Feature Stories | Mar 24 2009
By Greg Peel
From 2003 to 2007 the amount of debt accumulated by the US and the rest of the world expanded exponentially. Nowhere was this more evident than in the US housing bubble, which began to peak in 2006 but began to collapse in 2007. A combination of cheap money (a result of trying to bring the US economy back from the tech wreck and 9/11), the capacity for investment banks to invest at 40 times leverage (a legislative increase made in 2004 beyond the former 12x limit), the creation of complex mortgage securitisation instruments (which few understood), poor regulation of that market, an unregulated mortgage broking market, and the complicity of credit rating agencies (who applied AAA ratings to risky assets), conspired to create the “subprime crisis”.
The subprime crisis began because of the overwhelming greed of everyone from investment bankers to mortgage brokers and Bobby and Betty low-income citizens. When the housing bubble finally burst, the effect was to set off a chain of defaults of subprime mortgages. Because newly created instruments such as CDOs (collateralised debt obligations) involved a complex combination of prime, mid-prime and subprime loans, and a cascading default mechanism, all CDOs came into question as to their value – if any.
Adding fuel to the fire was the over-the-counter nature of the CDO. There was no visible trading market such as that of a stock market. No one knew who held the bulk of CDOs and indeed how many there even were. And given each CDO instrument was unique, it was not a case of comparing apples with apples either. The market responded by assuming the worst – that all CDOs were overtly risky and every investment bank, commercial bank and hedge fund held them. This sudden risk aversion quickly spread to the entire financial market and the entire world. Now risk was a dirty word. Risk has been built up on excess debt, and multiplied through leverage, and now the safest thing to do was to unwind that risk and reduce that debt. The initial frightened exit turned into a full scale stampede. The global financial crisis was born.
Exacerbating the problem had been lax accounting standards in the US as to the valuation of CDOs and other such instruments on a bank’s books. In short, banks could revalue CDOs at whatever they thought applicable. This provided the opportunity for banks to fudge value. But in November 2007 the Federal Accounting Standards Board tightened up the legislation, such that all CDOs must be “marked to market”. But there was no market. No one knew what these things should be worth. No one knew how many there were or who held them. The safest thing to do was to stay right away from them.
Thus the “market” price was effectively zero. Banks were forced to start writing down the value of these assets, now considered “toxic”. The further they wrote down value, the more capital they effectively wiped off their balance sheets, even though losses were not at this point actually crystallised. This led to a capital crisis. Most banks were forced to cut dividends and raise fresh capital. Others simply folded (Bear Stearns, Lehman Bros). When the market was reduced to a basket case late last year, the US government stepped in and started providing capital injections to those banks deemed “too big to fail”. They were deemed so because of the size of their positions and the interconnectedness of global financial markets. To let such a bank go would be to commit the global financial market to unspeakable catastrophe as the dominoes fell. Lehman Bros had merely provided a taste.
It was at that point last year that the then Bush Administration came up with the threads of a plan to take toxic assets off bank balance sheets. The plan was, however, shot down by a self-interested Congress. So here we are almost six months later with the revival of, and specific detail of, a similar plan under a new administration. With the exception of the recent rally, the stock market has done nothing but fall in the interim. Nero had fiddled. Rome has burnt.
Last night the US Treasury released a press statement to announce the details of its plan to address the problem of toxic assets. The Treasury described the problem as such:
“Losses were compounded by the lax underwriting standards that had been used by some lenders and by the proliferation of complex securitization products, some of whose risks were not fully understood. The resulting need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.
“As a result, a negative cycle has developed where declining asset prices have triggered further deleveraging, which has in turn led to further price declines. The excessive discounts embedded in some legacy asset prices are now straining the capital of U.S. financial institutions, limiting their ability to lend and increasing the cost of credit throughout the financial system. The lack of clarity about the value of these legacy assets has also made it difficult for some financial institutions to raise new private capital on their own.”
And that is why, in the first instance, both the outgoing and incoming administrations have provided a prop to the banking system in the form of taxpayer-funded bank capital injections. But so far the taxpayer has seen a loss on such investment. Something more decisive needed to be done, just as Secretary Paulson and Fed chairman Bernanke had decided in September last year.
