Tuesday, March 24, 2009

Washington Fiddles as Global Deflation Rages

From the Institutional Risk Analyst:

Below follow thoughts and observations on the Geithner/Summers public/private proposal to address toxic assets, at least as we understand it.

The managers of the private hedge and equity funds would put up 10-20% of the amount of the cost of the assets. Fed would fund the balance at sub-market rates, while the Fed and ultimately the taxpayer would assume the risk of any losses. And the investors look to get most of the profits. You can change the assumptions regarding asset performance or pay out rates, but if asset performance is as officialdom anticipates, then this plan is a monumental give away to the Sell Side dealers. Remember neither the managers nor the private investors are bearing any downside risk. Indeed, the Geithner Plan III represents a very cheap call option on the toxic asset pile.

As economist Dick Alford told The IRA: "The structure as described in the press is nothing more than the Fed, FDIC and Treasury providing some asset managers with calls on the upside--max loss equal to 3% of assets? When was the Fed or the FDIC authorized to sell or give away call options? I suppose that they will try to sell this as a non-recourse loan, but it isn't. It is an option… The investors would in effect be left with sub-market financing and ownership of much of the upside potential. The implied rates of return to the private side are staggering, especially given the absence of any downside risk."

Proponents argue that this plan will allow for "price discovery," but that kind of depends on the price you want to discover. The value of the "priced discovery" is very limited in the world of Washington, in part because the big banks refuse to admit that the true, economic value of many toxic assets is around $0.30 on the $1. Thus the price discovered will be a price premised upon no downside risk and guaranteed sub-market funding, all designed to help the bond holders of these banks avoid a haircut. If this is what Secretary Geithner calls a market based solution, then we may as well nationalize all the banks, flush private property rights and declare The Jubilee.

More troubling, the perception in officialdom is that many toxic assets that have been marked down dramatically ($0.20-0.40 on the $1) will continue to perform, and will thus continue to make timely payments. Secretary Geithner and Fed Chairman Ben Bernanke seem to believe that the economic value of these assets would, in "normal" market conditions, be upwards of $0.80 on the $1 of value. Thus we seemingly have a $0.50 per dollar difference between the theoretical price in the Geithner/Bernanke world and the $0.30 per $1 valuation in the markets today.

Illustrating the popular view that the financial crisis is "only" an accounting issue, an observer named "sourcethree" posted this comment on The Big Picture last week: "The change in the rules wouldn't have influenced the eventual outcome at Lehman, Bear, etc. because those firms did have too much in the way of real toxic assets that still would have overwhelmed whatever 'benefit' this evolution in the m2m rule would have meant to them… but it would help all banks more clearly define those assets that are toxic vs. those that are simply feeling the crunch of overwhelming selling/non-existent demand for non-credit reasons. Bank of New York is an example of what you're looking for - last quarter, they marked down their Alt-A MBS by $1.2 billion - they said even under their worst case scenario, the losses over time from these securities would only be $200 million - they even had a third party do a similar test and they came up with the same result - so, the difference here for just the last quarter was $1 billion and added to their already $6 billion in unrealized losses from prior quarters. Even if you doubt their assumptions used in their 'worst-case' scenario, the difference between the POTENTIAL credit impairment and the m2m loss they were forced to record was a factor of 6 TIMES."

But as we told the clients of IRA's Advisory Service last week, whatever relief that financial institutions and other residents of the hold-to-maturity world believe that they will receive through the modification of fair-value accounting and other official dispensation, they will lose through deteriorating economic fundamentals and falling cash flows supporting these assets as 2009 unfolds.

Or for those colleagues in the insurance world who thought they dodged the OTTI bullet propelled by fair value accounting rules, look for another projectile right behind it driven by economic factors, namely persistent deflation. As our friend Tom Zimmerman said during the last "Deflating Bubble" session hosted by AEI and PRMIA, subprime loss experience has peaked, prime residential loss rates are going to peak later in 2009 and commercial exposures will see loss rates peak in 2010. This Zombie Dance Party is just warming up.

The surprise facing Geithner, Bernanke et al is that by Q3, the true economic deterioration in many toxic assets will be clear for all to see. That $0.30 per $1 of face value bid that Treasury could hit today will be $0.15 per $1 of face value or less. The funds available today to deal with the financial crisis will be further dissipated. The opportunity cost to the Treasury of the Geithner/Bernanke do nothing approach to toxic assets will be enormous.

Speaking of poor fundamentals, when AIG released information about the amounts and recipients of roughly $100 billion of its government loans from September to December 2008, almost utterly unreported was the fact that the staid, boring, heavily regulated insurance businesses managed to run up losses on securities lending requiring $44 billion of government support.

By way of contrast, the credit derivatives widely blamed for bringing down the world's financial system were consuming $27 billion of support; municipal investment agreements (essentially, deposits) made by municipalities with AIG Financial Products took another $12 billion, and maturing debt took $13 billion. We wonder, just which unit of AIG lent the securities? What did AIG purchase with the proceeds of the securities loan? Could it be that the big story at AIG is the unsoundness of the insurer, not the credit default swaps? Why the misdirected coverage?

Our guess is that we are seeing an unholy alliance of insurance and bank regulators, who would rather point the finger at unregulated credit derivatives and support more regulation as the answer to everything. And don't forget the public officials who don't want people to wonder whether other staid, boring insurance companies that don't do credit derivatives might still have huge problems in their core portfolios. Since securities lending lacks the glamor of M&A or international "Master of the Universe" trading, the media is easily distracted.

After all, analysts have been sounding the alarm on AIG for many years, but it is difficult for the truth to penetrate Wall Street's managed version of reality. As we noted in our statement to the SBC, our friend Tim Freestone identified possible instability in the AIG business as early as 2001. AIG threatened to sue Freestone when he published his findings, which were documented at the time by the Economist magazine.

The Economist and Freestone stood their ground and Hank Greenberg and his lawyers eventually went away, but the markets took little notice. Notables such as Henry Kissinger questioned the Economist story and said "I just want you to know that Hank Greenberg has more integrity than any person I have ever known in my life."

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