while Team Obama prefers the Big Lie and assumes we are all too dumb to see through it.