Monday, March 23, 2009

Toxic Asset Bailout

Denninger has a very troubling concern about today's proposal to cleanse banks of toxic assets.

It works like this: Bank A pretends that it has $150 billion in reserves against which it is allowed to loan money. However, $100 billion of that are so-called "toxic assets"--Securitized mortgages backed by highly suspect Credit Default Swaps, for example. This $100 billion it claims to "have" in these mortgage holdings are actually worth about $20 billion on the open market, but it can't sell them for that because then it suddenly has only $70 billion in assets, which makes it over-leveraged on its existing loans, unable to make new loans, a target for an FDIC takeover, etc. But now, with the new cleanse program, it can form a new entity to bid on its own assets--a subsidiary that offers to pay $80 billion, say, for the $100 billion in securitized mortgages. The government, under the new plan, puts up a significant chunk of this money and guarantees the rest, so the bank's exposure in paying $80 billion for $20 billion in assets is actually only $5 billion or so. So the bank sells the assets for $80 billion, plans to write off the remaining $5 billion as a loss, and transfers the worthless mortgage-backed securities to the taxpayer...

Translation: disguised bail-out.

All of this is well and good (albeit potentially highly inflationary) until people stop buying US treasury debt. China claims that it will continue to buy US debt, but this will be yet another case of actions speaking louder than words...


Jeff Vail said...

Comment from Mish Shedlock, another financial blogger:

"The Government has agreed to finance 93% of the loan, and it is a no recourse loan. This provision is in place for one reason only: To insure that investors overpay for bad bank assets, at taxpayer expense."

nick said...

I have a feeling there is going to be a revolution if things become any more transparent. There has to be a limit to what people will put up with and such blatent corruption is becoming very noticeable

Jeff Vail said...

I don't think people will actually revolt unless there is a sudden realization that the dream of perpetually increasing material consumption--what all these government programs are implicitly selling--is a fantasy. That might happen, but I'm not counting on it. I think the ability of the political machine to package itself in an acceptable manner exceeds the ability of the masses to broadly see through this facade. More likely, in my opinion, is a slow, grinding reduction in the overall size of the pie and a simultaneous increase in the relative concentration of wealth among a few...

Ryan said...

Borrowed heavily from Daniel Gross:

Nobel Prize-winning economist Joseph Stiglitz said the plan "amounts to robbery of the American people. I don't think it's going to work because I think there'll be a lot of anger about putting the losses so much on the shoulder of the American taxpayer."
Geithner’s plan is designed to benefit professional investors: It provides them with lots of easy credit, limits their losses, and allows them to reap a disproportionate chunk of the benefits if the investments pan out. This will be a boon to outfits such as the Blackstone Group and big hedge funds. But it will not be much of a boon to people like me in the sense that taxpayers are assuming too much liability. I would actually be interested in participating in the plan as a private investor, like many of my friends and colleagues, and other small-account holders. But there is no easy way for us to participate in the plan, and that's a shame.
The design of the Geithner plan reinforces the notion that there are two sets of rules in the market, one for the really big players (matching investments, generous loans) and another for small investors and homeowners (expensive bailouts and foreclosure).
If we taxpayers are going to be financing something close to guaranteed returns for hedge funds and private-equity firms, why can't we get in on the sweet deal that's being offered to Wall Street? Why can't we buy the distressed assets the same way hedge funds will? If we think creatively, we can find a way to enable this.
As Matt Yglesias points out, at least part of the Geithner plan envisions the participation of mom-and-pop investors. The fact sheet says that for the "legacy loan" program, the less-leveraged component aimed at encouraging investors to buy loans from banks, "the participation of individual investors, pension plans, insurance companies and other long-term investors is particularly encouraged." But the "legacy securities" program, the more-leveraged version aimed at encouraging investors to buy mortgage-backed securities and other instruments from banks, does not mention allowing individual investors to participate.
Given the size of the assets involved and the structure of the investment-management industry, it's likely that only wealthy institutions and institutions that serve only wealthy individuals—hedge funds, private-equity firms, etc.—will be bidding on these distressed assets. Individual investors generally don't have the tools to analyze the securities and assets for sale. Banks such as Citi will be eager to sell off their junky assets in chunks of $50 million, not in chunks of $5,000. Bailouts and the unwinding of bubbles are necessarily wholesale operations, not retail ones.
But it wouldn't be hard to arrange for small investors to participate in the bailout. The government could partner with investment-management firms—especially well-regarded investment-management firms such as Vanguard and TIAA-CREF—to create mutual-fundlike vehicles in which individuals could invest as little as a few hundred dollars in the effort to stabilize the banking system. The feds could even offer such an investment as a check-off on tax returns. Or we could present it as an allocation choice for federal employees' retirement accounts. Legacy loans and legacy assets could be offered as an option for state-sponsored 529 college savings programs, in which investors typically commit to lengthy holding periods. Or they could be made part of the universal savings accounts that Obama supports.
Yes, there's risk involved. And there is something circular about this arrangement. We'd be lending money to ourselves to buy stuff that the government would probably end up owning anyway if we didn't buy it. But I'd rather lend my tax dollars to help ALL AMERICANS profit from the financial disaster than lend them to Blackstone Group CEO Stephen Schwartzman to help him profit from it.

Jeff Vail said...

No one will profit... It's just a transfer of debt that allows banks to eliminate their hidden losses by transfering them to the taxpayer. Profit would only be possible if we ignore the energy reality and find a way to keep growing financial wealth decoupled from energy reality...

nick said...

I think I see your point. A frog being thrown into a boiling pot of water will reflexively jump to safety, where as a frog slowly being boiled in a pot will be killed before it knows its too late. As long as TV shows like american idol hold peoples attention, the vast majority will be slowly boiled alive.

Ryan said...

Taleb weighs in...

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