Friday, September 19, 2008 6 comments ++[ CLICK TO COMMENT ]++

US Plan Probably Will Not Work

The free market is becoming less free, that's for sure. It's quite ironic that the "free market" Republicans end up undertaking huge socialization programs. Congress and Senate are controlled by Democrats but the Treasury is run by the Republican president. Having said that, I think the Democrats would have done something similar, but perhaps with a greater cost to investors and less so to taxpayers. This post is about the proposed strategy for the US governmen to buy distressed mortgage assets. But first some key events that are unfolding.

The SEC just banned short selling on 799 financial stocks. Financials will rally but it's not a market signal. It's close to a manipulation so it's questionable if the rally is temporary. I'm not sure what happens with inverse ETFs. Does this mean that no new ETF shares (of short funds) will be created? You are going to get some unpredictable results from the shorting ban.

The US government is also creating a $50 billion insurance fund for money market funds. Participants in this insurance scheme need to pay the government a fee so it's not clear if it is retroactive. That is, some money market funds bought assets that have and will face permanent impairment (eg. Lehman Brothers unsecured, junior, bonds) so will the insurance cover funds containing questionable assets? This is probably a good idea since banks tap money market funds for capital, not to mention cross-sell other services to money market depositors.

Anyway, the big news is word that the US government is proposing to buy illiquid assets which are generally of dubious quality. We don't know the details of the actual mechanics of the proposal but although it will be benefitial at the margin, I'm quite skeptical. Calculated Risk speculates on the the nature of the entity and let me quote some insightful items.

However this new entity would be very different from the RTC in a number of ways. The RTC was created to dispose of assets accumulated from failed Savings & Loans.

The new entity, according to the WSJ, would purchase illiquid assets "at a steep discount from solvent financial institutions and then eventually sell them back into the market".

With the RTC, the government already had direct responsibility for the assets since they acquired them from insured S&Ls that had failed. The role of the RTC was to liquidate certain of these assets.

In the current situation, the government has no financial responsibility for the assets, except for a few exceptions like the assets of Fannie and Freddie, and the NY Fed's assets acquired in the JPMorgan / Bear Stearns deal. The new entity will both buy assets "at a steep discount" and eventually sell the assets. So unlike the RTC, this new entity puts the taxpayers at risk.

I'm not an expert but I guess the RTC from the 1990's can be thought of as a liquidator while this new entity can be thought of as an investor. This means taxpayers are at risk.

If this is how the entity behaves--we are just guessing here--I already see one big problem. Why would any owner of these illiquid assets sell them to the government at a depressed value? Note that the S&L case involved failed/already bankrupt firms so they would have sold them for sure (i.e. they would have behaved like liquidators and tried to get rid of assets.) Here the institutions that own it will only liquidate if they can get a price that is better than their mark-to-market value (let's assume that one also doesn't think it will deteriorate further.) It depends on the price but if we assume that the government will not offer any more than the presently depressed market price, there is little incentive for the owners to sell them. Instead, the banks, insurers, and others, are likely to roll the dice and hold the assets, hoping that they perform better than the market thinks. The exception might be assets where the government pays more than what the bank thinks the assets are worth. Since illiquid assets are hard to value, the owners will have greater knowledge than the government entity.

Another previous entity mentioned today was the Reconstruction Finance Corporation (RFC) that was created in 1932 by Hoover. A key purpose of the RFC was to purchase preferred stock in banks to increase their capital positions and expand their landing [sic] capacity.

I'm not really sure what will happen in a situation like this. The problem is that it is not in shareholder interests to raise capital via share issuance (preferred or common.) The market price of the distressed firms are so low that any capital injection by the government via preferred shares can result in literal nationalization. Buying as little as a few billion of preferred shares in some of these firms can result in the government owning more than 50% of the company. Again, why wouldn't the company roll the dice and hope that the assets recover (rather than accepting the government preferred shares)?

I think the proposed solutions will help a little bit but it will likely have marginal impact in the long run. The ultimate solution has to come from Fannie and Freddie. I think if they can continue to lend, while avoiding shoddy mortgages, it will keep the current and future mortgage market going. The past--those who own the questionable mortgages--simply have to let the market decide their fate. Many of them will go bankrupt but that's due to their own past mistake.

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6 Response to US Plan Probably Will Not Work

September 19, 2008 at 1:47 PM

The problem isn't future mortgages. Fan & Fred have that covered, now with full .Gov backing. The problem is that the financial system is weighed down with a huge pile of questionable paper and confidence is bleeding away. That is a killer in an industry that depends completely on confidence.

The solution to it all is as obvious as it is unappetizing. Socialize the losses. The RTC mk. II will buy the dodgy paper at deliberately inflated prices and taxpayers eat the difference. Unfortunatey the alternatives are far worse.