The fundamental axiom behind a decision by the US government to buy such “toxic waste” off the banks is that not all of it is toxic. Think of yourself walking through the woods after a rain shower and noting a lot of different mushrooms popping up. Indeed no two mushrooms you can see even look alike. You are sure some of them are toxic toadstools, and you have no knowledge of how to identify the difference, so while you would love to pick a few tasty, edible mushrooms you simply decline because of the inherent risk.
Among the “toxic waste” of mortgage securities lie some toadstools – those overly laden with subprime default risk – but also lots of mushrooms – those which are prime with only minimal default risk. Because the market has not had the knowledge to distinguish between the two, they have taken the less risky approach of not buying anything until someone can point out which are which. As soon as that happens however, the market is actually keen to buy securities that have been oversold on fear rather than reality. Many CDOs will mature comfortably and return their face value.
And thus this is what is now going to happen:
“Using $75 to $100 billion in TARP capital and capital from private investors, the Public-Private Investment Program will generate $500 billion in purchasing power to buy legacy assets – with the potential to expand to $1 trillion over time”, the Treasury press release states.
The “legacy assets” have been divided into two groups – “legacy loans”, which include mortgages and pools of mortgages, and “legacy securities”, which include residential mortgage-backed securities and commercial mortgage-backed securities that were originally rated AAA (into which category CDOs fall).
Banks holding such legacy assets and wanting to get rid of them will go to the Federal Deposit Insurance Corporation (FDIC) which is the independent government-funded overseer of commercial banking in the US and guarantor of bank deposits. If the FDIC is happy that these assets fall into the low risk (mushroom) category, deserved of a high credit rating, then it will be willing to lend up to six times the value of what the buyer puts up to purchase the asset.
The buyer in this case is the private sector, but the government will then match the buyer’s bid and take half of the purchase. The Treasury uses the example of a CDO with a face value of US$100 being valued at US$84 by a potential buyer. The FDIC will provide US$72 of that value to the buyer as a loan and the remaining US$12 will be split between the private and public buyers who will put up US$6 each. This is the Public-Private Partnership part.
The plan is rather ingenious. Previous suggested plans to deal with the same toxic assets involved the government simply taking them from banks and either hanging onto them itself for later (hopefully profitable) divestment or auctioning them off to the private market. Either way, the government had to decide at what price it would purchase such assets. If the “fair value” of a US$100 face value CDO was US$84, but the mark-to-market price was only US$20, what should the government pay? Something in the middle? If it didn’t offer enough then banks wouldn’t sell and if it offered too much the private sector wouldn’t buy.
The Treasury press release outlined the “merits” of this new approach as follows:
“This approach is superior to the alternatives of either hoping for banks to gradually work these assets off their books or of the government purchasing the assets directly. Simply hoping for banks to work legacy assets off over time risks prolonging a financial crisis, as in the case of the Japanese experience [a decade of deflation]. But if the government acts alone in directly purchasing legacy assets, taxpayers will take on all the risk of such purchases – along with the additional risk that taxpayers will overpay if government employees are setting the price for those assets.”
Under Geithner’s plan, it is the private sector that determines what it wants to pay. One presumes that will be a “middle” price – a level high enough to encourage the banks to sell but low enough for it to be (hopefully) a profitable trade for the investor. Having allowed the more qualified private sector to make such an assessment, the public sector simply jumps in alongside. The private sector also feels safer knowing it has the government in the deal with it.
But the private sector is also only paying US$6 for a US$100 face value security. It is only US$6 that investor can lose. Assuming the purchase price is US$84 then the private sector has a US$6 downside and the public sector a US$78 downside (the government’s US$6 matching bid plus the FDIC’s US$72 loan) not counting the (low) interest payment on the FDIC loan.
The Treasury has put an elegant spin on this deal in its press release:
“The Public-Private Investment Program ensures that private sector participants invest alongside the taxpayer, with the private sector investors standing to lose their entire investment in a downside scenario and the taxpayer sharing in profitable returns.”
What it didn’t add was the other side of the equation: “…with the private sector sharing in profitable returns and the taxpayers standing to lose their entire investment” (of US$78 to the private sector’s US$6).
