FYI | Feb 11 2009
By Greg Peel
May I just say at the outset that I was as thrilled as most everybody else about the historic and symbolic change of leadership in the White House. It was clearly time to bring an end to a Republican oligarchy which had become blindly consumed by its perceptions of ultimate power. However, aside from being a journalist and thus, by default, overtly apolitical, one must now consider the actions of the new US administration in a purely pragmatic sense.
Symbolic change, by itself, will not save the world in the short term. There are many, including correspondents to FNArena, who ascribe to the view that nothing short of financially penitential solution is required to return the world to an even keel. Financials markets should be allowed to collapse, they believe, to teach the world a lesson and reinstate a more frugal existence. Such opinions are admirable, and reasonable, but are cold comfort to those immediately worried, for example, about their superannuation fund or retirement cashflow. Such a solution would also result in a multitude of innocent victims, which we might call collateral (debt obligation) damage.
It has long been accepted that a Republican administration in the White House is good for Wall Street and a Democrat administration is not. In short, Republicans traditionally stand for free markets, small government and lower taxes. By contrast, Democrats advocate controlled markets, big government and higher taxes. The Democrats are the socialists to the capitalists of the Republican ranks. Wall Street is the epitome of capitalism.
Capitalism has, however, failed. Not in its essence but in its abuse. That President Obama should be charged with the task of spending trillions in non-existent dollars to prevent his country going the way of ancient Rome is testament to decades of arrogant imperialist attitude. But charged with that task he is. It is no longer appropriate to consider the Democrat-Republican relationship as representative of a clear left-right divide, just as it is no longer appropriate to consider the Labor and Coalition parties in Australia to be so diametrically opposed. Necessity has become the mother of centrist policy. It was the Republican administration which took the first overtly socialist steps towards a quasi-nationalization solution for the US financial sector. It is the Democrat administration which is now trying to save capitalism.
Since the collapse of Bear Stearns last March the global economy has been hamstrung by frozen credit markets. Fear, suspicion and the desire for self-preservation has replaced the trust required for credit markets to exist. Risk appetite has turned to risk aversion. Without the considered acceptance of risk, economies cannot function. It took the collapse of Lehman Bros last September for the world to finally realise just how seriously the risk model had been abused over many years in the pursuit of profit at the expense of social cost. It is highly likely that America’s biggest banks are currently insolvent.
Indeed, the new Treasury Secretary on the block, Timothy Geithner, was asked this morning (Sydney time) by a Senate committee just which banks he thought actually were trading insolvent at present. Wisely, Geithner refused to pass comment in the knowledge that whatever he said would be commercially imprudent. Single out any one bank, and within seconds that bank’s share price would be near zero. Counterparties would rush to withdraw commitments, depositors would rush to withdraw savings. Of course Geithner could not answer the question, unless the clear answer was an emphatic “none”. But it wasn’t.
Last September the then Treasury Secretary, Hank Paulson, and the current Federal Reserve Chairman, Ben Bernanke, came up with a plan to save the world called the Troubled Asset Relief Program – the infamous TARP. Initially a one-page document, it outlined a vague intention to buy up all the “toxic” assets sitting on US bank balance sheets – the subprime mortgage securities, the collateralised debt obligations – whatever debt securities were being held by banks and now valued by the market at next to nothing, and marked on accounts as such due to mandatory accounting standards. The reasoning behind that plan might be considered twofold.
Markets for such securities had been over-the-counter and thus opaque as opposed to the transparent nature of markets in stocks or futures, for example. This meant there was no obvious way of determining just who had what and how much. Moreover, no two such securities were necessarily alike, and such lack of homogenity only added to the inability of markets to confidently ascribe value. The safe alternative was to assume no value. Yet is is well understood that while all CDOs et al have been considered under the same umbrella of toxicity for safety’s sake, a vast bulk would actually be true AAA-rated securities with value that might be realistically closer to 95 cents in the dollar than zero. But no one knew how those securities were distributed amongst the plethora of holders. To that end, credit markets froze out of ignorance.
