Daily Market Reports | Sep 26 2008
By Greg Peel
The Dow rose 196 points or 1.8% while the S&P rose 2% and the Nasdaq 1.4%.
The politicians have the upper hand. The Democrats have the majority in both houses. Waving poll results suggesting the public is against using taxpayer money to save greedy Wall Street bankers, well-meaning but ignorant senators have Treasury secretary Hank Paulson backed into a corner, and Fed Chairman Ben Bernanke is equally powerless. Exploiting their considerable leverage, angry senators (from both sides of “the aisle”) have pushed Congress into enacting a bill that will appease the will of The People. Unfortunately The People and their representatives are largely clueless as to what the problem really is, and how Paulson’s Plan A would resolve it.
It is simply too far removed from the day-to-day “real world” for the majority of Congress to appreciate that a straightforward plan to warehouse all the system’s toxic securities for later distribution would likely (a) unfreeze credit markets and (b) return a profit to taxpayers. Hence Plan B – which itself is still only a draft and will need to be debated yet further – involves an equity ownership balance to the debt ownership risk. Plan A was never without risk, but Plan B means the taxpayer will have its cake and eat it too, and that there will be a few extra pastries thrown in on the side.
The real risk is that that financial institutions, no matter how distressed, will now be the ones who reject the Plan.
Plan B involves buying up the toxic debt but in exchange also acquiring warrants over the equity in participating institutions. A warrant is a form of call option set at a strike price above the current trading prices of those institutions. Those warrants will be exercised when the share price of an institution returns to the strike price level, at which point the taxpayer will take control of some proportion of that institution’s equity. It means that as a reward for providing the institution with a “bail-out”, the taxpayer will enjoy a cut of the improved equity value that is assumed to accumulate once all the toxic debt is taken off the books and the institution can get back to normal operation and earnings growth.
However, exercise of the warrants will also dilute the value of the current shareholder base at the threshold of “improvement”. This means that current shareholders will only be able to look forward to a small recovery of lost value before the taxpayer muscles in and takes a cut. You could call it a form of performance fee, or you could call it a protection racket. If the shares in question do return to better levels you can be guaranteed the value of the acquired toxic debt will have also improved, which will also provide a profit to the taxpayer. The taxpayer will win twice, so long as Plan B actually works.
And therein lies the problem. Irrespective of being able to offload the unwanted debt that is crippling each institution, all institutions will still need to raise more capital. But just how keen will potential buyers of that capital be if they know that as soon as that their investment begins turning a profit, the taxpayer will step in and say thanks very much, I’ll take some (most?) of that?
Thus there is a risk that said institutions will elect to stick it out. If some institutions do elect to offload their distressed securities, then a price is set. Assuming that price is a “fire-sale” one, then there is an army of cashed up private equity funds and risk-hungry hedge funds just waiting to step in and snatch whatever it can from the government by offering a slight premium. Warren Buffett claimed he would have bought all of that debt himself if he could, but he doesn’t have US$700bn. Plan A would have seen the government take a quick-turn profit on these deals, and the bad debt would have “moved from weak hands to strong”, or at the very least moved back into the private sector where it belongs, with the government acting merely as an agent taking a commission.
But knowing this, one institution might say “We will opt out of the Plan and avoid having to give up equity, and then just sell our securities to one of these cowboys who wants them now a price has been set”. This seems quite sensible, but what if that’s what all the institutions decide? No one will sell anything and we are back where we started.
It will be a staring competition, because at the end of the day those institutions desperately need to sell this stuff to someone. If one blinks and sells to the government then there might be a rush, but if no one blinks then the system remains frozen. That would be disastrous. The equity element of Plan B puts the whole rescue package in jeopardy.
Furthermore, Plan B does not allow for US$700bn to be made available up front. Initially US$250bn would be provided, with another US$100bn top-up if needed, but the final US$350 will not be available until May.
If there’s one thing the global financial system does not have, it’s time.
There will also be some form of cap on Wall Street salaries, which was always on the cards. Ex-Goldman Sachs CEO Hank Paulson might be burying his mates by agreeing to this concession, but really it was a small price to pay to get the US$700bn. The equity warrant requirement will not be a small price to pay.
In giving up their toxic debt, institutions will have no way of ever recovering those write-downs they’ve been making since late last year. That is profit opportunity loss number one. If they do return to making a profit, that will be crimped when the taxpayer takes a cut. That’s profit opportunity loss number two. Now that the days of 30x leverage have gone, that’s profit opportunity loss number three. If you were an investment banker, you’d be wondering how you might ever return to any reasonable level of earnings growth. But then in the US, there’s no such thing as an investment bank anymore.
The other worrying difference in Plan B is one that removes the concern Congress had about giving the Treasury – and thus Paulson – too much executive power to control the taxpayers’ money. Thus the “bail-out” process will involve not one, but two, Congressional “oversight committees”.
Did anyone say camel?
If you can’t see why this is not a particularly useful concession, just imagine sending in the NSW state government to prevent the catastrophic collapse of global financial markets.
With all these concessions likely to be put in place (although Plan B has yet to be ratified and we could still be waiting another week), Wall Street’s response was positive but muted. Positive because any plan that might stabilise credit markets can only be a good thing, muted because this watered down version has a greater risk of not actually working (the Dow was up 300 points at its peak).
The response in other markets was also timid, with the US dollar dropping slightly. Oil rose US$2.29 to US$108.02/bbl on a weaker dollar, a hope for economic recovery (good luck), very low gasoline inventories, and yet another storm building in the Gulf.
Gold fell US$4.30 to US$876.40/oz, which seems the wrong way round, but it is more a case of sell-the-fact. Base metals were once again little moved given no one quite knows what is a good thing and what is a bad thing back in the “real” economy. The Aussie was little changed.
And speaking of the real economy, it was a case of reality check when last night’s weekly jobless numbers were released. The number of new claimants leapt up by 32,000 – much more than expected – but analysis of this figure is somewhat clouded by the number of workers temporarily laid off during the recent hurricane blitz. However, August durable goods orders were untainted, and that figure fell by a larger than expected 4.5%. Sales of new homes also plunged in August by an imposing 11.5%. Economists had expected a fall of only 1%.
This is the “real” world.
More onerously, the 30-year fixed mortgage rate (the most popular US mortgage) had fallen to 5.78% – its lowest level since February – but last week jumped back up to 6.09% as credit markets froze. If the Plan does not work, then God save us.
The SPI Overnight rose 63 points.
