Monday, March 23, 2009

So You Want 14x Free Leverage?

And yes, as reader Mike points out, it is 14x, not 12x (as ZH also erroneously assumed). The administration's 6x definition of leverage is really debt to equity. In their example where a PPIP participant invests $6 in equity, he ultimately purchases $84 in assets, or a total effective notional leveraging of 14x. (14x upside, 1x downside: taxpayer footing the difference. Where can I sign up?) But semantics aside.

As for signing up, today on the government's Financial Stability website, the Treasury posted the application for all aspiring and established fund managers who want to try their luck at abusing free taxpayer-subsidized leverage.

Among the selection criteria are:
  • Demonstrated capacity to raise at least $500 million of private capital.
  • Demonstrated experience investing in Eligible Assets, including through performance track records.
  • A minimum of $10 billion (market value) of Eligible Assets currently under management.
  • Demonstrated operational capacity to manage the Funds in a manner consistent with
  • Treasury’s stated Investment Objective while also protecting taxpayers.
  • Headquarters in the United States.
Curiously, the $10 billion minimum cutoff greatly facilitates the analysis of the earlier question of cui bono: luckily for both Blackrock and PIMCO, this criteria should not pose a substantial difficulty.

Additionally, The selected PPIP manager will "control the process of asset selection and pricing, and will also control the process of asset, liquidation, trading and disposition." Nothing like giving HF managers full authority to do as they see fit with a $1 trillion in toxic assets. A little more on the pricing issue - the term sheet states "Price of Eligible Assets for reporting purposes must be tracked using third party sources and annual audited valuations by a nationally recognized accounting firm." Of course, if our earlier tip that there are some serious shennanigans going on with these "third party [pricing] sources" this would only add gasoline to the MTM fire.

As for adding insult to injury, Hedge Funds will also be allowed to charge "private investors fees in their discretion." Not only are funds getting the greatest gift in the history of leverage, but they are also allowed to charge money for the privilege.

After looking at these terms, it should become immediately obvious why funds would be worried how the general public will regard their TALF gains (through a microscope). But not only that: hedge fund will only dispose of these toxic assets to comparably insulated hedge funds, thus starting a game of hot potato and greater fool at the same time, in which a certain toxic asset pool will be repurchased over and over until there is no nominal buyer left (nobody in their right mind would purchase an $84 toxic pool without $72 in non recourse loans backing their equity, especially not at a premium). Thus the gains will be merely short lived until, yet again, the greater fool disappears, and the last fund is stuck as bagholders unable to offload these assets, thus having to hold them to maturity, but much more likely to default.Those who manage to flip these "assets" early on will be the only winners in all of this, with the full losses again falling flat on the taxpayer's shoulders. Sphere: Related Content
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James said...

its the same problem with the stock market. Its just about the greater fool. After all its just a stock price.

Anonymous said...

Under the TALF, don't the participants have to hold the securities until maturity?

scriabinop23 said...

If I use $6 to buy $84 in assets, and my cost of capital (FDIC guaranteed debt cost) is below cashflow from these assets, I am using $6 to make that cashflow difference. After that difference pays off my $6 (actually $12, shared with the govt), I don't care what those assets are worth, I will do whatever it takes to keep them cashflowing.

Am I missing something here?

Daniel said...

"Am I missing something here?"

A conscience.

sysin3 said...

I'm just a commoner. A taxpayer. Just a simple engineer and a programmer, to boot.

So, please forgive my simpleton thougths ..... but this "plan" says to me that "we are all screwed by people who are already too rich to spend it in their lifetime."

Does that pretty much sum it up ? Just askin'.

In Debt We Trust said...

Sounds like Madoff 2.0

Or Social Security on steroids.

Same difference.

Anonymous said...

Your last dollar still sits parri-passu with the gov't check. Until you and the gov't, in this example, get $12M back in whole you aren't made whole on your outstanding equity...the leverage isn't 14-1

locust said...

So, under these guidelines, would Madoff have qualified?

ts said...

