Do Paulson and Bernanke Really Understand What's Going On? 19 comments
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The latest proposal put out by the Treasury with the Fed's blessing really makes you question whether they understand the real problems plaguing the U.S. financial system: undercapitalization of commercial banks, trillions of loans outstanding and an inability of both households and corporations to afford the debts they have subscribed to. If the government adopts the plan and buys the assets for anything close to current market prices, the banks will still be undercapitalized, people still will not be able to afford their payments, and credit contraction, along with plummeting confidence in the financial system, will continue spreading.
The only way for the plan to have any impact is for the Treasury to buy the assets at enormous premiums. "Hey Citi (C), you know those CDOs that you have marked at 50 cents on the dollar and Merrill (MER) recently sold at 20 cents? Well, we'll buy them for three dollars". I'm sure taxpayers would be thrilled with that strategy.
Why are banks currently unwilling to lend money to people and to each other? Because they have very weak capital positions, believe every other bank is in a weak position, and perceive consumer lending as much more risky than before. Look at Bank of America's (BAC) balance sheet. It has $1.7 trillion of assets, and only $84B in tangible book value (difference between "real" assets and liabilities).
Analysts estimate that the bank may sustain $60B+ in losses on its loan portfolio over the next three years, which will make it fall below its regulatory capital requirement by $5B+ (taking into account profits that the company is expected to generate, which are by no means guaranteed).
Given the thin margin of error on its capital position, Bank of America is unwilling to underwrite any more loans that it perceives as risky. And this is the largest bank in the country! Imagine how much worse the positions of smaller banks are.
How does the current proposal help? Assume that the Secretary is right, and a lot of the illiquid securities are currently trading at prices below their intrinsic value – an assumption that some would argue against. For Bank of America, securities that may be purchased by the Treasury are: $8.4B in residential mortgage securities, $10.2B in leverage loans and $2.2B in monoline securities (insured by financial guarantors). That's a total of $20B.
The bank has taken some marks against those, and let us assume generously, that the Treasury buys those securities at a 10% premium to their current value on the books. But that's only a $2B addition to Bank of America's book value, which will barely do anything to improve its capital!
In addition to $20B of securities, Bank of America also holds one trillion in loans that it has made out to businesses and consumers. This is where analysts expect the $60B+ of losses to occur.
However, the bank will not be willing to sell its non-securitized loans because according to regulation it can keep marking down its loan portfolio gradually, while in case of a sale it will take down an instantaneous hit by marking down the portfolio by the total expected loss. Not to mention that Treasury's $700B will simply be not enough to buy the loans of Bank of America alone.
The impact of the Treasury's proposal is larger if we look at other top banks, but not by much - Citigroup has ~$80B of similar securities exposure, and JPMorgan Chase (JPM) has ~$30B. So the biggest beneficiary would be Citi, the bank that pursued the most reckless practices. Even then, however, Citigroup's gain is at best under $10B – which is an insufficient improvement to its capital.
So why does purchasing these risky securities help the banks relatively little? Two reasons:
1) Because they are not the ones holding most of them! OECD estimates that there is about $3,000bn invested in collateralized debt obligations (CDOs – the most impaired security type in the current market) of which hedge funds have $1,400bn of exposure, banks $750bn, asset managers $565bn and insurers $300bn. And among the "banks" are included many foreign banks.
FDIC states that U.S. banks hold $1.1TR of mortgage-securities, while the total number outstanding is $5.3TR (according to IMF Financial Stability report). That means that the people who stand to benefit the most from asset purchases are hedge funds, which have little role in improving lending conditions for our economy, while the banks will remain in the dire capital hole they were in before.
2) Because most of the losses that will be incurred are not on the subprime securities of which there are only $1.5-1.8TR outstanding according to the IMF (and assuming 20% losses, that means $300B in losses, most of which have already been written off by the banks), but on $20TR of non-subprime mortgages and corporate loans/debt, which even assuming an optimistic 5% cumulative losses leads to $1TR in credit losses. The Treasury's puny $700B budget can't even put a dent in the market for these assets.
So what is to be done? Two steps that were used very successfully seventy five years ago:
A) Creation of an institution similar to the Reconstruction Finance Corporation that invested in the preferred stock of financial institutions. A new version would buy preferred shares in U.S. banks, thus improving their capital cushions, increasing confidence in the banking system and allowing lending to resume.
As for the size of the fund, a sufficient investment in our previous example, Bank of America, might be $30B, and given that Bank of America accounts for ~10% of total U.S. deposits, a $300-400B overall investment would be enough to cover the entire U.S. banking system.
That $300-400B will go much further than the $700B Paulson is proposing, and instead of the US taxpayers owning toxic assets of uncertain value, they would own a stake in actual viable institutions. Existing shareholders will be punished through a dilution of their stakes, and the government could exercise direct control over the pay packages of executives that contributed to this dire situation
B) Creation of an institution similar to the Home Owners' Loan Corporation that can purchase individual loans from the banks at a discount and restructure those loans before homeowners file for bankruptcy, by reducing the mortgage payments and overall mortgage value. While some families will still file for bankruptcy, this institution can reduce the number of foreclosures (that is expected to be upwards of 6 million over the next several years), keep the families in their homes and prevent further declines in house prices as millions of foreclosed properties hit the market.
The financial situation is difficult, and we have to act quickly, but we cannot allow the Treasury to scare us into a plan that will only compound this country's troubles in the long run.
Disclosure: None
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This article has 19 comments:
Poor people not affording homes is their problem....not the markets. Most people in Europe cannot afford homes, Why should we infringe on some people's rights to enhance the life of others?
When did people expect they should get everything just because they have a heart beat?
