Tuesday, March 31, 2009

Fed Takes Lead Role in Executing ‘Stress Tests’ of U.S. Banks

Posted on Bloomberg by Craig Torres and Lizzie O’Leary:

The Federal Reserve has taken the primary role in determining how much new capital the nation’s biggest banks need to weather the economic slump, people familiar with the matter said.

Putting the Fed in charge may help ease concern that different assessments by different agencies would lead to some firms being judged less strictly than others. Treasury Secretary Timothy Geithner has said he anticipates the results, due at the end of April, will result in “large” capital needs for some companies, offering investors a way of differentiating between weaker and stronger lenders.

Fed examiners are deployed alongside counterparts from three other agencies that oversee parts of the 19 banks that are involved in the so-called stress tests.

“You could argue this is a systemic risk issue and it is good to have another regulator step in and assert a uniform set of standards,” said Kevin Fitzsimmons, analyst at Sandler O’Neill & Partners LP in New York, and a former bank examiner at the Federal Reserve Bank of Boston. “The Fed has its hands on every institution that is a holding company.”

All 19 of the firms under scrutiny, from American Express Co. and GMAC LLC to SunTrust Banks Inc. and Citigroup Inc., are bank holding companies, giving the Fed an overarching role.

‘Consistency’ of Tests

Geithner unveiled the stress tests on Feb. 10. They were billed as a comprehensive set of standards for the financial system’s most important banks, regardless of their regulator. He stressed “consistency” and “realism” in congressional hearings that week.

While U.S. regulators don’t intend to publish the details of their stress tests, the results will effectively become known once it is determined how much capital each bank is required to raise. Under the terms of the February plan, firms will be given six months to raise the funds either from private investors or the government.

The tests are designed to mesh with the administration’s effort to remove distressed mortgage assets from banks’ balance sheets, which have hampered lending to consumers and businesses. Officials aim to have the first purchases of the toxic assets by private investors financed by the government within weeks of the conclusion of the capital-need assessments.

“Banks are going to have an incentive” to sell their devalued assets because they want to “go raise private capital from the markets,” Geithner said in an interview with NBC’s “Meet the Press” March 29.

Price of Assets

Still, it’s unclear whether most of the big banks will be willing to sell loans and securities at prices that may be below the current valuations on their balance sheets.

Bank of America Corp. Chief Executive Officer Kenneth Lewis said in a Bloomberg Television interview March 27 that the pricing of the assets is “going to be the key” determinant of his bank’s participation.

Citigroup CEO Vikram Pandit told reporters after a group of bank chief executives met with President Barack Obama March 27 that “we want to do whatever it takes” and work with officials “to promote a recovery.”

All of the 19 banks are bank or financial holding companies, according to the Federal Deposit Insurance Corp.’s Web site. Some of them have units overseen by the FDIC, Office of the Comptroller of the Currency and Office of Thrift Supervision.

OCC spokesman Kevin Mukri referred to prior Treasury statements noting that federal supervisors would coordinate in the tests.

OTS Ouster

Geithner removed OTS Acting Director Scott Polakoff last week amid concern about how the agency handled accounting for capital raised by banks it oversaw. John Bowman, the deputy director and chief counsel, was named acting director, becoming the third OTS chief so far this year.

The OTS failed to uncover “unsafe and unsound” practices at Pasadena, California-based IndyMac Bancorp Inc., an audit concluded last month. The Treasury’s inspector general disclosed on Jan. 30 that the OTS permitted IndyMac and four other unidentified lenders to improperly backdate a capital infusion, which helped them avoid regulatory restrictions.

“If these stress tests are going to be meaningful, as they should be, then banks are going to require more capital,” Patrick Cave, a former Treasury official who is now chief executive officer of Cypress Group LLC, said in an interview on Bloomberg Television. He added that the administration is right to pursue a “tough love” approach to any further assistance.

Economic Projections

Regulators’ assessments are based on two scenarios for the economy. The “baseline” forecast projected a 2 percent economic contraction and an 8.4 percent jobless rate in 2009, followed by 2.1 percent growth and 8.8 percent unemployment in 2010.

The “alternative more adverse” scenario had a 3.3 percent contraction in 2009, accompanied by 8.9 percent unemployment, followed by 0.5 percent growth and 10.3 percent jobless in 2010.

The Treasury estimates it has about $135 billion left in the $700 billion financial-rescue fund enacted in October. Banks who already received government funding also could get a capital boost if the Treasury agrees to convert its preferred shares into common equity. Obama administration officials haven’t said when they may need more rescue money and ask for congressional authorization.

PM tells Canada’s banks to expand overseas

In the Financial Times by Julie MacIntosh, Francesco Guerrera and Bernard Simon:

Canada’s banks should capitalise on the relative strength of their balance sheets by acquiring assets in the US and other countries, Stephen Harper, Canada’s prime minister, told the Financial Times on Monday.

Canada’s leading banks have stayed profitable and maintained dividends throughout the collapse of financial markets in other developed countries. Five of them – Royal Bank of Canada, Toronto-Dominion, Bank of Nova Scotia, Bank of Montreal, and Canadian Imperial Bank of Commerce – now rank among the 50 largest banks in the world.

Mergers between struggling global banks have been scarce, aside from those forced by governments, because few institutions have stayed strong enough to position themselves as buyers.

Mr Harper indicated Canada’s banks could lead an eventual charge toward consolidation, and said he would support such efforts as “an opportunity for Canada to expand its role in the world financial sector”.

“I’m not going to try running banks, but I hope our banks will see this as an opportunity to build the brand – the country’s brand, their own brand – and to expand their scope and profitability over time,” Mr Harper said. “I can assure you that the steps we’re taking in the financial sector will not be designed to promote greater protectionism.”

Several Canadian banks have a US presence. Toronto-Dominion sold its US TD Waterhouse brokerage operations to Ameritrade in 2006 in exchange for a stake in the new company. It took control of Banknorth in 2007, and bought Commerce Bank in 2008. Bank of Montreal owns Chicago-based Harris.

Mr Harper said he was frustrated some countries had loosened regulations that might have prevented the need for intervention in global banking systems.

“In the name of conservatism or free markets, in some cases, governments ignored very fundamental lessons we knew from history,” he said.

“Canada itself has shown that if you have a reasonable system of regulation, there is no need for governments to be nationalising banks and directing executive compensation and trying to micromanage economic activity,” he said.

“One could say we were over-regulated, but our solution is going to lead to us having the most free-enterprise financial sector in the world. We’re the only one not nationalising or partial-nationalising or de facto nationalising.”

Still, Canadian banking shares have suffered from scepticism over whether banks can maintain their dividends.

The potential for Canada’s banks to suffer a disadvantage against government-supported institutions was a “very real worry” in the short term, Mr Harper said, but not a long-term concern.

“I think in the longer term this government intervention in the final sector, if it’s not unwound, will lead to politicisation of the sector and poor management. I just don’t think government-run or . . . partially run banks are going to be very effective institutions over time.”

A Fix for Geithner's Plan

From the Washington Post by Lucian Bebchuk:

With the world's attention shifting to London and the upcoming Group of 20 summit, it's possible that the Treasury's proposal for dealing with banks' "troubled assets" will become old news. It shouldn't. The administration plans to provide as much as $1 trillion to privately managed funds that will buy troubled assets, which is indeed the best way for jump-starting this market. But it is important to add to the program a mechanism that would prevent excessive subsidies to private parties and keep costs to taxpayers at a minimum.

The first government plan to purchase banks' toxic assets, put forward by then-Treasury Secretary Henry Paulson, was withdrawn after objections that Treasury wouldn't be able to value the assets. In a white paper issued last September, "A Plan for Addressing the Financial Crisis," I proposed using privately managed and competing funds as an alternative and argued that such funds would better set prices for these sorts of assets. (See also Bebchuk's more recent "How to Make TARP II Work" working paper.)

