Friday, January 30, 2009

Goldman: Bank Rescue May Reach $4 Trillion (and "Bad Bank" Issues)

By Yves on Naked Capitalism:

Goldman, in a research note discussed at CNBC, says the total tab for the US bank rescue operation could run as high as $4 trillion:
The cost of restoring confidence in U.S. financial firms may reach $4 trillion if President Barack Obama moves ahead with a "bad bank" that buys up souring assets.

The figure far exceeds even the most pessimistic estimates of how great the loan losses might be because there is so much uncertainty about default rates, which means the government may need to take on a bigger chunk of bank debt to ease concerns.

Goldman Sachs economists said ideally the public sector would step in to remove the hardest-to-value assets, which would alleviate nagging worries about future losses and hopefully help get lending going again.

"Unfortunately, with an unprecedented meltdown in mortgage credit and a deep recession in the broader economy, there is a great deal of uncertainty about the value of almost every asset,"...

Goldman Sachs estimated that it would take on the order of $4 trillion to buy troubled mortgage and consumer debt. That number could shrink if the program were limited to only certain loans or banks, but it could also grow if other asset classes such as commercial real estate loans were included.

New York Sen. Charles Schumer has said that a number of experts thought that up to $4 trillion may be needed to buy the bad assets, an estimate that a Senate aide said was based on informal conversations with people in the industry.

Given the acute need the perps have for more dough, "informal conversations with people in the industry" are the functional equivalent of lobbying.

Now admittedly, Nouriel Roubini, who is both bearish and so far, quite accurate in calling the trajectory of the crisis, pegs total securities and loan losses at $3.6 trillion. But he has only $1.9 trillion of that with US firms, and his totals include unsecuritized loans, and appear to include commercial real estate loans, which the Goldman note excluded.

I'd love to know how anyone can defend a number more than twice as grim as Roubini's.

And even if one were to believe the Goldman figure, there is a practical problem: no way, no how is that much money going to be spent. We will limp along with a Japan style partial remedies. The US public will not stomach that level of spending on banksters in the absence of substantial spending for individuals hurt by the crisis. So you'd need to add a few extra trillion to come up with a remedy that looked fair, or at least not grossly skewed.

And we have a second set of possible issues with the Obama plans in the making, at least if the reports swirling around are remotely accurate.

A sketch of a plan has been circulating (I have seen this in print, and for the life of me, cannot track down a link) with $100 billion of TARP funds used to provide the equity for a "bad bank" that would buy dodgy paper, with another, say, $900 billion in loans from the Fed to give the new entity a $1 trillion+ balance sheet. Bloomberg tells us that the FDIC is likely to be put in charge. Reader Steve, who worked at the FDIC, isn't keen about the idea:
Anyway, the notion that FDIC should manage the thing is more than a little questionable, because FDIC has no experience managing sophisticated instruments (let alone derivatives), and the experienced credit hands have been gone from FDIC for years. I was told about a year ago that FDIC's bank liquidation group, which had numbered about 7,000 in 1992, was all of 200 people. So I expect that FDIC `management' will simply mean more business for Blackrock, GS, and Pimco, who will be `supervised' by a collection of sleepy FDIC functionaries. No doubt they will do `Sheila mods' while trading more complex government-owned assets as test cases for their own portfolios. To be blunt, FDIC and other regulators do not have the expertise to examine banks with sophisticated portfolios, let alone manage those portfolios themselves.

Of the billions in assets acquired by FDIC over the last year -- and most of those are simple credits -- how much has FDIC managed to sell? Seems to be zero; the only thing FDIC understands about liquidation these days is selling to private equity while retaining the quasi-totality of the risk.

Another element of the plan that has been mentioned sans much elaboration is that the bad bank would do loan mods.One theory we have heard is:
The bad bank hires laid-off mortgage brokers to refinance each homeowner with a mortgage that's been sliced and diced into exotic securities now sitting on the bad bank balance sheet. This is not feasible without owning a huge chunk of toxic assets, because claims on sliced-and-diced mortgages are spread all around the global banking system. Appraisals will be waived in situations of negative equity, and principal will be written down. This may include the homeowner granting the lender some sort of future ‘property appreciation right’ in exchange for a principal write-down.

Readers are welcome to correct me, but if I understand mortgage securitizations, this will not work (legally) in a significant portion of cases, one where the offering documents restricted loan mods. Note that there are three general types: no restrictions on mods, mods permitted up to a certain % of the pool, and no restrictions. Servicers do not appear to have done much in the way of bona fide mods (a payment catchup plan would not be what most readers would define as a mod, yet services include them in their reported level of mods), and it remains an open question as to whether the real issue is lack of incentives, given that some pools have no restrictions on mods (they get paid for the work involved in foreclosures, they do not get paid to mod).

So why won't this ducky plan work? Wellie, my understanding is that for those deals that have mod restrictions, to lift them requires the consent of at least a majority (in some cases 2/3 or 3/4) of the holders of EVERY TRANCHE in the deal.

US banks hold mainly what was once AAA paper due to its favorable risk weighting under bank capital regulations. The equity tranche usually stayed with packager, which in many cases was an investment bank. So the aggregator bank might wind up able to get a high enough percentage of those tranches.

But the intermediate tranches went to a whole host of players, and for subprime securitization, a lot went into CDOs. And from 2006 onward, most CDOs were sold overseas, often to not very sophisticated players (think German Landesbanken).

Now we'll see if this sort of "we can mod the loans because we'll own the securities" is part of the official plan. And if it is, one has to question either the competence or the intentions of the plan's architects.

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