Another rescue plan, another disappointment

Looks like I didn't post anything for a while. I suppose I'm busy...

Anyways, interesting stuff that happened:

A loop hole in the design of the bail-out to AIG, left in there because Treasury was worried about legal challenges, allowed AIG executives to take $165 million in bonuses. That has, conveniently?, given politicians in the US Congress the opportunity to jump on a "those greedy bastards" band wagon and pass a retroactive (IIRC) 90% tax rate on bonuses paid out in all institutions that received taxpayer funds. While I agree with the intention, I'm not so convinced about the means chosen to do so. I understand that this was the legally easiest way of doing it, but it does nothing for the underlying moral justification for forcing people to pay tax in the first place...

Of some personal interest to me has the decision by the Fed to finally go ahead with the direct purchase of long-term US treasuries. In order to buy the things, the Fed is printing money. So the policy has two effects: firstly, it injects more freshly printed cash into the economy (hopefully stopping the onset of deflation) and it pushes up prices of long-term US bonds and therefore pushes down real long-term interest rates (hopefully circumventing the problems in the transmission mechanism we're seeing at the moment). I think they've waited quite long to get this tool out of the box, but I agree with its deployment. The risk for the real US economy for the foreseeable future is a drawn-out deleveraging process that with it brings sustained price falls. That has to be prevented, pretty much whatever the cost.

Nevermind though, because the real news has been the final (for now) design of the banking rescue. The idea is as follows:

- Bad Assets on bank balance sheets have to be removed from there, which means someone has to buy them off the banks. But no one wants to have them, so there are no buyers and therefore no market that could tell us an appropriate price.
- A few months ago, in TARP MkI, Hank Paulson found that coming up with a price was a lot harder than he thought. While he and his team tried to figure out how to do it, the environment got a lot worse, and he switched ideas towards an equity injection strategy instead (which was subsequently bungled as well).
- So now Tim Geithner is back to the same idea, but rather than coming up with their own prices, they think they can create an "artificial" market to value the assets. Essentially, they are going to throw $100 billion into a pot and are asking private investors (such as hedge funds and distressed debt funds) to join in. They will then hold an auction, and so hopefully these private investors, subsidised with taxpayer funds, will go ahead and buy the assets.
- They then hope that everyone makes some money: the banks are relieved, and if the assets come back in value, the private investors (and their tax-paying backers) get to buy cheap and sell for much more.

That last one, in my opinion, is pure optimism. They're still treating this collapse in the value of assets (namely complex financial instruments ultimately backed by mortgages, but even physical assets, like US real estate) as something temporary. They seem to think that once confidence returns to normal, everything will be fine. And in that sense, the entire crisis right now is just a case of market failure, a temporary panic that will soon go away. Maybe someone's been spending too much time reading the final chapter of Keynes' "General Theory", I don't know. But it just screams naivety to me.

I'm going to put it out there that maybe the market isn't wrong now, but was wrong previously. Maybe these assets were so ridiculously overvalued that they will never come back to anything like the price banks paid for them. Maybe for some there just won't be anything like a liquid market ever. And if that is the case, these private investors are using the taxpayer subsidies to shift the problems from banks to their own balance sheets. That has the advantage of getting banks lending again (given some condition, see below), but means that now there are big private and institutional investors that end up with bad debts. Are we going to see the taxpayer being required to backstop those too? Indeed, will we see markets that shouldn't exist being kept alive artificially for the rest of time, by continuing use of taxpayer money?

As for that aforementioned condition, there is still the big problem Paulson faced months ago: The fair price of these assets is very low. But if the banks only receive a fair price for them, they are insolvent and by all rights bankrupt. The banks have to get a much higher price for them than their likely actual worth. So as part of the auction, things must be structured in such a way as to push up the bidding beyond a certain point - in effect either the subsidies must be so big as to shift all the upwards to some point (determined by who - by the banks?), or the auction process has to be designed to distinctly disadvantage the bidders. Hmm...I'm not sure I'd want to be in there.

And in other, rather less well-publicised news, apparently the US Treasury has taken the securities the Fed took on during its rescue of Bear Stearns by JPMorgan onto its own balance sheet. In effect, the US taxpayer has been burdened with another few billion dollars worth of potentially dodgy securities, quietly and under the cover of the bigger news. Wiki says that portfolio was down $2 billion in November '08 and I'd encourage people to find out where it's at now. Anyways, that wasn't exactly part of the plan as it had been explained to the public at the time...but I suppose the cynics out there always saw it coming, right?