In the case of legacy securities (CDOs and the like), the government will ensure competition by approving up to five (but maybe more) asset managers with a demonstrated track record of successfully purchasing distressed debt to make the bids. In the case of legacy loans (mortgages and pools of mortgages), the government expects the participation of a broad array of individual investors, pension plans, insurance companies and other long-term investors. The government money will all come out of existing TARP (Troubled Asset Relief Program) funds and the legacy security purchases will specifically come from the TARP subset known as the TALF (Term Asset-Backed Loan Facility).
As the money has already been pledged by Congressional legislation, Congress does not, in theory, have the opportunity to stick its nose in and scupper this deal too. However, mindful of its poor handling of the AIG situation and the anger it created, the government will allow public comment on this PPP deal before it begins implementation. There may yet be some tweaking. There is little doubt the private versus public risk balance will come in for some hearty criticism.
There is also more detail to be determined on top of this detail already suggested. The press release notes:
“Borrowers will need to meet eligibility criteria. Haircuts [risk discounts] will be determined at a later date and will reflect the riskiness of the assets provided as collateral. Lending rates, minimum loan sizes, and loan durations have not been determined. These and other terms of the programs will be informed by discussions with market participants. However, the Federal Reserve is working to ensure that the duration of these loans takes into account the duration of the underlying assets.”
It is unlikely the first toxic asset purchases under this deal will be made before the start of the US summer. In the meantime, the government is also conducting bank “stress testing” to determine which banks are worth saving with TARP funds and which ones are not. One presumes only those banks passing the stress test will be able to offer their toxic assets to the PPP. The testing is also not expected to be completed for a while.
So – here comes the sixty-four billion dollar question. Will the plan work?
A cynic could be quickly forgiven for suggesting that nothing the government has done to date has worked, so why should this plan be any different? However, it has been understood for eighteen months now that the root of the problem (or at least the root of fixing the problem) lay with toxic assets. Paulson and Bernanke knew this in September last year. Congress was too ignorant to understand.
In September AIG nearly went under and Lehman did. The Dow Jones Industrial Average was around 11,000 at the time. A fortnight ago it hit 6440 – a further fall of 41%. Everything either administration, hamstrung by Congress, has done in the interim has been to apply bandaids in an attempt to unfreeze credit markets and stop the economy sliding. But the toxic assets have been festering underneath those bandaids all the time.
If a bank can rid itself of toxic assets on its balance sheet then it can rid itself of the risk that ongoing mortgage defaults (spurred on by growing unemployment) will cause further loss in value of mortgage securities and thus further erosion of capital. Banks cannot grow the debt side of their balance sheets (lend money) until they can shore up the equity side (tier one capital). In the meantime, it’s just a case of survival, and damn the next bloke. If potential bank investors can be relieved of the fear of skeletons in a bank’s cupboard (toxic assets) then they will be happy to take on risk they can otherwise see and understand. Banks will see their share prices improve and they will lend money again. The economy can stop sliding.
That’s the theory, and it is a good one.
There are, however, a couple of points to consider.
Last week the US stock market turned around and began a bank-led rally. The reason for the rally (apart from the market being oversold) could be put down to three developments: (1) Citigroup announced it had made a profit in January-February outside of toxic asset write-downs; (2) Congress vowed to consider relaxing the mark-to-market rule; (3) there was talk of the uptick rule being reinstated.
Number (3) relates to the practice of short-selling – an adjunct to but not the underlying cause of the global financial crisis. Numbers (1) and (2) are related however and relate directly to toxic assets – the root of all evil.
After Citi made its announcement, other US banks and even banks elsewhere in the world made the same declaration – a declaration the market had not expected. We are profitable, the banks suggested, but for those toxic assets. The toxic asset problem had been exacerbated by the requirement to mark them to a market price that basically didn’t exist. Relax that requirement – allow banks to assume a “fairer” value based on actual risk, not in-the-dark market-perceived risk, and those assets would be worth more. Write-downs could be turned into “write-ups”. Bank balance sheets would be suddenly relieved. And beyond those assets, the banks are making money!
While the topic has not been formally addressed, one assumes that the government’s new PPP plan now alleviates the need to relax the mark-to-market rules. Under the plan, new market prices will be found and they will surely be higher than current market prices. Those market players who don’t get a chance to participate in the PPP directly will nevertheless take the lead of those who do and want to get in on the act in the secondary phase.