The program that Treasury Secretary Timothy Geithner announced last week will lead to the creation of such competing funds. It is structured to produce a market with a significant number of potential sellers facing a significant number of potential buyers.

But while the program is intended to partner public and private capital, the partnership it sets up is quite unequal. As things stand, the private side -- the private manager and investors possibly affiliated with it -- would capture 50 percent of the upside but would bear a disproportionately small share of the downside, contributing as little as 8 percent of the fund's capital.

Treasury officials believe that because private parties have not thus far established funds dedicated to buying troubled assets, favorable terms are needed to induce their participation. This logic is reasonable, but it is important to keep the government subsidy at a minimum. Without any market check, the terms set by the government could substantially overshoot what is necessary to induce private participation and end up imposing large and unnecessary costs on taxpayers.

A program of public-private funds should be designed to minimize costs to taxpayers. To attain this objective, the government should base the terms of participation on a process in which private managers compete to be in the program.

If the private side were to contribute only 8 percent of the capital, the government should seek to keep the highest fraction of the upside that would be consistent with inducing such participation. To this end, potential private managers would submit bids indicating the minimum share of the fund's upside that each manager would be willing to accept for an 8 percent investment, as well as the size of the fund that the manager would establish if accepted into the program. Treasury officials should then set the share of the upside going to the private side in each of the funds under the program at the lowest level consistent with establishing funds that collectively have the aggregate target capital.

Alternatively, assuming that the private side's share of the upside is fixed at 50 percent, the government should seek to get the largest possible contribution of private capital. Under this scenario, managers would submit bids indicating both the size of the fund each manager would establish and the maximum fraction of the fund's capital that the manager would commit to raising privately in return for 50 percent of the upside. Based on the bids, the government would set the fraction of capital provided by the private side at the highest level consistent with establishing funds that have the target amount of aggregate capital.

This second scenario would not only keep the government's subsidy at a minimum but would also induce the largest amount of private capital, thus conserving some of the government gunpowder that the program's current design would use. Because many banks might well remain undercapitalized even when their assets are valued fairly, restarting the market for troubled assets won't make these banks healthy; rather, it will make clear the need to recapitalize them and might require the government to inject substantial sums of additional capital.

Establishing privately managed funds that are financed with both private and public capital offers the best approach to restarting the market for troubled assets. Adding a market mechanism for setting the level of government subsidy is necessary to reduce the program's cost to taxpayers and would leave the government with the most ammunition for the tasks that still lie ahead.

Monday, March 30, 2009

AIG Was Responsible For The Banks' January & February Profitability

Posted on Zero Hedge by Tyler Durden:

Zero Hedge is rarely speechless, but after receiving this email from a correlation desk trader, we simply had to hold a moment of silence for the phenomenal scam that continues unabated in the financial markets, and now has the full oversight and blessing of the U.S. government, which in turns keeps on duping U.S. taxpayers into believing everything is good.

I present the insider perspective of trader Lou (who wishes to remain anonymous) in its entirety:

"AIG-FP accumulated thousands of trades over the years, all essentially consisted of selling default protection. This was done via a number of structures with really only one criteria - rated at least AA- (if it fit these criteria all OK - as far as I could tell credit assessment was completely outsourced to the rating agencies).

Main products they took on were always levered credit risk, credit-linked notes (collateral and CDS both had to be at least AA-, no joint probability stuff) and AAA or super senior portfolio swaps. Portfolio swaps were either corporate synthetic CDO or asset backed, effectively sub-prime wraps (as per news stories regarding GS and DB).

Credit linked notes are done through single-name CDS desks and a cash desk (for the note collateral) and the portfolio swaps are done through the correlation desk. These trades were done is almost every jurisdiction - wherever AIG had an office they had IB salespeople covering them.

Correlation desks just back their risk out via the single names desks - the correlation desk manages the delta/gamma according to their correlation model. So correlation desks carry model risk but very little market risk.

I was mostly involved in the corporate synthetic CDO side.

During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent - these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were "we have never done as big or as profitable trades - ever".

As these trades are unwound, the correlation desk needs to unwind the single name risk through the single name desks - effectively the AIG-FP unwinds caused massive single name protection buying. This caused single name credit to massively underperform equities - run a chart from say last September to current of say S&P 500 and Itraxx - credit has underperformed massively. This is largely due to AIG-FP unwinds.

I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period. Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period."

For those to whom this is merely a lot of mumbo-jumbo, let me explain in layman's terms:
AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam.

In simple terms think of it as an auto dealer, which knows that U.S. taxpayers will provide for an infinite amount of money to fund its ongoing sales of horrendous vehicles (think Pontiac Azteks): the company decides to sell all the cars currently in contract, to lessors at far below the amortized market value, thereby generating huge profits for these lessors, as these turn around and sell the cars at a major profit, funded exclusively by U.S. taxpayers (readers should feel free to provide more gripping allegories).

What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were a) one-time in nature due to wholesale unwinds of AIG portfolios, b) entirely at the expense of AIG, and thus taxpayers, c) executed with Tim Geithner's (and thus the administration's) full knowledge and intent, d) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.

For banks to proclaim their profitability in January and February is about as close to criminal hypocrisy as is possible. And again, the taxpayers fund this "one time profit", which causes a market rally, thus allowing the banks to promptly turn around and start selling more expensive equity (soon coming to a prospectus near you), also funded by taxpayers' money flows into the market. If the administration is truly aware of all these events (and if Zero Hedge knows about it, it is safe to say Tim Geithner also got the memo), then the potential fallout would be staggering once this information makes the light of day.

And the conspiracy thickens.

Thanks to an intrepid reader who pointed this out, a month ago ISDA published an amended close out protocol. This protocol would allow non-market close outs, i.e. CDS trade crosses that were not alligned with market bid/offers.
The purpose of the Protocol is to permit parties to agree upfront that in the event of a counterparty default, they will use Close-Out Amount valuation methodology to value trades. Close-Out Amount valuation, which was introduced in the 2002 ISDA Master Agreement, differs from the Market Quotation approach in that it allows participants more flexibility in valuation where market quotations may be difficult to obtain.
Of course ISDA made it seems that it was doing a favor to industry participants, very likely dictating under the gun:

Industry participants observed the significant benefits of the Close-Out Amount approach following the default of Lehman Brothers. In launching the Close-Out Amount Protocol, ISDA is facilitating amendment of existing 1992 ISDA Master Agreements by replacing Market Quotation and, if elected, Loss with the Close-Out Amount approach.

"This is yet another example of ISDA helping the industry to coalesce around more efficient and effective practices, while maintaining flexibility," said Robert Pickel, Executive Director and Chief Executive Officer, ISDA. "The Protocol permits parties to value trades in the way that is most appropriate, which greatly enhances smooth functioning of the market in testing circumstances."

And, lo and behold, on the list of adhering parties, AIG takes front and center stage (together with several other parties that probably deserve the microscope treatment).

So - in simple terms, ISDA, which is the only effective supervisor of the Over The Counter CDS market, is giving its blessing for trades to occur (cross) below where there is a realistic market bid, or higher than the offer. In traditional equity markets this is a highly illegal practice. ISDA is allowing retrospective arbitrary trades to have occurred at whatever price any two parties agree on, so long as the very vague necessary and sufficient condition of "market quotations may be difficult to obtain" is met. As anyone who follows CDS trading knows, this can be extrapolated to virtually any specific single-name, index or structured product easily. In essence ISDA gave its blessing for below the radar fund transfers of questionable legality. The curious timing of this decision and the alleged abuse of CDS transaction marks by and among AIG and the big banks, is striking to say the least.

This wholesale manipulation of markets, investors and taxpayers has gone on long enough.

Saturday, March 28, 2009

Germany Buys 8.7% Stake in Hypo Real for EU60 Million

On Bloomberg by Simone Meier:

Hypo Real Estate Holding AG said Germany’s bank rescue fund, Soffin, will acquire 20 million shares valued at 60 million euros ($79.8 million), giving the state a stake of about 8.7 percent in the lender.

