Recapitalize & Steepen; Markets Paralyzed
A: Alright, so I've read all the articles, read all the bloggers, and its clear there are very strong views on the flaws of this recapitalization plan that easily could exceed some $700,000,000,000. I'm more interested now on what the general theme is here. In my humble opinion, the goal is to recapitalize and strengthen the banks, period! Yea, Im sure there will be clauses inserted in the plan to help foreclosures, and work with struggled homeowners who might fall into foreclosure, but the main goal of this plan is to get the balance sheets fixed, the revenue generator for banks back running again, so that the lending can resume. Period. To do this, it seems first you recapitalize, then steepen the yield curve.
I'm so upset about all this bullshit you have no idea. I just know that the marks the future committee will be granting these toxic assets will be WAY HIGHER than true market value at the current time. But this IS the plan and those who mentioned write-ups will probably get them.
We are beyond what he said / she said at this point. We are beyond whether or not Paulson / Bernanke PUBLICLY acknowledged the health of our banking system at this point (behind closed doors, well then, that's a different story). We are beyond who dunnitt, at this point. I'm not saying I like it, I'm not saying it's right, I'm saying we are in dangerous territory, and Bernanke and Paulson know it. Their hand is revealed. The end game is either AWFUL or it's A BIT LESS THAN AWFUL w/ BAD SIDE EFFECTS. We will likely see the latter.
As Yves over at NakedCapitalism.com argues a recent NY Times article about the plan's intentions:
Vikas Bajaj of NY Times states: A big challenge for Treasury officials will be deciding whether to buy the troubled investments near the values at which the banks hold them on their books. That would help minimize losses for financial institutions.Yves is spot on. The entire point to this plan, as I read it before revisions are made public, is to buy distressed assets at prices SIGNIFICANTLY ABOVE current marks that the free market today is willing to pay! By paying a great price for these junk assets, the banks:Yves Counters: Huh? How can Bajaj not understand what this program is about? First, it is going to pay above, in fact considerably above, current market prices for the illiquid (frankly, often dud) assets. There is no point to this exercise otherwise. The banks are free to sell now at market price, but they aren't willing to. Hence the government is stepping in, paying over the mark.
a) get the toxic off their balance sheet AND
b) recapitalize
What you need to know is this, the markets are 'paralyzed' right now, as confirmed to me by an asset manager and a CDS (Credit Default Swap) trader. 
All eyes and trigger fingers are on what is to come. And as the waiting goes on, credit market indicators out there that we all use to check in on the fear level, or risk aversion, are going nutz. Something is going down, that is for sure! Oh, and by the way, you know we will eventually get economic data reflecting the past few troubled months here, so get ready for that too!
My bet is that a mega-revised plan packed with little add-ons to quell the public outrage will go through, banks will be recapitalized because they have to and our gov't will likely not stand idle, and you will see a steeper yield curve (above right is current US treasury yield curve); which is what they want to happen because it gives banks more chances for profits. The steeper yield curve this time around doesn't paint the rosy high growth / inflation from growth picture that it normally does. This time, we have significant negative macro forces at play that will likely result in higher longer term yields, at the same time our fed continues to battle a serious near term slowdown; hence the steepness.
Massive treasury issuance to fund all these programs/bailouts could eventually lead to longer term hyper-inflationary concerns, all dollar negative. For now, its about stopping a deflationary spiral. I guess I can imagine a world where this recapitalization plan fixes everything, and global investor confidence is fully restored, and no more failures occur, and the global economies don't slow down anymore, and the dollar ignores the national debt and account deficits (recall the Debt to GDP / Peak Credit discussion)....yea, I guess I can imagine that kind of world. But imagination usually doesn't translate into reality.
I expect the long end of the curve to see higher yields, and the short end to stay low as the fed will likely ease in response to a major event or very bad macro economic data. John Jansen over at Across The Curve, a great bond site, reflects in his post "Blank Check" and I agree:
Peter Orszag is head of the Congressional Budget Office and he testified before the House Budget Committee on Wednesday. He also testified that he expects the $700 billion authority, assuming it passes. to be fully utilized during fiscal 2009. I believe that the 2009 fiscal year will begin on October 1.Exactly. Only thinking out loud folks, this site is simply an open journal for me and others to blab on. Let's see how this Sunday evening looks in what is now a regular pre-global markets opening ceremony of rescues! It's a sad time for America.That is an enormous amount of borrowing by the Treasury and does not count funding of FNMA and Freddie Mac or purchases of MBS by the Treasury. Unless the economy heads into a serious contraction, very serious, current yields on 10 year notes and 30 year bonds will increase. We will be drowning in a sea of Treasury spittle.
Comments (14)
If the Treasury is going to buy these assets (what is the scope of 'these assets' anyway) above the valuations that they are held at at financial institutions (let's conveniently forget 'market value' for a moment), then I doubt that $700 billion will be enough. The way I read it is that the pricing of these assets would be done through reverse auctions. No?
Posted by chris | September 25, 2008 8:23 AM
chris - we just dont know enough details yet. There will be a committee organized with a GOD appointed to decide how assets will be priced, bid for, and which assets will be purchased.
But the key point is the goal of the program, and to me, that is to recapitalize the banking system and that means favorable deals. If they buy the assets at market value, or slightly above market value, I dont think it will achieve the END RESULT that the plan is intended to achieve!
Posted by Noah | September 25, 2008 8:34 AM
Yes, indeed. For most of these illiquid assets, there is no 'market value' to speak of since they rarely, if ever trade. I TOTALLY agree with your point of view !