Were the US government to remove the supposed toxic waste from private sector bank balance sheets and corral it into one entity, paying some consideration of “fair value” to do so, those banks would suddenly become unburdened and free to reinstate normal operations. Credit markets would, in theory, un-freeze. The wheels of the economy would turn again.
Moreover, as the banks in question would likely be prepared to offload the toxic assets at bargain basement prices, in order to maintain survival, the American taxpayer would supposedly be picking up a valuable longer term trade. The government would be able to sell the securities back into the market at a later date, and at a profit.
There was, at the time, a cautious acceptance of the TARP plan by most on Wall Street as a good one, but it quickly became academic. The fundamentals of the plan were hijacked by a self-interested Democrat majority in the House, and the plan morphed into a 300-page document of extensive caveats and concessions. The purchase of toxic assets was ultimately canned as a solution and instead the government made capital injections into troubled banks by way of preferred equity investments. The intention was that credit markets would un-freeze by virtue of such government participation and the taxpayer, as shareholder, would thus benefit from improved share prices. Various other accompanying programs were also implemented with the TARP funds.
None of it worked.
The Fed has been much involved in the various rescue measures, extending its balance sheet to become an intermediary of the last resort in corporate debt markets, underwriting the purchase of AAA-rated prime mortgage securities, and implementing a Term Asset-backed Loan Facility (TALF), as part of the TARP, intended to support credit markets at the consumer and small business level. All this was occurring as America rallied to vote in a new president, and was still being tweaked during George Bush’s “lame duck” limbo.
Without any specific resolution, an exhausted Henry Paulson released the reins. Barack Obama appointed a respected and well-received, albeit young, Timothy Geithner as Paulson’s replacement, and while the world cheered, sang and sobbed at the Obama inauguration, young Timothy burnt the midnight oil. Even before his inauguration, Obama had dropped hints about a new fiscal stimulus package and a reworking of the TARP. While Wall Street initially faltered at the uncertainty of it all, slowly even the capitalists began to believe in the potential of a new world order. Very slowly risk appetite began to return.
Wall Street began convincing itself that TARP II would finally prove a market-saving strategy, unlike TARP I. The Democrat administration, while demanding concessions such as executive salary restrictions, appeared ready to throw everything at it. (Paulson had long made similar assertions, but that no longer mattered). There was talk of creating a “Bad Bank”, which was ostensibly a reinstatement of the original Paulson-Bernanke plan. There was talk of easing mark-to-market rules on assets which might otherwise be much better valued. There was talk of further capital support for troubled banks, perhaps even as common stock purchases. There was talk of extending TARP funds well beyond the previous level ratified by Congress. It was with heightened anticipation that Wall Street postured ahead of last night’s big reveal. There was hope in the air.
That hope was quickly dashed.
An initial response from the analysts at GaveKal:
“Geithner’s package was a bitter disappointment because of its lack of detail and the feeling that, despite having had three months to cobble something together, the US Treasury is as clueless under Geithner as it was under Paulson.”
What Geithner proposed is as follows: (1) the TALF would be increased from US$200bn to US$1 trillion via ten to one leveraging of US$100bn of remaining TARP funds; (2) another US$50bn would be used to buy banks’ toxic assets in a private-public partnership on ten to one leverage (US$500bn) but could grow to a leveraged US$1 trillion; (3) remaining TARP funds would be used to inject more capital directly into banks, provided those banks pass a “stress test”; (4) US$50bn would be put towards providing relief for home-owners on the verge of foreclosure.
In essence, Geithner’s plan appeared to contain nothing at all new, just a commitment of ever more money. The only consolation might be the reintroduction of the Bad Bank concept, but the plan came with insufficient detail. Nor was there sufficient detail on what form bank capital injections might take, nor any figure provided for such. Nor was there any indication as to whether Geithner expected to have to go to Congress for approval of more money, other than to concede it was probable.
TARPII looked very much like a beefed up TARP I. And TARP I has not proven successful to date. Wall Street demonstrated its disappointment by selling the Dow Jones Index down 400 points, thus returning it to levels last seen at the bottom of the market in November. Bank stocks were the most heavily sold. Aside from a lack of anything new on the support side, the “stress test” caveat – in which banks recipient of capital injection must first prove economic viability – was poorly received. And there appeared to be no resolution on mark-to-market requirements.
