The Hedge Fund of America, LP 19 comments
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If you are a regular reader of Seeking Alpha, chances are you are a sophisticated investor and will already understand the concept of this entry well. Yet as I talked to some of my investors around town (and listened to members of Congress!), I realized there were so many misconceptions about the mechanics of Paulson's proposed rescue package, I wrote the following to my clients:
The Hedge Fund of America, LP
After listening to Congressional testimony and speaking with investors, it is clear people are confused about Treasury Secretary Hank Paulson's $700 billion dollar plan to rescue the financial system. There are many details and nuances to be worked out, and success is in no way guaranteed. Below is a simplified discussion of how the plan is structured, and what the plan is trying to accomplish.
Many are mistakenly under the impression the government is planning on raising $700 billion and making some type of expenditure that gets vaporized into an ailing institution, leaving the tax payer with a "bill" of $700 billion. This is a categorically false understanding of the plan, both in mechanics and financial reality.
The US Treasury is planning on raising $700 billion so it can invest in high yielding mortgage backed securities [MBS] currently owned by our nation's financial institutions. This does not constitute an expense; it is an exchange of cash for an asset. Mortgage related losses on securities have eroded capital so as to make it more difficult for many banks to make new loans, which is why this crisis is potentially devastating to the growth and health of the economy.
If executed properly, the plan could: allow financial institutions to get mortgages off their balance sheet, (while taking appropriate write downs), free up capital so institutions can once again lend, and actually make money for tax payers. Make money you ask? Yes. Here is how.
The Treasury is in the highly desirable position of being able to borrow billions of dollars for ten years at a measly 3.75% (the rate on treasury bonds). Under the plan, the $700 billion would be used to purchase mortgage backed securities with potential yields of 10-15% or even higher, depending on quality. Even if the government bought the most toxic debt and collected a couple of interest payments, they'd be in the money. Taxpayers would participate in gains as well as the losses. Every hedge fund in the world would love to have the government's low borrowing advantage and the benefit of time. What's more, there are plenty of distressed, high yielding opportunities out there.
One should not conceptualize this as moral hazard, socializing losses or rescuing the "bad apples" that created the problem. This is more akin to the US taxpayer committing capital to participate in a hedge fund with a large structural advantage. There are many risks involved in a government venture such as this, but conceptually it is simple: borrow at 3.75%, invest at 15%, and pocket the difference on $700 billion. Simultaneously this plan provides much needed liquidity to reignite frozen markets.
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This article has 19 comments:
How does getting two interest payments of even 15%, less funding cost of 3.75%, less capital loss of 100%, get to be a good deal "in the money"?
Fuzzy math.
So, will it be purchased for mark-to-market?
For book value?
For purchase price?
Wake up America. Paulsen gets $700,000,000,000 to spend without recourse.
It's just wrong.
Your entrepreneurial culture of bootstraps and gumption and is as strong as ever. The will is there, but there is no longer a way.
The light at the end of the tunnel is the train coming at you.
Sic transit gloria.
The piece of the puzzle I have not heard is this: how is the government going to assure the stuff they are buying is worth what they are paying for it? If that can be assured, there's no problem with the deal, financially. It still does not assure that it will have the desired effect of restarting the private capital markets. I also don't see any reason to think the capital markets won't restart by themselves. In order for buying and selling to take place, there needs to be a way for buyers to assure themselves they are getting what they are paying for. That's the same problem the government faces.
Is it "conceptually simple" to just assume that when the Government buys a loan it will automatically be made whole and people will stop defaulting?
"Simultaneously this plan provides much needed liquidity to reignite frozen markets"
Knowing that Uncle Sam is ready with his checkbook to save the banks when they make a bad investment - is that the kind of credit market we want back?
No, the Texas Mafia has no interest in reforming the system, whether economically or politically, because "The Lord helps him who helps himself". I wouldn't hold your breath aiting for anyone in this Administration to (Heaven forbid) actually do something POSITIVE....
Such wholesale sales are great for the buyer, and this buyer has deep pockets. You will almost immediately see hedge funds wanting to get in on the action as the prices move up in successive auctions. Watch some stuff be sold immedaitely after purchase in some cases as the smart money will realize that the next sale will be at higher prices.
Thus the $700B credit line revolves and more than $700B in stuff can be moved from the banking system to other hands - hands other than the government as well.
The tax payers will win and win big as only the government can lend borrow at graet long term rates and hold for long term. The FED is the lender of last result, but the government is the buyer of last result.
But Hold-to-maturity is the price Bernanke said we should pay to takeover these assets. So, the plan is to deliberately over pay for the Banks mistakes.
Worse, the Bailout won't work. The Banks are not lending the cash they already have, why would they lend (even if they have more cash) if they are afraid they won't get re-paid? The Bailout plan is attacking the wrong end of the problem. Effective demand should be stimulated not the supply of cash. Money supply is the quantity of money times the velocity of money. Without effective demand, velocity will continue to fall.
absurd. Whatever is appropriated is down-the-drain.
Huh? 15% is annual coupon. 3.75% is an annual funding cost. After 3 years you get 3 x 15 = 45 less 3 x 3.75 = 11.25. or a gain of 33.75. And now you lose 100% of your purchase price on the toxic asset that yielded 15% on that purchase price.
back to math class, please.
Problem is many MBS and CDO have tranches that do not get even the 20% recoveries. Those go to higher ranked tranches --which of course will not be offered. The toxic subordinated tranches will of course be offered for sale to Paulson.