New shares must be issued at least at the minimum price, or 3 euros per share, the Munich-based company said in an e-mailed statement today. The lender said it had a full-year loss before taxes of 5.38 billion euros last year after a profit of 862 million euros in 2007. The net loss was 5.5 billion euros, it said in a separate statement.

Hypo Real Estate, which lost 93 percent of its market value over the last 12 months, has already been bailed out by the German government and financial institutions with credit lines and debt guarantees totaling 102 billion euros. The lender almost went bankrupt after its Dublin-based Depfa Bank Plc unit failed to get short-term funding in September amid the credit crunch.

“It is a prerequisite for the intended recapitalization of Hypo Real Estate Group by Soffin that either Soffin or the German government gain full control over Hypo Real Estate Holding,” the Hypo Real statement said. “To this end it is intended to make use of the options that will be provided by the German Financial Markets Stabilization Amendment Act, which is currently being discussed in the legislative process.”

Germany’s upper house, the Bundesrat, will be asked to approve the Hypo Real Estate seizure legislation when it comes before them on April 3, following its passage by the lower house on March 20. The law also imposes a time limit, stipulating that any seizure has to be initiated by the end of June.

The lender’s nationalization would be the first of a German bank since the 1930s.

Friday, March 27, 2009

Opacity in a Time of Transparency: Assessing Financial Conduits

Posted on Option ARMaggedon by Keith Allman:

Transparency is key to helping us climb out of the credit crisis. Transparency of investments, risk assessment methodologies, parties, counterparties, and so on. However, financial vehicles allowing billions of dollars to pass through them—but that do not release information regarding their underlying assets—still exist. I’m speaking of multi-seller conduits, the commercial paper variety of which have about $730 billion outstanding in the U.S. Their accounting statements offer us generalities, such as asset allocation percentages in mortgages, auto loans, leases, credit cards, student loans, and other consumer-based asset classes, but none report data relating to their exact underlying exposures. If you thought CDOs were toxic, read on….

By way of background, financial conduits are entities that issue short-term debt, typically commercial paper, and use the funds from that debt to invest in long-term assets. These have included all types of structured finance products: from standard auto loans and leases, credit cards, student loans, trade receivables, small business loans to exotic insurance products and esoteric equipment financings. And of course they also invested in residential and commercial mortgage products, which included some of the most toxic assets: adjustable rate mortgages, option ARMs, and even timeshare loans. The profit dynamic at play is well-known: borrow short at a low interest rate, lend long at a higher one.

Strong credit risk management was (or, rather, should have been) the crux of the conduit business. Large banks—with their multitude of credit analysts, transaction specialists, portfolio managers, and quantitative analysts—thought they were well-equipped to manage in-house conduits. Indeed, prior to the credit crisis in mid-2007, funds invested in just U.S. based commercial conduit transactions totaled $1.4 trillion. Since then this number has been in sharp decline due to poorly performing assets and commercial paper liquidity. And so many conduits have either been wound down or have been taken back on balance sheet by issuer banks. But, as noted above, $730 billion remains outstanding in the U.S.

Its conduits’ opacity that should have us worried: The asset-backed securities in which conduits are invested have never been disclosed publicly; Moody’s, S&P, and Fitch don’t even rate their underlying assets. Of course this opacity was part of their appeal. Originators can essentially fund themselves at a low cost without disclosing to the public information about their assets. Selective disclosure of information has its obvious benefits of course.

The rating agencies exercise a little oversight with regard to conduits, rating them as a whole. But their knowledge of conduits’ underlying assets is not required to be disclosed to the marketplace. The whole arrangement is similar to what happens with structured investment vehicles or CDOs, with one crucial difference. Investors in SIVs or CDOs buy into rated tranches: the underlying assets are typically rated and publicly known. Investing in the commercial paper of a conduit is like going into a CDO or SIV blind.
Readers may wonder: if the individual asset-backed securities in which conduits are invested are not publicly-rated, is there any way for investors to independently measure underlying credit risk? The simple answer is no. Here it helps to understand how conduits are constructed.

Transaction specialists package into conduits assets brought to them by originators; quantitative analysts then model asset performance data to create loss expectations. The transaction specialist and the quantitative analyst then work together following rating agency guidelines to determine how much of the asset pool the conduit can invest in while adhering to the lowest rating at which its commercial paper can still be marketed to potential credit investors. If the bank’s conduit credit committee agreed, then the deal was done.

The conflicts of interest are even more pronounced than for CDOs, due to the greater opacity of the deal. Those structuring conduits are bank employees, and their bonuses are based on getting profitable deals done, not on accurately measuring credit risk. Since conduits’ revenue is dictated by their net interest margin, those structuring them are incentivized to invest funding proceeds in high-risk, higher yielding asset-backed securities.

Incidentally, there is one conduit that has done well: DZ Bank’s. They have their transaction specialists put up part of their bonus as first loss on the deals. If the deals go bad, they lose bonus.

In general credit card transactions are a good example. Both Moody’s and S&P issued criteria relating to ABS backed by credit card receivables, but the criteria were very general. S&P, for instance, suggested that for a credit card ABS to maintain an “A” rating, the deal had to withstand losses 2x-3x historical averages. Naturally it was in a transaction specialists’ best interest to work on deals that were closer to the 2 times figure since the historic average loss could be higher. For instance, if a transaction specialist had to choose between two deals: one with historical loss of 5% and the other with historical loss at 7.5% they would choose the deal with 7.5%. This is because they interpreted the guidelines to the minimum published. Both the 5.0% and the 7.5% historical loss deals could be stressed to 15% loss expectation to meet an “A” rating, but a 7.5% historical loss deal is riskier, which means its yield is most likely higher. In other words, in order to increase yield, conduits travel up the credit risk curve. Maximizing net interest margin becomes a matter of flying as close to the sun as possible: trying to pack in credit risk without sacrificing a marketable rating—typically “A”—for the commercial paper needed to fund the deal. Even slight deteriorations in underlying asset performance puts conduits’ “highly-rated” commercial paper at risk of loss.

Conflicts of interest are compounded by transaction specialists’ relationship with the lenders who originate the underlying assets. Originators want the cheapest possible funding, which meant the more the conduit purchased, the less equity they would have to invest in their own assets. Basically, each deal has two components, a portion purchased by the conduit (the debt part) and a portion that the originator of the assets retains (the equity). Say an originator has $300 million of assets, the conduit might purchase 90% of them with the remaining 10% retained as equity. That means that $270 million is owned by the conduit with the remaining $30 million owned by the originator. Originators constantly pushed transaction specialists for the highest possible funding amount for each deal. The problem is obvious: leverage. The less equity contributed at the beginning of the deal, the more debt needed to fund it and the more vulnerable the conduit becomes. Conduit advance rates fluctuate depending on the asset type and loss history, but are often above 90%.

This dynamic further incentivizes transaction specialists to structure transactions to the minimum standards of a single-A rating where possible. Take the credit card example again. Assume that the historical loss was 7.5% and that the rating guidelines suggested stressing the transaction 2x-3x to achieve a single-A rating. If the transaction specialist stressed the deal at 3x instead of 2x there would be an additional 7.5% of loss to cover. This loss has to be made up somewhere in the proposed transaction and is covered by forms of credit enhancement. One method of covering that is to increase the equity, which takes the first loss. This provides more buffer to the single-A rated conduit piece. However, the originator may not want to increase their equity stake and the transaction specialist wants a higher base for the premiums he is booking towards his bonus. The easy solution is that the guidelines suggested that 2x is acceptable, so just run expected loss at 2x, lower the equity, and increase the conduit’s investment. This way the originator gets as much funding as possible, while the transaction specialist gets his or her deal approved by the credit committee and books the deal’s revenue to justify more bonus.

