Tuesday, September 30, 2008

It's Pouring

by CB

Do you want to know a secret…….?
Do you promise not to tell……………?

Sure you do, everyone wants to know a secret. So come closer……pull your chair in pundits……lean in talking heads……shhh………even closer politicians…….come closer and I will tell you a secret……….


You probably think it’s a Wall Street bailout too. It’s not.

I can understand your confusion, what with all the politicians and everyone in the press calling it a Wall Street Bailout. And the 2 guys running for President telling us that gosh, they’re sorry, they don’t like it, but they have to luke-warmly support the “Wall Street Bailout.” Timidly, and completely without leadership or suggestions to improve it.

The $700 billion rescue fund is actually called the Troubled Asset Recovery Program, but I think Henry Paulson and I are the only 2 people calling it TARP. Paulson, because he made it up, and I because I’ve spent a lot of time dealing with tarps. I like tarps.

Tarps are thin but they do their job. I’ve relied on tarps to keep me dry when camping, I’ve slept on tarps as a layer between my sleeping bag and the ground, and I’ve washed many an artist tarp, splattered with paint, after it’s fulfilled its role to protect the floor from permanent damage.

If it’s pouring rain and you don’t have a tarp, boy you sure wish you had a tarp. This time around, we don’t just need a tarp, we need a $700 billion financial TARP. So I wish that the people hauling out the TARP would spare a few spare minutes to explain to people what it is that TARP will do.

An explanation in exchange for $700 billion? That only seems fair.

TARP will be a fund, a ‘portfolio’ if you will. TARP will purchase bonds from financial institutions and hold them until the price of the bonds improve, or they default. TARP is buying bonds, not stocks. TARP will buy distressed bonds, paying something approximating fair market value to the financial institutions, which will be a price well below cost. (If the price is above fair market value then the financial institution needs to give up some equity. But that’s still being worked out.)

Sometime in the future, when TARP has worked and the financial community returns to normal lending, the economy will improve. When that happens, the bonds that TARP owns will be worth more than TARP paid for them. TARP will sell the bonds and any gain will inure to the Treasury. Meaning us, the taxpayer. Any bonds that mature while TARP owns them will also generate a gain for TARP (because the bonds were bought at a discount and they mature at full value.) Unfortunately, some bonds will default. If a bond defaults then there will be a true loss to the taxpayer. Hopefully, there will be more gains than losses, and the ultimate cost will be less than the $700 billion. Hopefully a lot less.

The same is true in the case of AIG, where the Treasury lent them $85 billion to stay in business for an orderly liquidation, providing time for the Treasury to break up AIG into pieces and sell those pieces. Hopefully, because the Treasury avoided a fire sale, the pieces will add up to something approximating $85 billion and we’ll get our money back.

It is also similar to the Bear Stearns case (another NON bail-out) where JPMorgan bought Bear Stearns for basically no more than the value of Bear Stearns’ headquarters and the Treasury promised JPMorgan that if Bear Stearns’ portfolio valuations fell further they would purchase part of the portfolio. A sort of pre-TARP.

In the $700 billion program, the financial institutions that will sell bonds to TARP are, with a few exceptions, banks and insurance companies. Commercial banks, like YOUR bank. And insurance companies, like YOUR insurance company. Technically, there won’t be any investment banks participating because there aren’t any investment banks left. The only remaining 2, Goldman Sachs and Morgan Stanley, converted to become commercial banks in order to avoid following the path of Bear Stearns, Merrill Lynch, and Lehman Brothers. Into bankruptcy, or close to it. Well done, Chris Cox, head of the SEC, regulator of investment banks! It’s a rare regulator who takes on a job only to run every single entity he’s regulating into oblivion.

But, if you want to know another secret, the investment banks got to that point because they were already required to write down their bad investments to something approximating fair market value. They’ve already had to face the music, and taken their losses.

I’m sure that in the past year, as you’ve been reading all the write-downs taken by investment banks, you’ve thought to yourself, “Hey – what about all the insurance companies? What about all the commercial banks? Don’t THEY own the exact same securities, and a lot more of them? How come they’re not reporting big losses too?!”

