This week's run up in the market was, without doubt, purely an exercise in front-running the government's pumping of more taxpayers' funds into financial "assets" and the pricing in of yet another rally (as well as some greater fool expectations thrown in for good measure) in light of continuing depression-worthy economic releases. The two main expectations for Monday's Treasury announcement revolve around an "aggregator" bank and toxic asset "ring-fencing." These are unique in that both perform crisis intervention before recognition of bank insolvency, or apriori triage. A key question is whether this rally, which caused a 5% rip in the market last week, will persist or fizzle? What have prior bailouts demonstrated in terms of market performance:
From 9 weeks post Bear Stearns, to 4 weeks post Paulson's GSE initiative, to no rally post TARP - the half-life of rallies is getting worse and worse, as if rallies are pricing in future rallies. So does the upcoming bailout have the makings of actually fixing the structural problems in the economy? Some thoughts on the various approaches, from BAC:
This is an off balance sheet vehicle that pools multiple bank’s bad assets into one “Bad Bank” or “Aggregator Bank” that can both manage and dispose of the bad assets it buys from banks. To alleviate the pricing problem, the bad bank could focus on trading account securities and loans that have been most heavily marked down. By either taking these at the latest mark, or standardizing these marks across banks of the (relatively) more price transparent assets, the pricing issue – setting the correct price to protect taxpayers – could be avoided. The impact of this move would remove further downside uncertainty for the banks, freeing them up from those assets (while at the same time transferring all future upside to the government as well). However, that pool would be limited to those deemed sufficiently marked down to be able to avoid both price uncertainty and the potential that by setting too low of a price, further capital inadequacy issues would be exacerbated. These were the core problems of the first TARP program.
This approach has two attractions. First, it avoids having to deal with the pricing issue. This is important for loans with no ready price and with limited loss provision against them but high potential cumulative loss. Second, the assets remain managed by the given bank leaving no requirement for a management or legal structure and funding remains the responsibility of the bank. The main drawback however lies in the provisions for loss sharing. To date these have taken the form of a first loss tranche and a contribution to a second loss tranche. The protection of taxpayers lies in setting the size of these tranches relative to the overall pool of assets. A “true up” provision or “claw back” provides further protection in the event losses develop beyond anticipated in setting the first and second loss tranche positions. However, the drawback to these provisions is they effectively would bring asset loss uncertainty back onto the “good bank”. This would inhibit the ability to raise private capital to buy out the government share of ownership as long as loss uncertainty remained higher than the first tranche of losses. Managing this trade off and the size and scope of the pool of assets insured will be critical points to look for on Monday.
This has gotten little attention, but may become a feature of the comprehensive program, especially for SME and residential mortgage loans. In this type of program, the bank write down of a loan is subsidized by the government. The amount of the subsidy is scaled by the amount of new loan creation and is conditional on borrower payment history. It was successfully applied during the Mexico Peso crisis.
Capital and Funding
Capital for the bank could come from the existing TARP with funding provided by the Fed through section 13(3) lending authority. Total TARP funds remaining of around $375bn (assuming $50bn of unallocated CPP funds are shifted to the bad bank) imply that based on “Leveraging the TARP”, a larger pool of assets could be handled. For the Aggregator bank, a 10% capitalization level implies that say $50bn of TARP funds could support $500bn worth of bad assets. For the insurance program TARP funds work in conjunction with first loss tranche absorption from the given bank. For example, a 10% first loss piece plus a 10% second loss tranche absorbed by TARP imply $100bn of TARP funds could support $1 trillion worth of asset insurance, providing the Fed with a total 20% loss protection (10% from bank, and 10% from TARP).
The attraction of such an approach is that both capital and funding could be more than sufficient based on existing authority to create an impression of “overwhelming force” with positive near term market implications.
The bottom line is that while the government does have the capacity to leave a potential favorable impact on the financial system overall, it is contingent on i) a proper execution which, as we have seen, has been a huge problem for the administration in the past, even for a much more experienced Secretary of the Treasury than Geithner, and ii) while the financial system may end up being propped up yet again (temporarily) it would involve further incremental leverage, exponentiating the underlying reliance on less and less unencumbered capital, and thus putting the house of cards (as we like to call the global financial system) at even more risk of fat tail events. All this while the underlying economic deterioration is still an open question.
While one may argue that we are currently living the aftermath of the residential real estate collapse, Zero Hedge believes that the second leg to the current recession-cum-depression will become evident once the full impact of the crash in global commercial real estate, via the associated $3 trillion + in global CMBS and whole loan varieties, funnels through the world's economy. Upcoming major downgrades in senior and super senior CMBS tranches (note the AAA-BBB spreads below, implying either BBB is very cheap, or AAA is very rich) will incite an additional firesale of related securities that none of the proposed government programs will be able to compensate for, leading to yet another major bail out overhaul requirement.
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