Like so many other structured finance transactions, conduits are a ticking time bomb of credit risk. We now know of course that securities backed by consumer related asset-backed securities are highly vulnerable when the credit cycle turns over. Take Citigroup as an example. They still have $59.6 billion of commercial paper conduit assets off balance sheet. Of that 24% are backed by student loans, 17% by commercial credit and loans, 10% by credit cards, and 8% by auto loans—all of them highly vulnerable to credit losses in recession. And this is just one bank.

To make matters worse, what happens if conduits collapse? Publicly-rated RMBS and CDOs have massive amounts of data organized in databases. There are CUSIPs that allow third parties to search for transactions; some originators make public filings; and often prospectuses can be obtained to understand deal structures. It may be very difficult to work with so much complex data, but at least the data exists. It enables investors to value distressed assets. The data for assets sitting in conduits is extremely difficult to obtain. For clogged credit markets to clear, investors need to have some ability to measure valuation. For CDOs that can be very difficult. For conduits, it may be impossible.

Regulatory overhaul is the order of the day and conduits should not be overlooked. Lax review and disclosure requirements need to be reviewed and modified; the interests of those who structure them must be properly aligned as well. If financial transparency is necessary to climb out of the economic crisis, then conduits need to be opened up and reviewed in detail.

What Should Be Happening to Toxic Bond Prices?

On Portfolio.com by Felix Salmon:

Consider three assets. Asset A is a basket of subprime mortgage-backed bonds, sitting on the balance sheet of JP Morgan Chase. Asset B is an identical basket of subprime mortgage-backed bonds, being traded in the secondary market. And Asset C is a credit default swap written on that basket of subprime mortgage-backed bonds.

The Geithner bank bailout plan is released. What would you expect to happen to the prices of Asset B and Asset C?

If you're Krishna Guha of the Financial Times, you'd reason something along these lines: Thanks to the availability of cheap government funding to buy it, Asset A will rise in price. Since Asset B is identical to Asset A, then Asset B will rise in price too. And since the spreads on Assets A and B have both tightened, then the spreads on a CDS written on that asset must be tightening too, thanks to the CDS-cash arbitrage. So expect the CDS spread to narrow, just as the yield on Assets A and B has fallen.

Well, guess what. If you look at the market, Asset B has not risen in price, and the spread on Asset C has not tightened. And Krishna Guha is worried:

The plan's modest impact on toxic asset prices raises questions as to the sustainability of the rally in bank stocks. It is a reminder that even this plan, which most experts believe is well crafted, may not work.

I, on the other hand, would not expect the price of Asset B to rise, nor the spread on Asset C to fall.

After all, Asset B is likely not eligible to be purchased as part of the Geithner bank bailout plan. So why should its price rise? If anything, one would expect its price to fall: investors holding Asset B and who are eligible to get funding to buy Asset A are likely to dump Asset B today, in anticipation of buying Asset A tomorrow. Now there might be a bid for Asset B from banks hopeful that they will then be able to turn around and flip it in the government auction, but somehow I doubt that's a trade many banks would get particularly excited about these days -- although there are always exceptions.

As for Asset C, the availability of cheap funding to buy Asset A has no effect whatsoever on the underlying default probabilities for that particular basket of subprime mortgage-backed bonds -- so you wouldn't expect CDS prices or spreads to move at all. If anything, you'd expect the CDS spraeds to widen, since investors who are about to buy lots of subprime assets might well want to start hedging that position in the CDS market, giving themselves some downside protection.

Yet Guha is perfectly happy quoting ABX and LCDX prices -- which are credit default swap indices -- as indicia of what's happening to toxic-asset prices.

The real problem here is that financial journalists find it pretty much impossible to get out of the no-arbitrage mindset: we're used to living in a world where a thousand hedge funds descend on any possible arbitrage and close it in milliseconds. But that's not today's world, not by a long shot. We live instead in a world of massive CDS-bond basis spreads and many other arbitrages too.

And of course, there's the narrower problem that journalists -- including Guha's colleague Gillian Tett, whose book I'm reading now -- have a habit of looking at the level of the ABX and using that as the actual trading level of subprime mortgage-backed bonds, in cents on the dollar. It isn't.

So never mind all of Guha's elaborate theories about how the lack of price action in the ABX, in the wake of Geithner's announcement, might mean that there isn't as much of an illiquidity premium as policymakers seem to think, or that the Geithner plan simply isn't big enough. Both of those things might be true -- but there's no way you can possibly deduce them from looking at bond and CDS prices.

WestLB owners plan sell-off

In the Financial Times by James Wilson:

WestLB’s owners plan to put the bank up for sale through an auction that could herald a wider shake-up of Germany’s state-owned Landesbank sector.

The bank expects the offer to satisfy a promise to the European Commission to seek a change in its ownership, a condition of state aid given last year to help the bank through the financial crisis.

A competitive auction would bring the prospect of wider private sector involvement in Landesbanken. Only one – HSH Nordbank, which, like WestLB, has struggled with toxic assets during the financial crisis – is partly held by private investors.

However, the last such auction, of Landesbank Berlin, ended with German savings banks paying a substantial price to keep the bank in state-owned hands. It also took about five years, suggesting that any change at WestLB is far from imminent.

Heinz Hilgert, WestLB’s chief executive, said the auction would not preclude attempts at consolidating Germany’s seven regionally controlled Landesbanken. Mr Hilgert said it was not possible to say when an auction might start.

The Commission has demanded that WestLB present a restructuring plan by the end of the month, including ownership changes. Attempts to engineer a merger of WestLB with other Landesbanken have foundered, which WestLB said was partly because of the tight timetable demanded by the Commission, at a time when possible buyers are fearful of acquiring any problems on other banks’ balance sheets.

The bank, which has a balance sheet of €288bn, is owned by North Rhine-Westphalia, Germany’s most populous region, along with local savings banks. It is best known internationally for project and structured finance.

The Commission said it had not been formally notified of WestLB’s restructuring plan. But the bank has been in a long dialogue with Brussels, meaning WestLB is unlikely to be in any doubt about the stance of Neelie Kroes, the competition commissioner.

An auction could replicate solutions found in some other long-running state aid cases.

WestLB ring-fenced €23bn of toxic assets a year ago into a separate vehicle underwritten by its owners – a step that led to the state aid case with Brussels. It plans to split off a further €80bn portfolio of non-core assets – one of several such plans from German banks, which could form the basis of a wider national “bad bank” scheme to manage unwanted or toxic assets.

New York AG subpoenas AIG on CDS contracts: sources

From Reuters by Grant McCool:

American International Group Inc, which has received $180 billion in U.S. taxpayer money, was subpoenaed on Thursday by New York's top legal officer for information on its credit default swaps contracts, sources familiar with the matter said.

Details were being sought on the contracts going back seven months, including those that have been wound down by AIG's Financial Products unit and those that have not, involving billions of dollars, one of the sources said.

A spokesman for AIG declined to comment.

The request stems from New York Attorney General Andrew Cuomo's investigation into $165 million paid to employees at the unit in retention bonuses this month.

On Thursday, Cuomo did not comment on the subpoena, but he said in a statement that "CDS contracts were at the heart of AIG's meltdown.

"The question is whether the contracts are being wound down properly and efficiently or whether they have become a vehicle for funneling billions in taxpayers dollars to capitalize banks all over the world."

Goldman Sachs and major European banks, including Deutsche Bank, France's Societe Generale and the UK's Barclays, were major beneficiaries of more than $90 billion of money paid out by AIG in the first three-and-a-half months after its bailout by the U.S. government last September.

AIG has said it needed to keep certain employees to help unwind complex derivatives partly blamed for its troubles. Fifteen of the top 20 bonus earners have paid back their bonuses, Cuomo said on March 23.

AIG said on Thursday two top managers in Paris have resigned but will remain in place to oversee an "orderly transition," reducing the risk of default on derivatives contracts.

