Friday, January 30, 2009

The Bad Bank: Mother of All Put Options

By David Gaffen on the Wall Street Journal MarketBeat:

The U.S. has transitioned to a new presidential administration, but it’s still grappling with the issues faced by the previous — how to buy, sell or process those assets that are sitting on the balance sheets of the nation’s largest banks. And the most recent proposal being floated — a combination of outright purchases of bad assets and insuring other bad bets — is sort of the world’s largest credit-default swap, with about as much clarity, too.

The current proposal combines purchases of the assets on the balance sheets of the nation’s largest institutions, along with the guarantee against future losses on other assets, and once again, it leaves investors grappling for specifics as the wheels turn slowly. “The administration is promising decisive action — this is very partial and not very good taxpayer value,” says Simon Johnson, professor at MIT. “It may or may not clear the assets depends on the scale but doesn’t provide capital directly to the banks.”

Mr. Johnson says that more needs to be known about the exact proposal — what assets will be insured, what will be purchased, and at what price. He testified this week before a Senate committee on the issue, and believes that patience in Washington is thinning with regard to a bailout for banks. He says that the government’s $300 billion guarantee of Citigroup in November was a bad deal for taxpayers, particularly in considering the government’s warrants to purchase Citi stock at $10.61 a share (it was lately at $3.70 a share).

Josh Rosner, managing director at Graham Fisher & Co., a financial-services consultancy, says the two-tiered plan has myriad problems, particularly because it allows troubled institutions to designate certain assets as those it will hold for maturity — and have the government insure those assets.

But some of those assets, such as whole loans and certain collateralized debt obligations, are likely to show rising defaults, and this does not allow those losses to be recognized. It’s no coincidence, he says, that the large banks sport stock prices that aren’t all that different from where they were in mid-November.

“Two months after the Citi wrap, we still don’t know what we’re on the hook for,” he says. “Look at at AIG, Citigroup and Bank of America stock since we entered into this arrangement — it hasn’t worked.”

Shares of BAC hit a 52-week low of $5.05 a share on Jan. 20; they were lately at $6.62 a share. An index designed by SNL Financial to track the share performance of participants in the Treasury’s Troubled Asset Relief Program, the SNL TARP Participants Index, is down more than 42% in the past three months, compared with a 9% decline for the Standard & Poor’s 500 stock index.

At this point, much is unknown, but it appears policymakers are still dancing around the issue. One of the repeated mistakes of governments and lending institutions over the past year-and-a-half has been to delay the inevitable — Citigroup and others elected not to mark down positions because of some fundamental belief that the market’s expectations were entirely too pessimistic. But this attempt to take a little from column A and a little from column B might fall into the same category.

“We don’t understand anyone’s reluctance, other than dyed-in-the-wool, scorched-earth ideologues, to have the banks start over with new capital,” writes Dan Alpert, managing director at investment bank Westwood Capital. “At first, the government’s, but in short time private capital, in lieu of taxpayers overpaying for assets at a price sufficient to support existing bank capitalization based on smoke, mirrors and overstated asset values.”

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