Makes me kind of glad I pay my taxes here, as much as I disagree with them at times. :P

The markets don't like this stress-testing either

Ok, interesting...

http://www.businessspectator.com.au/bs.nsf/Article/SCOREBOARD-$pd20090224-PJS5Z?OpenDocument&src=sph
The markets had a bad day on Monday, they weren't convinced by the whole "stress-testing" thing either, it seems. Here's why:
http://www.informationarbitrage.com/2009/02/citigroup-the-difference-between-dramatic-action-and-drama.html

http://www.businessspectator.com.au/bs.nsf/Article/UPDATE-1-US-regulators-stand-ready-with-more-bank--PJJYZ?OpenDocument
http://www.bloomberg.com/apps/news?pid=20601087&sid=a94Scjej8WNs&refer=home
So basically once these stress-tests are done, the government money will be provided as follows:

1. The banks issue convertible preferred shares to the government.
2. If the stress testing shows a problem, the amount of needed capital is determined and that amount of these preferred shares will be converted into normal shares, with the main payment to the bank occuring at that point.

The idea is that the taxpayer only has to pay once there is a problem, and the convertible shares don't necessarily constitute a dilution of the common equity holding before then. As I said before, and everyone else seems to be saying, still no clear line on who is expected to suffer here. They act like a few hundred billion dollars worth of dodgy investments aren't out there to be paid for.

Speaking of which: http://www.bloomberg.com/apps/news?pid=20601109&sid=aGqIiR1PCrq8&refer=home
http://www.ft.com/cms/s/0/50bcd2cc-01e5-11de-8199-000077b07658,s01=1.html?nclick_check=1

http://www.businessspectator.com.au/bs.nsf/Article/21st-century-banking-$pd20090223-PHQCM?OpenDocument&src=sph
http://www.businessspectator.com.au/bs.nsf/Article/Banks-play-battleships-$pd20090224-PJS9G?OpenDocument&src=sph
I like these articles. I had been thinking about this sort of area (information asymmetry brought about by dodgy accounting rules as contributing to credit crunches) as a thesis topic, but I moved away from that a little bit.

Meanwhile, the real economy all over the world is getting more and more out of shape:

http://www.businessspectator.com.au/bs.nsf/Article/The-return-of-capital-controls-$pd20090223-PJ7FE?OpenDocument&src=sph
Eastern Europe is falling to pieces, there is talk about capital controls now to prevent currency collapses set to rival those of the Asian Financial Crisis. It will certainly be interesting to see how the EU reacts to that sort of thing - strictly speaking a lot of these countries are meant to be future members of the euro zone and are very important trade partners. Monetary policy in these countries is heavily influenced by Frankfurt (the seat of the ECB) and Brussels. If they don't do anything, or end up being blamed for anything, you would expect any prospects of European integration to slow down dramatically.

And as for the US, people are still struggling to grasp the seriousness, for the most part. "Black Swan" author Taleb is of course on the other side of that particular divide.

At any rate:
http://www.bloomberg.com/apps/news?pid=20601109&sid=aAZzcqBRclVE&refer=home
http://www.bloomberg.com/apps/news?pid=20601087&sid=aDhMMI9EMl5Q&refer=home
http://www.businessspectator.com.au/bs.nsf/Article/Macquarie-$pd20090223-PJ6AG?OpenDocument&src=sph

Weekend Stress

So, what's going on this weekend?

On by far the most important front, the US banking "rescue", we have some news about the form these so-called "stress tests" will take. The idea is that in order to make sure no one gets funny ideas about the banks possibly being insolvent (which they are) they have quick and proactive access to taxpayer funds whenever necessary.

http://www.businessspectator.com.au/bs.nsf/Article/UPDATE-2-US-bank-stress-tests-to-show-capital-need-PH358?OpenDocument
Of course the details are scarce at this point, just as all the details about the plan as a whole. The reason for that, I suspect, is that they have no idea about the details. The situation is dire: many banks (not all of them, mind you) have had the assets wiped from their balance sheets, and because they can't be allowed to just collapse and take everyone else with them, the government has stepped in to keep them alive. But that's hardly enough - now they are stuck in a zombie-like state with no choice but to try and bring their leverage ratios down: so grab as much cash as they can and hold on to it without taking many risks. The by-product of this is that they don't lend to anyone, and where there is no lending there is no investment and no job creation.

