TARP Passes - Now What?

With much anticipation and fanfare, the U.S. House of Representatives used most of last week to turn a $700 billion TARP proposal into an $800 million piece of legislation (see prior post “Ignore the $700B TARP rejection” September 29-08); the extra $100 million went to a variety of special interests and tax cuts. Think sprinkles on a chocolate sundae.

Now that Treasury Secretary Hank Paulson has his checkbook approved, let’s turn our minds to what impact his buying is going to have on the balance sheets of the very banks that Main Street thinks are being “bailed out” by this new legislation. If you watched Warren Buffett’s PBS interview on Wednesday, he intimated that Secretary Paulson might be able to buy $2 trillion face value of subprime “mortgages” for $700 billion. For those who want me to do the math for them, that would amount to $0.35 on the dollar.

Here’s a more plausible scenario, which doesn’t take away from what Mr. Buffett was saying:

Assume the Treasury buys $1 trillion of mortgages at face value from key domestic players;

Assume they are currently being carried on the books of BofA (BAC), Citigroup (C), Goldman Sachs (GS), JPMorgan (JPM), Merrill Lynch (MER), Morgan Stanley (MS), (PNC) and US Bancorp (USB) at $0.80 on the dollar on average;

If the Treasury spent the entire $700 billion on this $1 trillion portfolio, these banks would need to take another $0.10 write down, which represents $100 billion of new charges;

The aggregate shareholders’ equity of these eight institutions (rough estimate) is $590 billion.

If the above scenario plays out, these eight institutions will write off 17% of their share capital when they do their “toxic waste” dump on Uncle Sam. If we accept that this notional $1 trillion loan portfolio is currently being carried at $0.80, which seems low, for every one cent of new write downs on the $1 trillion portfolio these eight firms will be writing off 1.7% of their share capital.

Mr. Buffett wants Secretary Paulson to “pay market price” for these assets, and well below current carrying values. How else will the American taxpayer make money on this TARP program, as Mr. Buffett visualizes?

Think that a $0.10 discount wouldn’t float Secretary Paulson’s boat? How about $0.20? That would mean that these eight institutions would wipe out 34%, or $200 billion, of their collective share capital over the next few months.

If these eight institutions aren’t overcapitalized today, this math suggests that more equity will have to be raised over the next few months than has been cobbled together so far this year.

Even if that figure is overstated four times, this group (let’s call them the “Group of Eight”) still needs to line up another $50 billion of new equity in the wake of utilizing this so-called “bailout”. If it was like pulling teeth to get $5 billion from Berkshire Hathaway at 10% coupon with 100% warrant coverage, what’s the next round going to look like?

Secretary Paulson is going to have a terrible dilemma on his hands when he sits down to negotiate with the folks at Citigroup or Merrill Lynch. The better the price he gets for U.S. taxpayers, the worse the pain will be for the institutions in question. By selling a few securities into the marketplace to “test pricing” before the Fed pays “X,” how will anyone really know who is on the other side of the trade, validating the price that is being quoted?

If, as Mr. Buffett suggests, Citigroup wants to sell $100 billion of securities to the Fed, they may first have to sell $10 billion in the open market to find the clearing price. If one of the buyers for these $10 billion of securities is a member of the Group of Eight, won’t they be incented to overpay a snick so as to preserve the marks on their own books? And isn’t that exactly why it has taken a year for these chickens to start to come home to roost?

Mr. Paulson will want to get a good price for the taxpayer; that’s what Congress has been promised. But, weak banking institutions turn to the Federal Reserve for help. The lower the price Paulson pays, the more likely it is that the bank in question will have to raise capital in a brutal market. Or rely on the FDIC for help.

The real and perceived conflicts inherent in the process to come will be incredibly difficult to manage, even for men as talented and qualified as Messrs. Paulson and Bernanke.

Disclosure: None

Comments

[Steven Hansen:]

the banks can only sell to the fed at a price at which they are prepared to take a loss. if the price is too low the bank will destroy its asset base. this is the oppositions primary argument why this program will not achieve its intended purpose.

i have been converted to the nationalization of banks camp. this gets money (credit) flowing immediately, allows the government time to work the toxic crap off of the books, and costs literally nothing.

2008 Oct 05 09:29 AM

[PastTense:]

Paulson doesn't have any dilemma on his hands: he is going to ignore this additional fluff from Congress and do what he wanted to do: transfer the losses on the mortgages from the banking industry to the American people.

2008 Oct 05 11:05 AM

[Bob228:]

The plan will be revisited due to increased scrutiny and better focus. The goal will be restated as returning adequate capital and liquidity to the Financials. The economic costs will be paid by the Financials - not the taxpayer.

Paulson has neither the time or influence the change. Derived Investment Value (DIV) will be the asset pricing tool. That price, allocated loan losses, plus Preferred Stock/Senior Convertible Sub Debt (issued by seller/bought by Bailout) will equal original asset value/cost.

Warrants and monetized value in tax losses will act as kickers to the 'Bailout TARP'. Part of the Kicker Overage will be used by Congress to Fund a Homeowners Relief Fund Bill sponsored by Maxine Waters and Charles Schumer.

2008 Oct 06 08:14 AM

[xz1:]

Remember the "toxic" assets on banks balance sheet is already marked down significantly. Even if fed pays less that, there is not much room to go below, otherwise, it is meaningless to have this program. the most likely outcome is that we will see banks solely concentrated on toxic stuff vanishes by liquidation while well diversified unfortunately banks like GS and MS really benefit from the TARP.

2008 Oct 06 09:17 AM

[mediapro:]

I am inclined to agree with poster: The Hand.

SA had an earlier article by Diane Ritter that explained the pprocess for those interested in this more palatable solution:

seekingalpha.com/artic...

2008 Oct 06 04:15 PM

[elliot_mllr:]

This article emphasizes why the mark-to-market rule has been revised and may need further liberalization.

2008 Oct 06 04:17 PM

[Birdinhand:]

If the Fed's plan thaws the credit markets and the housing market begins to rebound, the motgage values begin to improve as house equities improve and as a result the mortgage back securities increase in value. Is this not what the Fed's plan is all about?

2008 Oct 16 11:54 PM