What this means is that banks who stay out of the selling process, deciding instead to keep their toxic assets, will still get the opportunity to mark them at new, higher prices (as the rules currently allow). This will provide the balance sheet boost needed AND keep the upside – the potential for write-up profits – with the bank.
Banks that do decide to sell to the PPP will, in doing so, have only one chance to write up the value of those toxic assets and no chance to hold to maturity for what – believe it or not – would prove a net profit from the original purchase price. It is assumed that the potential buyers of the toxic assets – those market participants forming the private part of the PPP – will pay what they see is a discount to fair value. Otherwise they would not see upside or potential profit from the deal.
Is it thus possible that after all the waiting, all the hoopla, and a 500 point rally in the Dow in one night that we might just end up with a stalemate? Is it possible that the banks line up on one side and say “I expect this much” and the hedge funds line up on the other and say “Well I’m only going to pay this much”. Or is it possible that Geithner throws a party and none of the banks turn up at all?
One interesting and potentially relevant development last night was the revelation that Goldman Sachs was looking to sell maybe 15-20% of its 4.9% stake in China’s ICBC bank.
Goldman Sachs entered the subprime crisis with two important things going for it. It was America’s biggest investment bank and it did not hold any subprime CDOs. Thus as the likes of Bear Stearns fell, Goldmans should have stood resolute. The only problem was that as Goldman was as inexorably linked to the interwoven international credit markets as anyone else, it, too, suffered as a result of the subprime crisis morphing into a global financial crisis. Goldman was forced to become a commercial bank and thus satisfy stricter regulations, and was forced to take on a government capital funding in the form of a TARP hand-out.
The once market leader in financial innovation has been brought to its knees as just an also-ran bank. Not only is Goldman now under greater regulatory scrutiny and can take fewer risks, legislation just passed by the House imposes a 90% tax on executive bonuses paid to recipients of TARP funds. For Goldman and its management, it seems like life is no longer worth living.
The response is thus that Goldman is prepared to sell some of its “jewel in the crown” Chinese investment and use the funds to pay back its TARP injection – a move that any bank is allowed to make at any time. Once out of the TARP clutches, Goldman can move to reinstate itself as a financial leader, and maybe even push to regain some form of investment bank status. Goldman Sachs has no tie-up with a deposit-based bank and thus no need of an FDIC deposit guarantee.
While many might think such a move is only to return to the dark days, the point is that if banks are looking to pay back their TARP obligations as quickly as possible, are they still wanting to ditch their toxic assets as well? If their balance sheets can survive alone, it would be more profitable in the long run to hold onto those assets.
Which brings us back to our potential stalemate.
Another point to consider is that, if there were no stalemate and this PPP plan actually worked (as many believe it will), are we not just putting off the inevitable for another day? To use leverage to fight leverage is to fight fire with fire. In the wider picture, the US$13 trillion the US government has conjured up to date to fight the global financial crisis (soon to be US$14 trillion?) is roughly equivalent to the estimated losses suffered by all Americans in asset value decline. The GFC is a result of an excessive build-up in debt – debt used to buy such assets. The government has now replaced that debt with printed money.
The US government has basically decided it can print as much money as it likes in order to maintain the lifestyle to which America has become accustomed – a lifestyle which, as the GFC indicates, is excessive and unsustainable. The government wants to make sure America can remain King of the World.
The other way of looking at it is, as the Obama administration would like you to look at it, that such drastic measures – from TARPs and TALFs and quantitative easing, and now this new PPP – is that all measures are a way to prevent disaster, right the ship, and only then worry about what went wrong in the first place. Then to introduce regulation that would prevent such a thing ever happening again.
There are many who believe the plan will work, and clearly Wall Street likes it on face value. It has been likened to a not dissimilar plan implemented after the Savings and Loans crisis of the early nineties – a plan from which the American taxpayer ultimately made a profit. But the 1990s recession only paved the way for a bigger, 2008 recession. What are we paving the way for now?
I hope the plan works. While I believe we are seeing only a bear market rally in anticipation I hope I’m wrong. But it will probably be our children or their children who ultimately pay the price.
Nyah – waddya gonna do?
