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.
Posted by jeff
Mon Sep 29th, 2008 07:10 AM
I agree that incentives will be perverted by this bailout, but..... We are in a long-term de-leveraging cycle. I mean like ten years. Institutionally, ideas about risk will be permanently changed as will the regulatory machinery. But you can be sure this whole cycle will happen again....but only after so much time has changed and so much change has come to the world and markets that we can all be collectively "surprised" again. By then no one will even remember the "Merrill mark". To me the big question is. This bailout assumes that the Merrill mark, was way below economic value for the assets and the bailout plan will catalyze a revealuing of paper back towards rational economic value. There are lots of smart guys who are thinking along these lines, are they write or has the psychis damage done already guaranteed a deep recession and guaranteed that performance of this bad debt will be worse than the sharpies expect. NO ONE KNOWS!
Posted by mh23
Mon Sep 29th, 2008 08:12 AM
I enjoy philosophical discussions as much as the next guy, but I must say that these are great times to take action and make money. Over the past several weeks there have been tremendous opportunities in the commercial paper/preferred stock market , both on the income side, and amazingly, on the trading side as well. As soon as Merrill was acquired by BOA I saw the writing on the wall. In times like these one needs to look to the fundamentals of banks like WFC, BAC, and to a lesser extent C and see whether or not the game has changed to put them in a great position to succeed over the next 5-10 years, which is my time frame for all "investments" as opposed to trades.
The bailout is a poorly thought out band-aid, but it will probably do the trick and prevent a systemic failure. That we are heading into a protracted and somewhat deep recession is certain, but when we come out of that, the new mega-banks that offer the full menu of financial services will be the only game in town. For better or for worse, they will do to banking what the oil mergers did for exxonmobil. Track those stocks for the last ten years and you get a sense of some of the opportunites to make enormous profits if you have the patience to wait. I am aware that oil is a commodity, but the synergy and power created by the oil mergers during the Clinton regime is undeniable.
As for Manhattan real estate, it will be a depreciating asset for several years, after which time it will be flat for several more years. I don't think that people fully appreciate the sea-change that has taken place. What do you think, Noah.
Posted by Noah
Mon Sep 29th, 2008 08:48 AM
mh23 - I think you are spot on. Im AWFUL at investing in stocks for longer than, oh I would say, 18 months. AWFUL! I have never had a real job, and the only retirement account I have is the one I funded on my own accord.
I have always been independent. With that said, for me, Im looking at the TRADES that will make me money on this downturn. But that is just how I play the game. I will likely change though, as I do agree with you. The BIG 4 survivors will be JPM, BAC, WFC, and C (because C cant fail) on the banking side. Im leaving out the old IBs for this comment.
I think you are right.
Posted by Noah
Mon Sep 29th, 2008 08:52 AM
Jeff - good point! And yes, we will be 60 when the next credit boom nears its peak!
Posted by brenda
Mon Sep 29th, 2008 09:15 AM
wtf? Citi taking over Wachovia and agreeing to absorb $42B in losses, with the FDIC receiving $12B in warrants, etc. to insure against further losses.
Is this Citi's payback for being kept quietly alive? Harsh medicine. Citi can't deal with the mergers that have already occurred over the past few years. This is one fugly giant.