Cuomo's office has been looking into various aspects of the financial industry meltdown since last September, including whether the credit default swaps (CDS) market was manipulated by short sellers spreading false rumors.

At the time AIG did provide the attorney general's office with documents on CDS, another source familiar with the matter said.

The sources requested anonymity because they were not authorized to speak publicly on the issue.

The CDS market is largely unregulated and opaque, comprised of privately negotiated contracts among fund managers and broker-dealers. They may be used for emerging market bonds, mortgage backed securities, corporate bonds and local government bonds.

We need a better cushion against risk

In the Financial Times by Alan Greenspan:

The extraordinary risk-management discipline that developed out of the writings of the University of Chicago’s Harry Markowitz in the 1950s produced insights that won several Nobel prizes in economics. It was widely embraced not only by academia but also by a large majority of financial professionals and global regulators.

But in August 2007, the risk-management structure cracked. All the sophisticated mathematics and computer wizardry essentially rested on one central premise: that the enlightened self-interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring their firms’ capital and risk positions. For generations, that premise appeared incontestable but, in the summer of 2007, it failed. It is clear that the levels of complexity to which market practitioners, at the height of their euphoria, carried risk-management techniques and risk-product design were too much for even the most sophisticated market players to handle prudently.

Even with the breakdown of self-regulation, the financial system would have held together had the second bulwark against crisis – our regulatory system – functioned effectively. But, under crisis pressure, it too failed. Only a year earlier, the Federal Deposit Insurance Corporation had noted that “more than 99 per cent of all insured institutions met or exceeded the requirements of the highest regulatory capital standards”. US banks are extensively regulated and, even though our largest 10 to 15 banking institutions have had permanently assigned on-site examiners to oversee daily operations, many of these banks still took on toxic assets that brought them to their knees. The UK’s heavily praised Financial Services Authority was unable to anticipate and prevent the bank run that threatened Northern Rock. The Basel Committee, representing regulatory authorities from the world’s major financial systems, promulgated a set of capital rules that failed to foresee the need that arose in August 2007 for large capital buffers.

The important lesson is that bank regulators cannot fully or accurately forecast whether, for example, subprime mortgages will turn toxic, or a particular tranche of a collateralised debt obligation will default, or even if the financial system will seize up. A large fraction of such difficult forecasts will invariably be proved wrong.

What, in my experience, supervision and examination can do is set and enforce capital and collateral requirements and other rules that are preventative and do not require anticipating an uncertain future. It can, and has, put limits or prohibitions on certain types of bank lending, for example, in commercial real estate. But it is incumbent on advocates of new regulations that they improve the ability of financial institutions to direct a nation’s savings into the most productive capital investments – those that enhance living standards. Much regulation fails that test and is often costly and counterproductive. Regulation should enhance the effectiveness of competitive markets, not impede them. Competition, not protectionism, is the source of capitalism’s great success over the generations.

New regulatory challenges arise because of the recently proven fact that some financial institutions have become too big to fail as their failure would raise systemic concerns. This status gives them a highly market-distorting special competitive advantage in pricing their debt and equities. The solution is to have graduated regulatory capital requirements to discourage them from becoming too big and to offset their competitive advantage. In any event, we need not rush to reform. Private markets are now imposing far greater restraint than would any of the current sets of regulatory proposals.

Free-market capitalism has emerged from the battle of ideas as the most effective means to maximise material wellbeing, but it has also been periodically derailed by asset-price bubbles and rare but devastating economic collapse that engenders widespread misery. Bubbles seem to require prolonged periods of prosperity, damped inflation and low long-term interest rates. Euphoria-driven bubbles do not arise in inflation-racked or unsuccessful economies. I do not recall bubbles emerging in the former Soviet Union.

History also demonstrates that underpriced risk – the hallmark of bubbles – can persist for years. I feared “irrational exuberance” in 1996, but the dotcom bubble proceeded to inflate for another four years. Similarly, I opined in a federal open market committee meeting in 2002 that “it’s hard to escape the conclusion that ... our extraordinary housing boom ... finan­ced by very large increases in mortgage debt, cannot continue indefinitely into the future”. The housing bubble did continue to inflate into 2006.

It has rarely been a problem of judging when risk is historically underpriced. Credit spreads are reliable guides. Anticipating the onset of crisis, however, appears out of our forecasting reach. Financial crises are defined by a sharp discontinuity of asset prices. But that requires that the crisis be largely unanticipated by market participants. For, were it otherwise, financial arbitrage would have diverted it. Earlier this decade, for example, it was widely expected that the next crisis would be triggered by the large and persistent US current-account deficit precipitating a collapse of the US dollar. The dollar accordingly came under heavy selling pressure. The rise in the euro-dollar exchange rate from, say, 1.10 in the spring of 2003 to 1.30 at the end of 2004 appears to have arbitraged away the presumed dollar trigger of the “next” crisis. Instead, arguably, it was the excess securitisation of US subprime mortgages that unexpectedly set off the current solvency crisis.

Once a bubble emerges out of an exceptionally positive economic environment, an inbred propensity of human nature fosters speculative fever that builds on itself, seeking new unexplored, leveraged areas of profit. Mortgage-backed securities were sliced into collateralised debt obligations and then into CDOs squared. Speculative fever creates new avenues of excess until the house of cards collapses. What causes it finally to fall? Reality.

An event shocks markets when it contradicts conventional wisdom of how the financial world is supposed to work. The uncertainty leads to a dramatic disengagement by the financial community that almost always requires sales and, hence, lower prices of goods and assets. We can model the euphoria and the fear stage of the business cycle. Their parameters are quite different. We have never successfully modelled the transition from euphoria to fear.

I do not question that central banks can defuse any bubble. But it has been my experience that unless monetary policy crushes economic activity and, for example, breaks the back of rising profits or rents, policy actions to abort bubbles will fail. I know of no instance where incremental monetary policy has defused a bubble.

I believe that recent risk spreads suggest that markets require perhaps 13 or 14 per cent capital (up from 10 per cent) before US banks are likely to lend freely again. Thus, before we probe too deeply into what type of new regulatory structure is appropriate, we have to find ways to restore our now-broken system of financial intermediation.

Restoring the US banking system is a key requirement of global rebalancing. The US Treasury’s purchase of $250bn (€185bn, £173bn) of preferred stock of US commercial banks under the troubled asset relief programme (subsequent to the Lehman Brothers default) was measurably successful in reducing the risk of US bank insolvency. But, starting in mid-January 2009, without further investments from the US Treasury, the improvement has stalled. The restoration of normal bank lending by banks will require a very large capital infusion from private or public sources. Analysis of the US consolidated bank balance sheet suggests a potential loss of at least $1,000bn out of the more than $12,000bn of US commercial bank assets at original book value.

Through the end of 2008, approximately $500bn had been written off, leaving an additional $500bn yet to be recognised. But funding the latter $500bn will not be enough to foster normal lending if investors in the liabilities of banks require, as I suspect, an additional 3-4 percentage points of cushion in their equity capital-to-asset ratios. The overall need appears to be north of $850bn. Some is being replenished by increased bank cash flow. A turnround of global equity prices could deliver a far larger part of those needs. Still, a deep hole must be filled, probably with sovereign US Treasury credits. It is too soon to evaluate the US Treasury’s most recent public-private initiatives. Hopefully, they will succeed in removing much of the heavy burden of illiquid bank assets.

Thursday, March 26, 2009

Geithner Rolls Out New Rules for Wall Street

From the Housing Wire by Kelly Curran:

In effort to mend the “critical gaps” which have led to multiple failures within the nation’s financial system, Treasury Secretary Timothy Geithner unveiled Thursday morning the framework of a new regulatory reform for Wall Street.

“To address these failures will require comprehensive reform — not modest repairs at the margin, but new rules of the road. The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial market,” Geithner said during congressional testimony.