But so far the plan has been no different in design and execution from the ones Paulson put forward: Bad communication, no clear position on who will take the losses that someone is going to have to suffer and no urgency in actually making it happen.

At any rate, these stress tests seem to be meant to serve as an automatic stabiliser for banks that move towards the wrong side of zombie-ness, thus hopefully avoiding bank runs like the one that brought down Bear Stearns.

http://money.cnn.com/2009/02/20/news/companies/boa.merrill.reut/index.htm?postversion=2009022020
More details of the disgraceful way in which the Merrill takeover by BofA was handled are emerging as well. As some of you would have heard, Merrill CEO Thain and his top people essentially paid themselves billions in bonuses early in order to get as much money out of the banks' carcass as they could before selling it to BofA. That bank's CEO Ken Lewis it now turns out apparently knew of this scam and was happy with it, presumably because he wanted to keep as many of the talented Merrill staff on board as possible. As people have found in the past, combining investment bankers with their distant retail relatives tends not to work, with the former leaving in droves.

Which now means: Ken Lewis let Thain spent billions of BofA shareholder capital on a rather questionable cause. But I suppose that's okay...I heard that BofA is now worth less in terms of market capitalisation than the government money it already received, so in a way its main shareholders are the US taxpayers. And they're quite a harmless bunch, it turns out.

http://www.businessspectator.com.au/bs.nsf/Article/Foreclosure-fury-$pd20090220-PF5HT?OpenDocument&src=sph
The politics meanwhile continue unabated. The discussion on whether or not Average Joe should be bailed out of a mortgage they can't afford is probably not really that important from an economic policy perspective. Fact of the matter is that the US in aggregate was borrowing on a massive scale compared to their actual income, egged on by measures to mitigate risks (or perceptions thereof, as it turned out) and low interest rates. Even leaving aside the anecdotal evidence of questionable sales practices when it came to handing mortgages to people, I think we can safely say that the people caught up in the housing bubble on the buying side were probably no less irresponsible than those institutions who thought loading massive amounts of CDOs on their balance sheets was a good idea. And just as much as it hurts one's sense of justice to bail out a bank that should obviously be bankrupt, we might just have to bite the bullet and be pragmatic about the fact that any recovery is not going to be accelerated by tens of millions of bankrupt people who can never again get a loan for anything.

Of course, the question of whether an effective plan to deal with the foreclosures can actually be developed, given its linkages with the financial system, is an entirely different matter.

And as far as the next few years are concerned? Things aren't looking too flash to me. Stimulus packages tend not to be of much use if the banking system can't distribute capital normally, and so the apparent urgency with which the Obama administration pushed the thing through stands in stark, and inexplicable, contrast to the time they're taking to do anything about the financial system - and especially the lack of information on the progress they're making with it.

Maybe it's got to do with the fact that despite some of the recent rhetoric, the powers-that-be are still being too optimistic.

http://www.federalreserve.gov/newsevents/press/monetary/fomcminutes20090128.pdf
The Fed seems to think that we're looking at positive US economic growth in 2010. Apparently someone there thinks they'll get 4.5% that year! You have to wonder how some of these guys are appointed.

http://www.bloomberg.com/apps/news?pid=20601087&sid=aB0FYEQkR4Es&refer=home
And in a similar bout of optimism (hope?) Barack Obama wants to bring the US budget deficit down to 3% of GDP by the end of his term, that is in 2013. I'm not sure how that works...take a deep breath...huge financial crisis, 10%+ unemployment, a truly crappy healthcare system (which I believe he promised to expand to cover more people more cheaply at one point), two wars that aren't over yet and presumably won't be for some time (at least one of them, at any rate), a banking rescue, an auto rescue, a mortgage foreclosure rescue, investment in infrastructure and building a new, green economy.

Somehow I think getting out of Iraq and raising taxes on rich people isn't going to do it. I continue to be somewhat bearish on US treasuries over the medium to long term.

http://money.cnn.com/2009/02/20/news/companies/bank_failures/index.htm?postversion=2009022022
And just to underscore a point, people (equity research people, necessarily more optimistic than risk management research people) think we're looking at a 1,000 US banks failing over the next five years. They're small and medium-sized ones, not headline material, but it's hundreds of billions of dollars nonetheless.