I also get the feeling Secretary Paulson, a long time Wall Street insider, is asking for $700bn to rescue his friends and is fighting to keep any of that bail out money from reaching hands of ordinary Americans. A financial bail out might be necessary, but it stinks.
And if he does manage to funnel that money into the hands of his Harvard buddies, we'll soon get back to business as usual. As soon as home values recover, you can bet they'll succumb to greed and stack debt on debt to make money and loan it back to us with interest.
I support what I hear coming out of congress. We need to keep folks in their homes and rescue the housing market, specifically. And, almost as an after thought, we can help bail out the financials. They need it, and they need oversight.
Speaking of oversight, I heard it called archaic and out dated. It might be, but we have oversight folks, and I include everyone's pal Mr. Greenspan among them, actively turning a blind eye to the phenomenal money created. What is not outdated is the obligation our oversight has to prevent such crisis. As long as times are good, no one raises any red flags.
So, rebuild some insight, keep tax payers in their homes and toss a little money at the financials. But more importantly, we need a structural change to get away from the excessive greed that got us here to begin with. We need to get back to fundamental money supply and stop creating paper promises based on asset values.
And no golden parachutes funded with tax payer money for folks who are already rich. In fact this problem is so great, they have staggered not only the US economy but the world economy, their actions boarder on treason. Jail time would be appropriate for some.
And to hear Obama blame Bush is simply idiotic political rhetoric. This problem has been in the works through many administrations and legislatures, both Rep and Dems, for a great long time. Decades.
Perhaps you can clarify where credit default swaps enter into all this. Wasn't all this bad paper insured against default? Who, other than AIG sold the insurance? How is it possible that the notional value of the insurance far exceeds the total amount of debt? Does a seller of the debt keep the insurance, and then the buyer buys a new insurance on it? Or when they repackage the loans do the buyers of the loan package buy new insurance? Or? Do insurance sellers know they are selling more than one insurance coverage on a loan?
Did you see Krugman's take on Paulson's plan? Krugman says we should demand equity ownership in the institutions from which we buy the debt. Makes perfect sense. If the intent is to free up credit, by improving the equity positions of the lending institutions, then pour equity capital into them. This also does more to resolve the deleveraging paradox (where everyone is deleveraging, which deflates asset prices, which worsens everyone's debt to equity ratios).
Will rescuing the financial institutions help the housing problem? I don't see how. Those who are qualified to get home mortgages already can through Fannie Mae etc.
Did you see where Microsoft is going to borrow, using commercial paper, to help fund the purchase of $40 billion worth of their shares? That really helps the credit crunch and the economy, doesn't it? So they don't see any avenues for expansion? Worried about the value of management's stock options are they?
The situation in fact varies widely from country to country. In the UK around 70% of housing is owner-occupied; whilst this country doesn't have the subprime issues afflicting the United States, it does have the same overinflated house prices pumped up by a government that wants consumers to feel rich, borrow more than they can afford, and keep the economy - and the financial system - growing (no matter how narrowly focused that growth is). Ireland and Spain also have high rates of home ownership, and each are also on the cusp of the same housing meltdown now affecting the UK. In the case of Ireland the problem lay in joining the EUR and applying interest rates set primarily with Germany in mind and far too low for the Irish economy. As for Spain - think Las Vegas and you'll be on the right track.
On the whole, German-speaking countries have avoided these excesses, in large part because they have barely been infected by the idea of residential property as an investment rather than a roof to live under. There are exceptions of course (e.g., Berlin apartments and Swiss resorts), but on the whole the generalisation is true. Switzerland, for example, has had no housing bubble outside the ski stations, and even senior corporate and banking types are quite happy renting because that's part of the culture.
I just haven't bought into the solvency argument. I see it as a liquidity problem. Money created through mortgage backed derivatives is now fast disappearing. Most of the money floating around the world is fiat money. Imagine if the entire derivative market failed.
I get the feeling Paulson wants to buy up he bad debt to pump money into the banking system so we can continue down the road of excess consumption. Get back to business as usual. I think that's a mistake to rebuild the house of cards.
The "alternative" Paulson speaks about is depression. I think congress understands this but just won't use the "D" word.
To User 207572: as I mentioned, Treasury's $700B budget comes nowhere close to covering the universe of assets that are becoming impaired.
To ksh: unfortunately I don't believe the Congress understands this alternative. In a rush created by the administration, Paulson & Bernanke, Congress had little time to listen to any other opinions.
To Asbytec: I hope you're right and it is a liquidity problem. What makes me doubtful is that is how Bernanke has been tackling it so far, exchanging half of Fed's balance sheet for suspect assets, but conditions have kept deteriorating, with lending declining and spreads continuously widening.
To the social scientist. A lot of the paper is theoretically insured both through financial guarantors like Ambac and the CDS markets. However financial guarantors seem to be practically insolvent at this point and the extent of CDS coverage is unclear. We know AIG wrote CDS on ~$450B of senior CDOs straight-up, but most other firms, for example Lehman, would have offsetting CDS exposures, which is why traders from other banks had a frantic Sunday two weeks ago trying to reconcile those offsetting positions. So the notional of CDS market is $62TR, of which Lehman accounted for $2TR, but net is much smaller. AIG did not have offsetting exposures though, so if they defaulted, people who bought insurance from AIG would have to mark those assets to market.
CDS would not apply to the assets that the government purchases, because the selling bank can't just pass the contract along with the asset. However the financial guarantors obligations do apply, so if those guys magically recover, the government losses should be smaller
I did see Krugman's several articles on this and agree with his assessment - hope he can get heard by people on the Hill.
Saving the financial institutions will theoretically help housing indirectly through propping up other lending lines which will not let the economy slide into a very deep recession (as it seems all but certain that were are sliding in one)