The Hazard of the Rescue

A: We are hours away from the finalized plan being made public, but a draft of the plan is up on Calculated Risk. Here is my problem with the recapitalization plan; it is punishing mark to market behavior that some firms decided to do to act in the best interest of their shareholders; to strengthen the position of the firm. Those firms that kept marks at the model price, hesitant to update from price discovery, will snake their way out of very ugly mess, rescued by the TARP plan. Lets look at Merill Lynch, the fire sale of what used to be $30Bln in assets back in July, some to Lone Star at about 22 cents on the dollar (arguably 5 cents), their sale of Bloomberg stake, and their ultimate sale to Bank of America. Props to Mr. Thain for acting in the interests of your shareholders; Mr. Fuld, well, how do say it, lost his game of 'chicken' with the markets.

This TARP (Troubled Asset Relief Program) is a recapitalization plan for the banks, with add-ons, oversight, and limits attached to it so as to quell public outrage over the perception of another wall street sector wide bailout. It's really a recapitalization plan of our banking system. The core of the plan is to:

a) buy distressed assets from banks balance sheets
b) buy these assets at marks HIGHER than the current market was willing to pay
c) recapitalize the banks so that lending can resume
d) jump-start private sector interest in the distressed secondary mortgage market to facilitate deleveraging at higher marks

There will be add-ons in the package for homeowners, foreclosures, oversight, transparency, CEO caps, ownership stakes, etc..as demanded by Congress as Senators fear the risk of their jobs for voting on this package. The perception is, this HAS TO HAPPEN. Its a lesser of two evils. Either we do this and things get REAL BAD or we do nothing and things get REALLY REALLY REALLY BAD. Which do we choose? It seems the ultimate ramifications of this package are being put on the back burner for now, as Mish points out, this could very well lead to a rise at the long end of the curve, meaning higher rates for borrowing across the board.

What kills me is when I look back at the actions of Merill Lynch, a firm that made the tough choice to sell toxic assets to the market at super distressed levels & their Bloomberg stake, so as to rid themselves of toxic assets, raise capital, and position the firm to weather the rest of the storm ahead. In both announcements, MER stock traded higher in the days after.

With fire sales, comes price discovery that ricochets through to other firms' holding similar illiquid toxic assets:

"When Merrill sold off their distressed assets at a reported 22 cents on the dollar, arguably 5 cents on the dollar, it issued in price discovery for what these distressed assets were currently worth on the open market. "

Now, back to the rescue plan. Look at the name of this plan, TROUBLED --- ASSET --- RELIEF --- PROGRAM!! The logic is to buy troubled assets that the current market values at close to nothing, offer relief to these handcuffed lending institutions, recapitalize, and get that bank lending again! Right now, credit markets are paralyzed waiting for action.

To do so, the troubled assets that need to be off-loaded MUST be removed at prices HIGHER than what the current market is willing to pay! Think about it, these guys can sell for 5 or 10 cents on the dollar right now if they wanted to, but they don't want to because it will HURT them, not HELP them. If they could sell at say, 35 or 40 cents on the dollar, well they can withstand that kind of shock for already marked down distressed assets, take the hit, clean up their balance sheets, restore investor confidence, raise more capital, and start lending again. It's all about where they could sell those junk assets at!

In comes the Treasury. The very prospect of $350Bln - $700Bln coming in to buy distressed assets, on its own will have the effect of bouncing the secondary mortgage market from levels say a month ago. That is very important. So when time comes for the committee in charge of buying distressed assets to 'pull the trigger', the market is likely to be significantly higher already. In addition, there will be other players fighting to get in on the action too, jumping on board the gravy train. I can see the explanation already for paying high levels for these distressed assets, "...we paid the price that the market placed on these assets at the time of our purchase". Yea right, of course you did, AFTER your plan rallied interest for these assets!

I shouldn't be so surprised, because again, this IS the plan. There is no point to it if we were going to pay super low prices that the market was valuing these assets at BEFORE this plan was first conceived. But that is the sales pitch we will get from the backers of the rescue package. That we, the taxpayer, are buying super distressed assets at super fire sale prices, and there is a very good chance we make money on this trade in X years. Yea right. I don't buy it. It stinks. It stinks real bad.

One hazard of this rescue is that it punishes firms like Merrill Lynch for their behavior of selling assets at fire sale prices when they had to. Too big to fail? What a great business model these days and down the road.

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