Rally It Up - But What About Good Assets & The Household?

A: Another crazy day in the world of equities. This time the spark was Geithner's toxic asset plan. You've probably read about it everywhere so I won't dissect it, but basically the goal is to revitalize private capital via incentives to take on risk provided by the public; a so called public-private investment program (PPIP). The plan eliminates a major chunk of uncertainty for tradable markets and when applied to a market that plunged 60% or so, you end up with a monster rally. I learned long ago that bull markets don't rally 23% in a month off bottoms, bear markets do. So please do not confuse this bear market rally, which are always fierce, with the start of a new bull market because everything is OK again. As equities reprice the clarity that was just provided (whether you like the plan or not doesn't matter here), you must prepare yourself for a few future realities: more sour upcoming macro economic data reflecting the past three months of economic activity + spreading of toxicity to higher quality debt classes as more performing loans deteriorate + fed printing money to buy the government issued bonds to fund the incentives for the PPIF. So while this trillion dollar asset purchase plan works to rid one area of the banks balance sheet, trust me, other areas are still worsening! The fed & treasury's job now is to maintain order, limit chaos, and prevent global collapse. Well, we just saw their latest move. Don't think for a second that all these free lunches come with no strings attached.

It seems to me the goal of this plan is to just get private money into the market for residential mortgage backed securities that weren't trading. Why weren't they trading? Because the current bid in the marketplace was too low for banks (for what its worth, I am hearing that the banks are having a great quarter) to consider selling at; we know what happens when banks sell securities below their current marks, and the need to raise capital due to the writedowns. Enter the treasury to make the trade work.

Calculated Risk puts it best:

The key problem with the Geithner plan is that it incentivizes investors to pay more than market value for toxic assets by providing a non-recourse loan and with below market interest rates. The investors do not receive this incentive, the banks do. And the taxpayers pay it, so this is a transfer of wealth from taxpayers to the shareholders of the banks. The taxpayers will pay the price of the option in the future, the investors receive any future benefit, and the banks receive the current value of the option in cash. Geithner apparently believes the future value will be zero, and that is a possibility. If so, this is a great plan - if not, the taxpayers will pay that future value (and it could be significant).

Lower than market rates, financing provided by FDIC, use of leverage, and investors can buy assets with very little equity at risk; what a world! So, the public-private investment fund will buy the stuff that nobody wanted to raise their bid for in the free, open market last week? Okay. So lets use leverage, subsidies, and put most of the downside potential onto the taxpayer so that private money is incentivized to buy these bad assets that nobody seemed to want yesterday. Great, confidence seems to be restored and there is a market again for these securities. Nothing like artificially propping up a market when the bid is too low!

But what about the stuff that is considered GOOD on the books, and is not being traded in this program? Let us not forget that this plan is for the more toxic assets, the assets with no bid that were being held on the books of banks at much higher mark-to-model prices. Does this mean that ALL toxic assets are now transferred off the books, and all is well again? Candy canes and sugar cones? Doubtful.

Second, think about who this plan helps and who it doesn't. Are consumers really getting jobs, salary, and repaired balance sheets from this? I mean, did the economy just turn around on a dime because of this bad bank asset plan and the huge stock rally that came with it? Did households balance sheets just fully delever and get repaired? Did distressed sellers just get a solid bid at full ask and go into contract on their homes they have been trying to desperately sell? Did the mall landlord just fill all their empty spaces? Did the office complex owner just rent out their vacancies? Did those with massive credit card debt just wake up debt free? No, no, and no! So I ask you, what happens to the assets on the books that are considered good right now, but then start non-performing if the economy continues to struggle? Let's at least keep it real here and avoid the smoke & mirrors that this is a magic bullet to fix our ailing economy. The banks may be in better shape, but the household is not!

Via Steve Waldman:

Of course the whole notion of repairing bank balance sheet is a lie and misdirection. The balance sheets we should want to see repaired are household balance sheets. Banks have failed us profoundly. We want them reorganized, not repaired. A world in which the banks are all fixed but households are still broken is worse than what we have right now. Too-big-to-fail banks restored to health are too-big-to-fail banks restored to power. The idea that fixing legacy banks is prerequisite to fixing the broad economy is a lie perpetrated by legacy bankers.

Waldman also discusses the saving grace for bondholders of troubled banks' and why it is worth it to participate in this plan, and take a loss on one investment to secure that no haircuts are taken on bigger holdings. An excellent point and a great read.

Back to the point. Have we forgotten that this is a complete debt crisis that is quickly spreading to higher quality debt classes. It was only four days ago that Moodys came out and announced that they may downgrade $241 billion of securities backed by prime quality 'Jumbo' mortgages:

In a move reflecting widening stress in the U.S. housing market, Moody's Investors Service on Thursday said it may downgrade $240.7 billion of securities backed by prime-quality "jumbo" U.S. residential mortgages because defaults will be higher than they expected.

Moody's put on review for downgrade 4,988 tranches of jumbo residential mortgage-backed securities with a current outstanding balance of $173.3 billion, and an original balance of $240.7 billion. The securities are backed by mortgages issued between 2005 and 2008.

It said 70 percent of the 2005 senior securities will likely remain investment-grade, with the rest falling to "junk." Securities issued later may suffer deeper downgrades. Moody's also said subordinated securities from 2006, 2007 and 2008 transactions "will likely be completely written down."

I think we will end up seeing PPIP round two and maybe round three before all is set & done, especially if the first round only works to remove toxic subprime/alt-a assets held on books that were causing the arteries to clog up. What about jumbo-prime, lbo's, cmbs, credit card, helocs, option arms, cosi/cofi, auto loans, student loans, etc.. Do not forget the nature of this crisis (debt) and how many types of debt were securitized back when there was a market for these assets. And do not forget about the consumer balance sheets that are still distressed and comprise 70% of the US economy.

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