Posted by chris | September 25, 2008 9:35 AM
I think there are still significant hopes that some of this paper has been haircut beyond very draconian default and severity trends. Here's the rub. The longer the credit crunch lasts and the longer other world economies have to catch down to our own, the worse unemployment will be and the worse the defaults and severity will be. its a dynamic environment that feeds off itself. Time is of the essence and if the government ends up overpaying for some of this crap, but the paper that really is good on current economics is saved from turning bad due to a depression, its worth every tax payer dollar in my book. That said reverse auctions are probably the best mechanism for proceeding. Shit canning mark-to-market doesn't look like its going to happen, is probably too late and would probably just make people more worried due to increased opacity.
Posted by jeff | September 25, 2008 9:41 AM
well said Jeff...
Posted by office-noah | September 25, 2008 10:05 AM
Someone calculated that the top 20 US banks (ignoring the rest) are still paying 40b in dividends... which compares to ~35 billion in interest on a 700bn investment (assuming a 5% interest rate for no good reason). It is outrageous that taxpayers are recapitalizing the banks while this money is flowing out the back door.
Please note that I understand how serious the issues in the credit market are... and the reasons that action is being taken.
Still, it drives me nuts that banks are not paying for some of this.
Posted by anonymous | September 25, 2008 11:22 AM
Noah -
The credit markets are paralyzed. I work for a well capitalized conservative bank as a corporate banker and it has become impossible for even our investment grade clients to raise capital. This shit is gonna hurt the real economy.
So moral outrage/anger aside (which I share with you as we are not a wall street bank and never took all that risk) what is the alternative? Yes, the plan needs improvement, getting warrants will be one, more oversight, curbs on banking pay etc etc. But something needs to be done fast to avoid a deep recession.
On the specific issue of market valuation and why no one is buying undervalued debt assets on banks books'? I have spoken to a number of investors and the issue is that most of the money sloshing around right now is with equity investors (private equity funds, hedge funds etc.). These guys are looking for 30-40% return/large upside. By very nature, these debt instruments limit your upside, unless you can get leverage. There is no debt available (some exceptions including Merrill deal/seller financing) to buy these assets. As long as US Treasury does not “significantly” overpay for these assets, a 10-15% ROI is a highly likely outcome.
This problem is not just limited to mortgage securities. Lot of leveraged loans are trading at 85 cents on the dollar. From a pure default/recovery analysis perspective, they are undervalued. But again, the upside is limited par/100 (15-20%). The investors are looking for leverage to buy these assets and generate significantly more upside, but leverage is not available.
This bail out package may not solve all the problems, but unless someone suggests a better alternative, this is our only hope.
Posted by EV | September 25, 2008 11:42 AM
If it takes 3 years for the market to recover and we experience significant Inflation, then the Bailout is a BUST.
10 to 15% ROI will be negative if you adjusted for Inflation. The Tax payers not only lose from the Investment, but ultimately, they are stealthy taxed through inflation while the Heads of the Financial Industries makes huge bonuses.
If the heads of the Financial Industry were just incompetent, you have to wonder what good is our education system since most of them graduated from the best Universities. If it is not incompetence, then it is fraud on a Massive Scale.
BUT, if this is Incompetence, surely the Bailout is an incompetent plan as well.
This is all sickening. Good think I'm a multi-million dollar Borrower with high income producing NYC properties with a large equity position. When we get the Hyper Inflation, I'm set.
I just wonder if there will be enough protest from average Americans to start the Wage Inflation Spiral.
Posted by Investor Llew | September 25, 2008 12:36 PM
Noah, is it safe to assume that NYC residential real estate prices are coming down in the near future and buyers should hold off on buying for a few months? I have been looking in a specific area for a while and found 2 properties that I like and have bids on but am nervous about pulling the trigger. Your thoughts?
Posted by Anonymous Buyer | September 25, 2008 2:50 PM
anon buyer - well, i certainly see pressure building to support some price softening in the coming quarters.
Its an individual decision based on what is right for you, and your investment/living strategy. Please email or call me if you want to discuss in more detail.
Noah
Posted by Noah | September 25, 2008 2:57 PM
I guess we are giving up all hope that the government will not overpay. But are there "safeguards" to keep this from happening that haven't been mentioned. For example, if in a Dutch auction the buyer sets the top price, and some price discovery events have happend so far (such as Merril selling at 22cents on the dollar), won't there be an outcry of the game being fixed and political repercussions to follow if the opening bid is set significantly higher than the priced discovered prices to date?
Another example, Mr. Buffett said the Treasury will buy low and make substantial money. This happened with the RTC. Doesn't this put further pressure on the Treasury not to bid too high.
Lastly, if everyone knows lots of money to buy distressed assets are out there just waiting for a good price, wouldn't the Treasury be getting itself off the political hook by bidding low thus setting a low price and unlease the private money to start making their bids.
My point here is that it certainly could go the otehr way but won't there be enuf of a paper trail to show the rip off for which there would be a political price to pay. That would be the biggest incentive for the Treasury not to overbid.
Posted by Query1 | September 25, 2008 3:33 PM
Can someone explain to me why the bailout cannot include provisions where for the banks that are being bailed out the government in essence get equity in the form of warrants or stock in exchange for bailing them out of these toxic holdings.... giving the government some upside.... in this bailout.
Posted by anon | September 26, 2008 12:47 AM
Noah,
Do you have an opinion on the recent surge on the ABX indices?
Posted by pants | September 26, 2008 2:45 AM
pants - not sure, BUT its only the AAA ABX that bets are being made on the positive side. Ill guess, the fannie/freddie bailout and the expectation that govt will bailot everyone is my guess, are bets that smart traders were making.
ABX's I dont look at as often anymore as I do TED spread, corporate bond spreads (CDX), and LIBOR spreads.
Posted by Noah | September 26, 2008 6:50 AM