Let’s leave aside for a moment whether it will work or not (it won’t). Let’s do a thought experiment to see how it will function…

Suppose for a moment you’re a bank. You have an asset on your books at par but it’s really worth 84 cents (assume there are no criminal liabilities for wantonly falsifying the value of your assets, if these apply). You identify ‘em and throw ‘em out to see if you can get some scratch. To play, you will have to:
(1) Be willing to take the loss. There are stress tests coming up! But maybe you don’t care. You’ve already thrown this B-tranche second mortgage paper with a 40% default rate on the s***-pile already and written it off. Now you have an incentive to dump it at whatever you can get. Maybe the guys who just bought those bulk foreclosures in Temecula from Citigroup for under $100K per will show up at the auction.
(2) Be willing to take 84 cents. Suppose you only get 70, can you still do it? How about 50? Remember: once you choose the asset, there are no take-backs.
(3) Be willing to sell all your marginally okay stuff, leaving you with crap nobody will touch even at auction. This leaves you with the cash but a worse future liability problem. (Geithner must be employing the same mathematical brain trust that worked for the NAR and said home prices were recovering when you couldn’t sell condos and townhouses anymore.)
(4) Have something to do with the capital you get back, assuming you’re either not just replacing what you lost in order to pass the stress tests, or too scared to buy anything but T-Bills. (Maybe invest it in residential real estate loans. Those have been real winners so far. And the guy from NAR says the market’s turned the corner because home sales are up 5%!)

Now, suppose you’re the government. To play, you will have to:
1) Be as stupid or more stupid than Tim Geithner. Actually not a requirement, but it helps.
2) Be willing to loan 72% of the funds for a tiny fee and not have any claim on equity. That’s how I read it. The FDIC will loan 6/7 of the capital and get paid, what? A debt guaranty fee, probably of about 0.25%. I see no mention of them charging, you know, interest. (Incidentally, the fee will go to the DIF, so all the FDIC employees working to select the assets and perform the related services will be working for free).
3) Be willing to claim massive profits from the income flow on your tiny sliver of equity, which of course makes up for the massive losses you will experience on the decline in the value of the assets you have purchased.
4) Be too lazy to stack $1 trillion in taxpayer money into a pile and set it on fire.

Now, suppose you’re a hedge fund. To play you must like being given free money. That’s it. However, you will have to adapt your strategy to different situations.

Scenario #1, the bank just dumped this 84 cent asset at auction and you can pick it up for 70.

Solution #1: FLIP IT BABY! Maybe you have a friend at Merrill. They’re a “bank” now, by the way. They buy it back for 75 and since they have a few more loan guarantees and TARP funds lying around, they put it right back up for auction and get 55 cents. Sell it back to them for 60. Lather rinse and repeat. Fun for the whole family!

Scenario #2, the bank just dumped it at 84 cents and when you take delivery the smell is so bad it makes all your hair fall out. Loss Mit says if you can get 30 cents for it you’ll go straight to hell right after you die but be the envy of everyone at the trading desk.

Solution #2, BUY AND HOLD. Even the worst toxic waste still has a few people paying the bills. A CMO of seconds and HELOCs with 50% defaulted will still push out 3-4% in payments per year. Particularly if you own the servicing and you start talking to relatives of the recently deceased and tell them that Grampa Joad would have really wanted that mortgage paid off in full, including the late fees he incurred while he was lying around in the morgue. Just hold tight and milk out that 50%+ ROE until the fluids from the decomposition process start to eat through the metal seals. Then you place that call to Timmeh over at Treasury and say you’d like to stay but things just didn’t work out and they might want to call over somebody from Superfund.

Anonymous said...

1000 pardons. FDIC loans 83% of the fees. In the example it was 72 cents on the dollar.

Anonymous said...

is there a chance the republicans vote this scheme down?

Anonymous said...

Geithner is proposing illegal bailouts. Geithner is proposing that the Fed and FDIC give grants in the form of undercollateralized loans. Congress has not given the Fed or FDIC legal or budgetary authority to make grants.

Geithner's bailout financing is just as illegal as Oliver North's freedom fighter financing in Central America. If Geithner, Bernanke, and Bair follow through with this plan, they should go to jail, just like Oliver North did.

The Attorney General will have a duty to prosecute Geithner and Bernanke or resign.

Anonymous said...

How does a retail investor get long exposure to this scam?

Anonymous said...

Why 14x leverage- surely Treasury gets 50% of proceeds?

daddyo said...

I would say 7X leverage to the investor.

84 in assets.
72 debt
6 govt equity
6 investory equity

The returns are based on 84 in assets. So investors have dibs on 42 assets, gov't has dibs on 42 assets. 42/6 = 7x leverage.