Now what?
It would have been with heavy hearts and world-weariness that traders filed out of Wall Street last night. However, on closer inspection, and with the benefit of a bit more time to absorb the written document that accompanied the verbal announcement, perhaps TARP II is not quite so impotent after all. Perhaps it is simply a case of one Timothy Geithner proving naive and timid in his first real public appearance test.
Wall Street has assumed the devil is in the lack of detail. On closer scrutiny of what detail actually was provided, the analysts at GaveKal see that in reality the devil was only in the lack of public assertiveness. The plan itself actually isn’t that bad, they suggest.
Firstly, one trillion dollars of TALF is a “big deal”. The Fed stands ready to act immediately (although Congressional approval for the funds will be needed) and the leverage, and subsequent “huge” expansion of the Fed’s balance sheet will help to revive credit markets and boost the money supply.
The public-private “Bad Bank” plan is complicated and lacking in detail, but it is assumed private involvement will come with some “pretty generous” government guarantees. A cleansing of toxic waste from bank balance sheets will be beneficial to shareholders provided the government is not merely offering to buy assets at fire-sale prices. The latter is unlikely, GaveKal believes, if one considers the implications of the accompanying capital injection plan.
Having cleansed the toxic waste from their balance sheets, banks with assets of over US$100bn will then enjoy unlimited contingent equity support. The pricing of such support looks “very generous” as it will be based on only a “modest” discount from share price levels prevailing at the close of business on February 9. Such market-based pricing means existing shareholders will avoid the sort of value dilution which resulted from the rescues of Fannie Mae, Freddie Mac and AIG.
A “stress test” will be applied to establish whether banks have enough capital to continue sufficient lending even “in a more severe decline in the economy than projected”. But having passed the test, those banks will then enjoy a “guarantee buffer” of unlimited contingent capital. This is a form of insurance – an idea that was vaguely rumoured to be under consideration last week – that will come at a bargain cost compared to what the private sector would require to insure banks against ultimate disaster. (GaveKal suggests such a cost would effectively be infinite).
The “stress test” will also address the issue of mark-to-market, although this was buried in the detail and easy to miss. “The Treasury will work with bank supervisors and the Securities Exchange Commission and accounting standard setters,” the document suggests, “in their efforts to improve public disclosure by banks. In conducting these exercises, supervisors recognize the need not to adopt an overly conservative posture or take steps that could inappropriately constrain lending”. In other words, officials will view bank assets with a consideration of fair value, rather than a market value representative of fear, in order to arrive at a reasonable conclusion.
All in all, this is not a bad package. It was just not delivered very well. Says GaveKal:
“In sum, yesterday’s package seemed fairly generous to the banks and also fairly comprehensive. It included provision for a bad bank, for low-cost catastrophe insurance against an economic depression and for potentially unlimited capital injections at prices that are not punitive to existing shareholders. It also implied a tacit suspension of mark to market accounting when this constrains lending. However, whether an Administration that was too politically timid to spell out these measures in public, will have the courage to implement them is another matter.”
The GaveKal analysts back up their questioning of the administration’s courage with somewhat of a behind-the-scenes look at Democrat party negotiations. On one side, Geithner and his supporters were keen to free the banks from toxic assets. On the other, Congressional leaders were more preoccupied with punishing bankers and providing capital only if bank shareholders were also punished. But it is impossible to both punish a bank and beneficially restructure it at the same time. In the end, Geithner pointed out that his predecessor’s approach had been very punitive to bank shareholders (the preferred equity capital injections not only diluted existing shareholder capital but they relegated shareholders to a position behind the taxpayer in terms of distributions) and yet no good had come of it. The approach had not worked.
And thus we have the problem – one which GaveKal points out contributed to the ruin of the Carter administration – that Obama’s capitalistic intentions, required to save the US economy, may well end up continually hamstrung by the party’s left faction and the socialist agenda therein. But for everything there is a season, and a time for every purpose under heaven. We can only wait to see how things play out from here.