Note that the fact that Paulson has said that the program is expected to cost "hundrerds of billions" suggests exactly what I said above. If .Gov just buys at market prices taxpayers wouldn's suffer hundrerds of billions in losses.

September 19, 2008 at 2:31 PM

Helping with future mortgages will put a floor under the real estate price declines. The really bad real estate will end up worthless regardless of what you do. The so-called McMansions, not to mention all those housing developments in the middle of nowhere, are toast no matter what. Whoever that owns these assets are going to lose money no matter what. What I am concerned with is reasonably ok assets being treated the same as those worthless ones. If mortgages remain affordable (right now supposedly it's difficult even for good borrowers to get a loan) then market forces will put a floor underneath the reasonably good (and good) assets.

I'm against blind socialization. I know it helps our Ambac position but this won't help in the long run. As Calculated Interest poitns out in another post, financial institutions will still end up with less capital if they sell off the assets and write off all that loss. Whoever that owns the bad assets are going to fail anyway.

Then there is the question of whether the US government can handle such a large bailout. With some expecting $500 billion to $1 trillion (including the money market fund support) it really begs the question whether this is a short-sighted move. If the US government loses confidence with foreign investors, the cost will be far worse for Americans than some of the current issues.

Every action has a cost. If the govt extends its balance sheet significantly, foreign lenders may balk, resulting in increased interest rates, higher cost of financing, etc. This will aggrevate the economy and that's the last thing we need.

As far as I'm concerned, all of this looks like a rushed attempt with very little concern with the potential sell off in US Treasuries or US$. I agree with the move to prevent a run on money market funds (this is critical) but mass buying of illiquid assets seems questionable.

September 19, 2008 at 2:52 PM

If the dodgy paper is bought at a sufficiently high price it -will- solve the capital problem.

It should have no effect on our Ambac position either way as Ambac is still on the hook for insurance sold on structured paper.

September 19, 2008 at 4:17 PM

The key word is "sufficiently high". I don't think it's going to be anywhere near the price that you are talking. I think they will buy at the current depresed value, and possibly even at a lower price. Even if they buy it at a slightly higher value, it won't be enough.

As for Ambac, it depends on if the government will cut a deal with them (similar to their commutation of some deals in the past.) A floor in real estate may also, in the worst case, improve their recovery value on foreclosed homes.

September 19, 2008 at 5:06 PM

If they want to buy at deeply discounted values nobody will sell... Sales at deeply discounted values are already possible to guys like Lonestar. Nobody wants to sell at those prices because it will kill their balance sheet. .Gov is going to be pretty determined to make this work, even if it entails a massive cost to taxpayers so they will bid what the industry will accept. I suppose taxpayers could be granted the now usual warrants to compensate.

Notice the timing. The fixed income markets and the banking system had a heart attack this week because of LEH and AIG and could only just be resuscitated. This has .Gov scared shitless that next time things will blow up completely. So here comes the bailout to end all bailouts... Pronto, hopefully before another major crash that could tip the debt markets over the edge and the world economy with them.

Ambac will almost certainly have to pay. Even if .Gov, or private holders want to cut a deal Ambac would still have to pay out under the terms of that deal. Citigroup got $850m in badly needed cash to let Ambac off the hook and others will want decent terms as well. I very strongly doubt .Gov is going to massively subsidize Ambac by letting it walk away from soured policies.

You are imo correct though that anything that helps stabilize the housing market should at the margin limit losses from structured credit. Still, Fan & Fred have that coverd as their particular bailout is working exactly as intended. Agency MBS have tightened a lot over Treasuries and mortgage rates are coming down quickly as a result (provided you are credit worthy and have something of a down-payment, no more ninja-loans for now).

And in case you're wondering: Yes, I was rather nervous this past week and still am. A total blowup of the banking system seems to have been very close and you know I am no optimist on the aftermath of that. I suspect this is why .Gov blinked on the AIG bailout, with the banking system nearly failling apart the likely alternative would have been too horribly to contemplate.

September 20, 2008 at 10:52 PM

I don't think the government is going to hand over money for free (i.e. buy way above the market price.) This is one reason I don't think this thing is going to work.

Horrible news on the Ambac front with respect to collateral posting :( Anyway, Ambac will pay if it cuts a deal with the government but that's ok. It'll be for mutual benefit of both, kind of like the Citigroup deal you are referring to.

What are your holdings? If you are diversified across sectors (preferably across continents) the long-term returns will be ok. I personally am not diversified and that's one reason I'm looking at Japan, Russia, China, and the like. I would still like to run a concentrated portfolio but want to be able to survive if there is a credit bust in the US.

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