That was a good question!

It all has to do with everybody’s favorite topic, accounting rules! Sometimes, they give people choices, and sometimes they don’t. And sometimes, those choices turn into a noose and make every other entity afraid to lend to you. If I don’t know what a commercial bank’s portfolio is worth then I don’t know how much capital they have. And I can’t extend credit to them - I can’t lend them money. And if I can’t lend them money then they can’t lend anyone else money, including you. Eventually, when no one will lend to them they can’t satisfy their capital requirements or their depository requirements, and they can’t open their doors. They aren’t a bank any more. Ditto for insurance companies, and credit unions, and every single party in the highly interconnected financial web.

We’ve already seen it happen a few times, and the financial web has been able to tenuously endure. But it cannot sustain an unending succession of failures without the interconnections resulting in the complete collapse of all banks. To quote Harry Bailey and the building & loan, “You're thinking of this place all wrong. As if I had the money back in a safe. The money's not here. Your money's in Joe's house……”

We’ve complicated things since the simple Bailey Building & Loan. We’ve widened the web and created securities that rely on a complex models and take hours to value, but financial institutions still exist by borrowing money from some and lending it to others. That process cannot come to a complete standstill without dire consequences. In a shorthand example, Monday another bank failure, Tuesday another bank failure, Wednesday everything OK, Thursday ALL banks fail.

The Fed and the US Treasury have been trying to keep the web of inter-bank lending in place by stepping in to extend credit themselves. But they waited too long. And just offering banks a bit of cash does not solve the problem of valuations. It doesn’t answer - what is the value of the securities that financial institutions hold? It doesn’t assure all other institutions that valuations are sound, so it cannot foster widespread lending and bring about a return to normal lending practices.

To solve the problem of valuations there must be a market for the bonds that banks own that everyone is worried about. In order for there to be a market there must be 2 sides – a buyer and a seller. At the moment, we have no buyers. No buyers = no markets = no valuations = no one will lend to anyone else.

The credit markets, as they say, have ‘seized up.’ Like an engine that fails due to lack of lubrication. Or over-heating.

TARP will be the buyer. When you have buyers and sellers you have valuations. TARP will, in effect, be the buyer of last resort. (In this case, the buyer of only resort.) And by creating a market again, the credit markets can eventually return to normal.

We didn’t have to get here. They waited far too long, they didn’t remove the stigma of emergency borrowing from the Fed, and they didn’t fix the problem BEHIND the valuations. Which is that borrowers are unable to make their mortgage payments. They sat back and allowed the sub-prime mortgage problem to grow into a wider mortgage problem, and expected banks to manage their way out of it via highly expensive foreclosure and bankruptcies. What a waste of money!

So here we are. It could have been prevented; it wasn’t.

A rescue could have been initiated earlier; it wasn’t.

Billions – HUNDREDS OF BILLIONS - of dollars of losses could have been avoided. Industries like construction and manufacturing and shipping could have been prevented from slipping into recession. Thousands of jobs could have been saved.

Will there be an indirect benefit to Wall Street? Probably. As there will be an indirect benefit to other parties in the chain that became the mortgage crisis. Including real estate, construction, manufacturing, and every person that has an equity line of credit. But this isn’t being done to bail out Wall Street. It’s the necessary evil needed to avoid a financial meltdown. And it doesn’t help that simple explanations haven’t been forthcoming from those we elected or appointed to work on our behalf.

Finally there has been action. It is sadly, better late than never.

It is POURING. Bring out the TARP!

1 comment:

psi said...

while an accurate summary, this doesn't cover what we should demand as taxpayers for setting up a tarp- a buyer of last resort. This should not have happened. But now that it has, merely providing liquidity is only half a solution.
We should be asking ourselves fundamental questions about modern economics and complex financial instruments that allowed such a huge problem to remain opaque until it failed.
It's funny that bush mentioned a house of cards in his recent address. A poorly chosen metaphor politically,, but surprisngly accurate.