Geithner discussed the need to create tools to identify and mitigate systematic risk, including tools to protect the financial system from the failure of “systematically important” financial institutions — an issue brought to the forefront amid spiraling anger over the bailout and then bonuses at American International Group Inc. (AIG: 1.10 -8.33%).

“The crisis — and the cases of firms like Lehman Brothers and AIG — has made clear that certain large, interconnected firms and markets need to be under a more consistent and more conservative regulatory regime,” read a press release from the Treasury Department Thursday.

In addressing systematic risk — one of the four components of regulatory reform mapped out by Giethner’s team, and the first of which the Treasury will focus on — the Treasury said, like many officials this week, there must be a single independent regulator with responsibility over systemically important firms — regardless of whether they own a depository institution — and critical payment and settlement systems.

The Treasury said it will also work to implement higher standards on capital and risk management for those “too big to fail” firms by setting more robust capital requirements and imposing stricter liquidity, counterparty and credit risk management requirements. Also, the regulator of these entities will need a “prompt corrective action regime” in the case capital levels decline — similar to the powers of the FDIC, Geithner explained.

Another part of the Treasury’s plan in addressing systematic risk would require all private investment funds and hedge fund advisors with assets above a certain threshold to register with the Securities and Exchange Commission. See Full Story. “The Madoff episode is just one more reminder that, in order to protect investors, we must close gaps…” the Treasury said.

Geithner proceeded to outline actions to extend federal regulation to all trading financial derivatives and develop stronger rules for money market mutual funds, in order to reduce the risk of runs on the funds.

Geithner said his testimony today focused on systemic risk both because financial stability is critical to economic recovery and growth, and because systemic risk is expected to be a primary focus for discussions at the G20 Leaders’ Meeting in London on April 2. But in the coming weeks, according to the Treasury, Geithner will also outline a framework of action, likely to require legislation, in relation to protecting consumers, eliminating gaps in the nation’s regulatory structure and fostering international coordination.

“We must not let turf wars or concerns about the shape of organizational charts prevent us from establishing a substantive system of regulation that meets the needs of the American people,” Geithner said.

Wednesday, March 25, 2009

Double Dippers: Has the Gaming of the PPIP Begun?

In the New York Post by Mark DeCambre:

As Treasury Secretary Tim Geithner orchestrated a plan to help the nation's largest banks purge themselves of toxic mortgage assets, Citigroup and Bank of America have been aggressively scooping up those same securities in the secondary market, sources told The Post.

Both Citi and BofA each have received $45 billion in federal rescue cash meant to help prop up the economy and jumpstart the housing market.

But the banks' purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders. Alt-A and option ARM loans have widely been seen as the next mortgage type to see increases in defaults.

One Wall Street trader told The Post that what's been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

The secondary market represents a key cog in the mortgage market, and serves as a platform where mortgage originators can offload mortgages in bulk that have been converted into bonds.

Yields on such securities can be as high as 22 percent, one trader noted.

BofA said its purchases of secondary-mortgage paper are part of its plans to breathe life back into the moribund securitization market.

"Our purchases in [mortgage-backed securities] increase liquidity in the mortgage market allowing people to buy a home," said BofA spokesman Scott Silvestri.

A Citi spokesman declined to comment, though people familiar with the bank say it argues the same point.

Citi's and BofA's purchases highlight the challenges both banks face while operating under intense public scrutiny.

While some observers concur that the buying helps revive a frozen market, others argue the banks are gambling away taxpayer funds instead of lending.

Moreover, the MBS market has been so volatile during the economic crisis that a number of investors who already bet a bottom had been reached have gotten whacked as things continued to slide.

Around this same time last year some of the same distressed mortgage paper that Citi and BofA are currently snapping up was trading around 50 cents on the dollar, only to plummet to their current levels.

One source said that the banks' purchases have helped to keep prices of these troubled securities higher than they would be otherwise.

Both banks have launched numerous measures to help stem mortgage foreclosures, and months ago outlined to the government their intention to invest in the secondary market to expand the flow of credit.

Another, yawn, Canadian bank preferred share sale

Posted on Globe & Mail StreetWise by Andrew Willis:

Another day, another preferred share issue from a financial institution.

Toronto-Dominion Bank stepped up Wednesday with the latest in a series of stock sales, tapping investors for $200-million of preferred shares that yield 6.25 per cent. Subsidiary TD Securities is leading the financing, and the underwriters have an option to bump it up to $275-million.

Income-hungry investors have been chowing down on preferred shares offerings for the past six months, as banks and insurers shore up their balance sheets. Royal Bank of Canada and HSBC did preferred shares earlier this week. At some point, this appetite will be satiated, but until that day, the issues will keep coming.

Share sales from financial institutions underpined a record $6.8-billion in preferred share underwritings in 2008, according to data from the Investment Industry Association of Canada. If loan losses continue to mount, and investors continue to step up for offerings, that record could fall this year.

Is the Geithner Plan an FDIC Plan?

Posted on Portfolio.com by Felix Salmon:

I'm beginning to come around to the idea that the FDIC will play the single most important role in determining the way that the Geithner plan plays out. If the banking system is indeed as unhealthy as everybody thinks it is, the FDIC essentially has two choices: it can either ratify high prices being paid for toxic assets by extending financing guarantees for them, or it can force lower prices to be paid for toxic assets, force banks to mark their assets down to levels at which they violate their minimum capital requirements, and intervene to close those banks down.

So I fired off an email to the FDIC this morning, asking if I could talk to someone there about the role that the agency played in constructing the plan and the role it's going to play as the plan is implemented. I got this reply from a spokesman:

The FDIC is still reviewing the proposal. You should address your questions towards Treasury since it is their proposal.

In public, however, the FDIC gives every impression of being a big supporter of the plan. Its head, Sheila Bair, for instance, released this statement:

"Today's actions demonstrate the strong commitment of the FDIC, Fed, Treasury and the Administration to use creative and innovative programs to address the serious economic issues facing our country. The Legacy Loans Program, while providing substantial upside potential to private investors and the government, will also clear these troubled assets from banks balance sheets - enabling them to lend and restore economic growth."

And the FDIC's web page on the program says that it is being launched by "the FDIC and Treasury", rather than by Treasury alone.

There's one other important consideration to bear in mind here: the massive regulatory overhaul which is going to happen over the medium term. There's a crazy alphabet soup of regulators in Washington right now, and a lot of them are going to have to be abolished. Is the FDIC jockeying for position, here, making itself as indispensible as possible in an attempt to survive the coming upheaval? It's entirely possible.

The tabular banking-PPIP disconnect

Zero Hedge has a very interesting table from Goldman Sachs. Click to enlarge.

It shows Goldman’s estimates for how banks are carrying assets like commercial mortgages and consumer loans on their books. According to the table, they’re carrying those assets at ludicrously optimistic averages of between 89 per cent and 96 per cent of their original purchase price. Yeah. Right.

That preposterous positivity has huge implications for Tim Geithner’s toxic asset plan, or PPIP.

As Zero Hedge notes, if banks have expectations for bid levels north of 90 per cent then the PPIP is likely to be “a lot of hot air”.

At current government subsidies and market uncertainties, private investors may not be incentivised enough to bid $84, or even $50, for a loan pool valued at $100 by Citigroup et al. At the same time banks may not be willing to accept lower bids for their assets, as doing so will cause a ripple of further writedowns and losses. Participating in the PPIP is, like valuing banks’ assets, entirely at the institutions’ own scurrilous discretion. For now, at least.

Successful bank rescue still far away

In the Financial Times by Martin Wolf

I am becoming ever more worried. I never expected much from the Europeans or the Japanese. But I did expect the US, under a popular new president, to be more decisive than it has been. Instead, the Congress is indulging in a populist frenzy; and the administration is hoping for the best.

If anybody doubts the dangers, they need only read the latest analysis from the International Monetary Fund.* It expects world output to shrink by between 0.5 per cent and 1 per cent this year and the economies of the advanced countries to shrink by between 3 and 3.5 per cent. This is unquestionably the worst global economic crisis since the 1930s.

