U.S. Government - The Mother of All Hedge Funds

On Monday, treasury secretary Tim Geithner announced an elaborate plan to get rid of current toxic assets on banks' balance sheets and once again create new ones. In this run to make quick fixes by the administration and congress, the US is losing credibility in the eyes of international investors.

The market was euphoric Monday and why wouldn't it be. Now the US government has officially joined the herd of hedge funds and in fact is pledging future generations to prop up institutions that would be much better served otherwise. Just a few days ago Ben Bernanke, the Fed chairman, was lamenting in front of congress that AIG was running a hedge fund and all problems at AIG were due to this. And now the 3 most important agencies of the government's financial system have joined forces to run the mother of all hedge funds.

The irony is that in these so called public-private partnerships, all the risk is borne by these important institutions. And we have to remember that in this rush for quick fixes, the government has finally pledged trillions of dollars. It's very unfortunate to see important people making hasty decisions that undermine the future security and prosperity of the whole nation. I wonder how these officials can believe that they will be able to pull off such gimmicks without the rest of the world noticing. Are they so stupid or are they just governed by their own whims and Wall Street's commandments?

First of all, any such scheme is bound to fail - that is guaranteed. Because if these assets are of any value (as so many people now, including the government, want us to believe) then why would banks get rid of them now? Banks can legally mark those assets and hold-to-maturity assets. There is no law that asks them not to do so. No new legislation is needed. FASB rules don't deny an institution the right to classify an asset as they want to classify it and if the intention of the financial institution is to hold them to maturity then no mark-to-market is required.

However, banks know that these assets are worth nothing. Most of the securities are complex securities which probably (if any) only their underwriters understood. Most of those people have since left. And covenants of those complex securities already made them under water. It does not matter whether you hold them to maturity or perpetuity. For other securities, banks will demand a high enough price to sell them to PPEs. Now, given that PPEs require only a 10 cents to a dollar investment from private partners for a 50-50 partnership, the remaining 90 cents risk is borne by the government. So a clever investor would immediately see the benfits. While private investors will make money (except when security goes to under 10 cents), the government will 100% lose money.

Here is the math: say they bought a security for 60 cents and finally, security went to its fair value, 1 dollar. In that case, a 40 cent profit will be split 20-20 each. While private investors made a 20 cent profit on a 10 cent investment, see how the government did. Our intelligent officials made a 20 cent profit on a 50 cent investment. All is good except when we bring in the leverage of the FDIC into the picture. The FDIC is providing the leverage of 6:1, where out of the $1, 50% is from the treasury. Considering government is treasury+FDIC+Fed, basically, the government is providing a 12:1 leverage. Most healthy banks would shiver at such leverage for an essentially all risk assets portfolio. When a portfolio has both good and bad assets then 12:1 might be manageable. But when you only have toxic waste then you want to be prudent before you leverage that much.

Consider a 20% failure on these securities; the government (again treasury+FDIC+Fed) will not recoup any money. It's a gimmick where three agencies are trying to fool international investors by deliberately fudging the who-holds-what clarity. These problems brought us here in the first place and now instead of private institutions, we have government playing that role. This plan was clearly pushed upon the government by people from Wall Street. So while a few investors will double or triple their investments, the US government will be in for a rough ride. But who cares about that anymore. This is the epitomization of greed on Wall Street.

The dollar is all set to tumble, and with it once again will come higher inflation for the American people. But for investors looking for opportunities, sell banks (BAC, C and JPM) and financial shares into the rallies. Any rally, until the government steps away from such gimmicks and concentrates on real long-term growth strategy, will be a good time to sell into it and take the profits. There are much better alternative plans that the government can focus on, but instead they are choosing to first have a quick fix and waste trillions. So if this continues, the US dollar will be a good sell against a basket of currencies, including the euro.

Disclosure: No position in any stock discussed here