One must judge plans for stimulating demand and rescuing banking systems against this grim background. Inevitably, the focus is on the US, epicentre of the crisis and the world’s largest economy. But here explosive hostility to the financial sector has emerged. Congress is discussing penal retrospective taxation of bonuses not just for the sinking insurance giant, AIG, but for all recipients of government money under the troubled assets relief programme (Tarp) and Andrew Cuomo, New York State attorney-general, seeks to name recipients of bonuses at assisted companies. This, of course, is an invitation to a lynching.

Yet it is clear why this is happening: the crisis has broken the American social contract: people were free to succeed and to fail, unassisted. Now, in the name of systemic risk, bail-outs have poured staggering sums into the failed institutions that brought the economy down. The congressional response is a disaster. If enacted these ideas would lead to an exodus of qualified employees from US banks, undermine willingness to expand credit, destroy confidence in deals struck with the government and threaten the rule of law. I presume legislators expect the president to save them from their folly. That such ideas can even be entertained is a clear sign of the rage that exists.

This is also the background for the “public/private partnership investment programme” announced on Monday by the US Treasury secretary, Tim Geithner. In the Treasury’s words, “using $75bn to $100bn in Tarp capital and capital from private investors, the public/private investment programme will generate $500bn in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time”. Under the scheme, the government provides virtually all the finance and bears almost all the risk, but it uses the private sector to price the assets. In return, private investors obtain rewards – perhaps generous rewards – based on their performance, via equity participation, alongside the Treasury.

I think of this as the “vulture fund relief scheme”. But will it work? That depends on what one means by “work”. This is not a true market mechanism, because the government is subsidising the risk-bearing. Prices may not prove low enough to entice buyers or high enough to satisfy sellers. Yet the scheme may improve the dire state of banks’ trading books. This cannot be a bad thing, can it? Well, yes, it can, if it gets in the way of more fundamental solutions, because almost nobody – certainly not the Treasury – thinks this scheme will end the chronic under-capitalisation of US finance. Indeed, it might make clearer how much further the assets held on longer-term banking books need to be written down.

US economy

Why might this scheme get in the way of the necessary recapitalisation? There are two reasons: first, Congress may decide this scheme makes recapitalisation less important; second and more important, this scheme is likely to make recapitalisation by government even more unpopular.

If this scheme works, a number of the fund managers are going to make vast returns. I fear this is going to convince ordinary Americans that their government is a racket run for the benefit of Wall Street. Now imagine what happens if, after “stress tests” of the country’s biggest banks are completed, the government concludes – surprise, surprise! – that it needs to provide more capital. How will it persuade Congress to pay up?

The danger is that this scheme will, at best, achieve something not particularly important – making past loans more liquid – at the cost of making harder something that is essential – recapitalising banks.

This matters because the government has ruled out the only way of restructuring the banks’ finances that would not cost any extra government money: debt for equity swaps, or a true bankruptcy. Economists I respect – Willem Buiter, for example – condemn this reluctance out of hand. There is no doubt that the decision to make whole the creditors of all systemically significant financial institutions creates concerns for the future: something will have to be done about the “too important to fail” problem this creates. Against this, the Treasury insists that a wave of bankruptcies now would undermine trust in past government promises and generate huge new uncertainties. Alas, this view is not crazy.

I fear, however, that the alternative – adequate public sector recapitalisation – is also going to prove impossible. Provision of public money to banks is unacceptable to an increasingly enraged public, while government ownership of recapitalised banks is unacceptable to the still influential bankers. This seems to be an impasse. The one way out, on which the success of Monday’s plan might be judged, is if the greater transparency offered by the new funds allowed the big banks to raise enough capital from private markets. If that were achieved on the requisite scale – and we are talking many hundreds of billions of dollars, if not trillions – the new scheme would be a huge success. But I do not believe that pricing legacy assets and loans, even if achieved, is going to be enough to secure this aim. In the context of a global slump, will investors be willing to put up the vast sums required by huge and complex financial institutions, with a proven record of mismanagement? Trust, once destroyed, cannot so swiftly return.

The conclusion, alas, is depressing. Nobody can be confident that the US yet has a workable solution to its banking disaster. On the contrary, with the public enraged, Congress on the war-path, the president timid and a policy that depends on the government’s ability to pour public money into undercapitalised institutions, the US is at an impasse.

It is up to Barack Obama to find a way through. When he meets his group of 20 counterparts in London next week, he will be unable to state he has already done so. If this is not frightening, I do not know what is.

The Complexity of the Bank Bailout Plan

Posted on Portfolio.com by Felix Salmon:

A smart comment came from chacona in the wake of yesterday's bailout discussion:

As for the ideas, I learned one big thing that seems to be of great importance: nobody understands the Geithner Plan.

To a first approximation, this is undoubtedly true. (It's certainly true for me: there are large chunks of it I still don't understand in the slightest.) For instance, during the discussion, we got into a debate about whether or not CDOs will be included among the toxic legacy assets eligible for the plan; it seems they won't be, but it's not crystal-clear, and if they're not, doesn't that leave a rather obvious weakness on banks' balance sheets unaddressed? And that's not even what David Reilly is talking about here:

No sooner might the Treasury Department mop up those assets than $1 trillion or more in new ones spring up to take their place.

He's talking about off-balance-sheet vehicles: although there's a general conception that banks have taken their SIVs back on balance sheet, Reilly says that the Big Four US banks still have a whopping $5.2 trillion in off-balance-sheet assets. That's about 37% of GDP right there.

Reilly isn't talking about SIVs, he's talking about assets which the banks thought they had safely sold to external investors in the form of asset-backed securities but which they might yet be forced to take back. For instance, Citigroup has already said that it expects some $92 billion in securitized credit-card debt to come back to it.

I'm very unclear on how exactly this works, but ultimately it smells to me very similar to the notorious "liquidity put" that Citi wrote to its SIVs. We'll sell you the assets, it basically said, but don't worry, if they turn out to be particularly toxic, then we'll take them back. In doing so, it retained a lot of tail risk, but didn't need to show that risk on its balance sheet.

There are other big known weaknesses with the plan as well: even Brad DeLong, who's making a name for himself as the most high-profile non-Administration supporter of the plan, said in the discussion that the plan "becomes very dangerous indeed" if the Big Four banks cooperate rather than compete, and also that the plan seems to be "too small to work" given the $2 trillion in expected losses on mortgage securities due to defaults.

That said, there are people -- especially in Washington -- who have a much stronger grasp of the details of the plan than I think any of us in the Seeking Alpha discussion had. One of them emailed me this morning, making a number of important points.

First, the FDIC will charge for its guarantee -- somewhere in the region of 50bp to 100bp. What's more, if the FDIC ends up losing money on this deal, it will make up those funds with an assessment on total bank liabilities. In other words, the banking system in general will be asked to cough up the losses, rather than the US government.

This does make it seem as though smaller, healthier banks risk being penalized to bail out the larger and more irresponsible ones -- but as Brad says, someone's got to ultimately bear the losses, and we're all going to end up shouldering some of the burden somehow.

What's more, the FDIC does support this plan: it wasn't dragooned into it just to provide the extra dollars needed to get to $1 trillion. And given its guarantee fee, it might conceivably even make a profit on the whole thing. One aspect of the deal worth noting is that even if a public-private partnership and a bank come to agreement on a price for transferring the toxic assets, the FDIC can still veto the deal. You need three-way agreement for any bargain. That makes it harder for the plan to work, in the sense of money changing hands, but does make it more likely that the FDIC will avoid massive losses.

It's also worth noting that the amount of leverage that the government allows with respect to any given asset is going to be a function of the perceived safety of that asset: maximum leverage won't be applied willy-nilly to everything.

Finally, my correspondent says he views as a virtue of the plan the fact that regulators will push banks to mark their assets to the prices set by the auctions, even if they choose not to sell their assets at those auctions. That will accelerate failures of insolvent banks -- and if an insolvent bank is going to fail, it's better that it does so sooner rather than later.

Can this plan then be viewed as the most empirical and useful part of the stress test? Is it at heart a further step towards nationalization, or at least widespread FDIC intervention of failed banks? My feeling is that the plan is designed to maximize the prices of the toxic assets and thereby minimize the number of banks which need to be deemed insolvent. But I guess we'll see, once the plan gets up and running.

Tapping AIG Furor, Regulators Seek Power to Seize Nonbanks

From the Wall Street Journal by Sudeep Reddy:

Treasury Secretary Timothy Geithner, left, talks with Fed Chairman Ben Bernanke before the start of a House hearing on AIG.

The government's top financial regulators are channeling widespread outrage over retention bonuses at American International Group Inc. to quickly win authority they have sought for much of the past year to seize nonbank companies and freeze their contracts.

The House Financial Services Committee plans to vote as early as next week on legislation that would give the government that authority. Federal officials already has such power over banks. The Obama administration is pushing for fast action on the issue, even before Congress tackles a broader overhaul of financial regulation.

Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke, in congressional testimony Tuesday, said the lack of authority to seize AIG -- the way the Federal Deposit Insurance Corp. places failing banks into so-called receivership -- forced the government into the position of owning almost 80% of the insurance giant, and serving as its major lender, while lacking the power to stop multimillion-dollar bonus contracts signed before the government intervention.

"If a federal agency had had such tools on Sept. 16, they could have been used to put AIG into conservatorship or receivership, unwind it slowly, protect policyholders, and impose haircuts on creditors and counterparties as appropriate," Mr. Bernanke said.

Discuss

More

At the Future of Finance Forum, Treasury Sec. Timothy Geithner discusses the need for better resolution authority to unwind large, complex institutions with WSJ's Executive Editor Alan Murray.

While the power seems likely to be granted by Congress, it's unclear which wing of the government would be given the authority. Mr. Geithner proposed that any emergency action be based on a determination by the Treasury secretary along with the Federal Reserve and the federal regulator overseeing the company.

He said that in addition to the power to seize a company, the proposed authority would give the government rights to sell or transfer assets or liabilities of the firm and renegotiate contracts, including those with employees.

Rep. Barney Frank (D., Mass.), chairman of the House Financial Services Committee, declined to say whether the power would be provided to the FDIC, the Treasury or some combination of the two. Speaking to reporters after Tuesday's hearing, Mr. Frank said that he had discussed the issue with President Barack Obama and that the committee would vote on a bill either next week or the following week. But the legislation would still be at least a few weeks away from enactment, because it must go through the Senate as well.

Several lawmakers expressed their displeasure with the AIG intervention during Tuesday's hearing. But the outrage that consumed Capitol Hill -- and much of America -- for the past week appeared to have softened.

Mr. Geithner and Mr. Bernanke have faced a storm of criticism since the disclosure 10 days ago that AIG had paid $165 million in bonuses to employees in the same unit that triggered many of its problems. But they blunted much of the anger by focusing their testimony on the limits to their authority and the regulatory holes that created the problems around AIG.

The two officials, joined by Federal Reserve Bank of New York President William Dudley, explained that they sought to block the bonuses but were advised of the limitations to breaking the contracts.

Mr. Bernanke said that upon learning of the payments, he asked that they be stopped. Informed that they were mandated by contracts, Mr. Bernanke said he "then asked that suit be filed to prevent the payments." But legal staff counseled against that because laws in Connecticut, where the AIG unit is based, could result in the "perverse effect" of doubling or tripling the payouts to those employees through damages.

Still, Messrs. Bernanke and Geithner on Tuesday faced continued criticism over other decisions on AIG and the wider government financial-rescue efforts. Mr. Bernanke was asked repeatedly about the tens of billions of dollars AIG has paid out to major banks, including foreign institutions, using government money. He maintained that AIG needed to meet its obligations to prevent a default that he said would cause "chaos in financial markets." He also noted that European governments have bailed out their banks without distinguishing between European and American creditors.

Treasury resale may prove best option

From the Financial Times by Julie MacIntosh, Aline van Duyn and Deborah Brewster:

The US government’s efforts to jump-start its toxic asset resale programme by luring investors with debt financing has prompted criticism that private funds will not shoulder enough of the risk. But it may be the best way to bring markets back to health and making good on government investments.

A new US Treasury programme aims to find private-sector buyers for troubled loans and securities that continue to clog banks’ balance sheets. A few investors who buy into pools of assets using government financing may hold them to maturity, later splitting their returns with the government.

But most buyers may want to sell them – potentially with the debt still attached – on a shorter time frame to lock in returns if the market floats higher. The government would also realise gains on its equal equity investment in tandem. But if the assets lost value, it could bear most of the losses.

Guy Haselman, a principal at hedge fund group Gregoire Capital, says there is potential for playing the system if the assets are flipped between banks and investors. “When the taxpayers find out that the acquiring hedge fund will have the ability to sell the asset any time, especially right back to the selling bank ... and get a commission from the buying bank, then it could get more politically ugly,” he said.

But one person familiar with government thinking said it envisioned groups of investors would commit to holding their pools of assets for several years – not weeks or months – before selling, in the same way investors in private equity funds commit their capital.

The creation of a market for these assets is the government’s goal, and those who lauded the plan after it was announced on Tuesday said investors must be allowed to reap gains on their investments for it to work.

“The government shares in all upside, so to the extent that private investors make money, so does the government,” said Jason Goldberg, analyst at Barclays Capital. “I’m not sure how it could be called ‘gaming’ the system.”

Investors considering whether to participate in the programme raised more questions on Tuesday over their ability to exit investments and on how the assets will be packaged and priced.

Those who are betting the programme will succeed are basing those wagers partly on the belief that a lack of liquidity is the main reason for the assets’ fall in value.

But if depressed prices reflect the weak underpinnings of the housing market, consumer credit and the overall economy, gains could be scarce – or longer in coming. These assets are, after all, backed by home mortgages, car loans and other forms of credit that eventually need to be paid off. Their quality, rather than their liquidity, may be the problem.

“While most have focused on the dramatic upside possible and the leverage offered, the buyer still ends up losing 100 per cent of his albeit small equity interest should he only marginally overpay, and so even the buyers may be nervous,” said Tim Backshall, chief strategist for Credit Derivatives Research.

Some voiced concerns over whether loans held by banks would be cheap enough to draw investment. The leverage offered by the government may not bridge the gap between what buyers want to pay and what some banks are willing to accept, for fear of further markdowns.

“We believe the programme will be more successful in attracting security related assets, which are generally marked-to-market, relative to loans,” said Mr Goldberg.

The government may be hard-pressed to find buyers for assets that are backed by second-lien home mortgages even if it offers to finance the purchases with 99 cents of debt for each penny invested, one banker said, because those assets appear to be inherently worthless.

...............................................

A sweet deal for investors?

The Geithner plan unveiled this week presents investors wanting to buy toxic loans from banks with three options:

1. Buy a loan (or security), hold it in the hope its value will appreciate and then sell it

2. Hold the loan to maturity

3. Buy loans, restructure them and sell them on

If they choose the first option, investors could get a sweet deal at little risk:

The chart below shows a hypothetical scenario in which a public-private partnership buys a loan initially worth $100 from a bank at the reduced cost of $84. The private investor would invest $6 in equity, the Treasury would take a further $6 in equity and the remaining $72 would be funded by FDIC-guaranteed loans.

The chart shows net profits for the taxpayer (the Treasury plus the FDIC) and private investors, at a range of selling prices when the loan is sold after one year.

It assumes that 2% interest is paid on the loan, while the FDIC is paid a ‘guarantee fee’ of 1% (the actual rates are not yet known).