The Face of TARP

"I'M FROM THE GOVERNMENT AND I'M HERE TO HELP YOU" - Cue 'em Up, October 13, 2008

What's that old saying that there is no problem too complex that it cannot be made worse?

Now we have to listen to Paulson's go-to-guy trumpeting how the government is quickly contracting with law firms, asset managers, and ... otherwise setting itself up as a mega financial manager.

Were your eye's rolling back in your head?

Truly, we are very near the point at which the Bush Treasury should ... stop talking.

A BRADY-PLAN FOR RMBS

I have just one, two sentences that would accomplish more, more quickly:

"I can announce today that the government will begin to offer terms to lenders on defaulted mortgages, of the sub-prime and alt-a category, and those terms will share, probably 50/50, in home price declines, where negative equity exists. All of this activity will exist within the framework of existing law."

Two, three more, and I've got just about the whole thing:

"For now, we are encouraging the Fed to continue to expand its use of special facilities, on a temporary basis, so that firms can manage their liquidity across a spectrum of asset classes and, thereby, meet short-term calls for collateral and the like.

While the banking system, including the finance-arms of companies that drive consumer credit availability, adjusts until it is fully repaired, we will engage in a certain amount of making sure that financing is available to the business sector, by providing capital relief, in a variety of forms*, that allow asset qualities to be conservatively accounted for, until investor confidence is restored.

G7 finance ministers are working with central banks to reduce and neutralize many off balance-sheet exposures, efficiently and quickly, so that the system is no longer burdened by these uncertainties and systemic risk factors are not magnified, in the current environment, by instruments outside the control of regulators."

*there are various forms of capital requirement relief. off hand, there is the obvious capital-injection. There is also the possibility of lower regulatory capital requirements (cf Japan, 1990s). Last, there is consolidation, in which some investors lose their capital so that others can offer a 'stronger hand' behind risky assets management.

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Taking Names

Mankiw takes names.

From the outside, this seems so ... high school.

It's one thing if the physicists of the world come out with a statement, or the Academy of the Sciences, etc.

But for economics, which so few see as a 'hard science', this looks like an unwanted politicization of the profession (or even a Monica Goodling, Federlist Society, "hire list").

Yes, others do it too.

I'm sure opinions will differ on this opinion.

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The Value of Certainty

A BRADY-PLAN FOR RMBS

Here is one of the most important or interesting stories of the past weeks.

CIBC offloads the downside risk on its CDOs, selling it to Cerberus.

To my eyes, this lends credibility to the notion that this is what the government ought to do for the banks of America. That is, a Brady-plan for RMBS (residential mortgage-backed securities).

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Go Ben, Go

THE FED THROWS UP FLYING BUTTRESSES

I so totally approve of this approach. (h/t across the curve).

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Regulating Credit Default Swaps

It's time to think about re-regulation of the financial industry and keep notes.

Here is question one:

Should one bank speculate in the credit(s) of its

• -trading partners
• -clearing partners

It would seem like there is a plain conflict of interest, absent a "Chinese Wall".

Question two:

How should the financial reporting disclosures of these ... contingent liabilities / assets ... be changed?

Should it matter how something is accounted for, if you write a credit-enhancement (or other derivative inducement) on a product you are selling yourself, versus one that is arms-length? Should one be more conservatively accounted for than the other?

...more to come ...

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The Depository Trust Makes a First Stab

The DTC, grand pooh-bah of major clearing, makes a first pass at trying to clear up misconceptions about Credit Default Swaps.

The most important:

• At settlement, the payments are netted. That step greatly reduces counterparty risk(s). The amount that they expect (or estimate) to change hands over the Lehman default is ... circa $6 billion. That's a very small figure compared to the daily dollar amounts traded in Foreign Exchange.

Things they need to do.

• -They should take the step of publishing the net exposures, by institutions. That will chip away at that $34 trillion figure and provide much need transparency.
• -"less than 1%" should actually be quantified. Is it near $348 billion or is it $440 billion? How does that net out?

Things we need to do.

• -"Vast majority" has to turn into all and every, just as soon as possible.

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Clueless Non-Financial Manager Watch

Only six days before, when a Wall Street analyst had asked GE chief Jeff Immelt about the possibility of the company's selling new equity, Immelt had answered unequivocally: "We just don't see it right now. We feel very secure about how the funding looks." - Jeffrey Immelt

And the others, drank the Kool-Aide:

Executives Gary Wendt and Denis Nayden had aggressively globalized the business, and now all the major economies (and most of the minor ones) were growing simultaneously at healthy clips, an unprecedented occurrence. Interest rates were low. Every kind of asset seemed to be appreciating. For a big finance operation with low funding costs, opportunity was everywhere. During that period GE Capital levered up, growing its ratio of debt to equity from 6.6 to 8.1. Profits quadrupled to almost $11 billion, more than the profits of Procter & Gamble or Goldman Sachs.

And, finally, we can say that the Emperor - you know who - has no clothes:

Analyst Nicholas Heymann of Sterne Agee spoke for many when he wrote: "Investors now understand that GE uses the last couple weeks in the quarter to 'fine-tune' its financial service portfolios to ensure its earnings objectives are achieved. It turns out it really wasn't miracle management systems or risk-control systems or even innovative brilliance. It was the green curtain that allowed the magic to be consistently performed undetected."

[It's okay, everyone knew it. But Mona Lisa smiles have to come uncovered, from time to time, that's all, just so we don't completely detach from reality...]

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Can the Economy Run At These Rates of Interest

The A2/P2 rates are ... nasty; but, if you did not know the history of this series and someone asked you off-hand if the U.S. Economy could "run" at these rates of interest, would you say, "yes"?

Probably would, right?

The fact that financial paper, typically the most sound, is yielding more than non-financial ... continues to suggest that banks are a locus of the problem.

The A2/P2 rates are perplexing, to the extent that these rates don't just represent problems at a few large borrowers but the whole market and broadly representative of all rates paid, not just those measured.

ARM TWISTING?

If money-market funds have pulled back from CP, irrationally, even after the Fed has guaranteed all money markets, then the Fed could use some moral suasion to get the market going again...

Either that, or someone has to make the case why credit-risk *ought* to be priced so much higher, right now.

FRB: Commercial Paper Rates and Outstandings
Discount rates [nb. CP discount rates are not readily comparable to annualized bond rates]

Term	AA nonfinancial	A2/P2 nonfinancial	AA financial	AA asset-backed
1-day	1.52	5.24	1.71	3.97
7-day	1.48	5.85	2.02	4.22
15-day	2.30	6.05	2.36	4.23
30-day	1.65	6.24	4.01	4.33
60-day	1.75	6.21	3.51	4.14
90-day	2.12	n.a.	3.82	4.66

Trade data insufficient to support calculation of the 90-day A2/P2 nonfinancial rate for October 9, 2008.

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The End of Unsecured Lending?

THE SPICE MUST FLOW

The spice is flowing (see pic). There has been a reduction in the amount that businesses can place directly, but it is in line with recent dips and the slack has been picked up by dealer placements.

The price of this unsecured lending has gone up, but the spice is flowing.

How much and why the price has gone up requires more data. A few data points and a survey summary statistic ... are insufficient.

Whatever the case, the oft-repeated line about companies not meeting payroll appears to be, as I mentioned, urban legend, repeated to the highest levels of government, even. Is that Orwellian, or just par for the course?

To the extent that it is simply balance-sheet capacity that is driving up the cost of CP or investor skittishness (money market funds getting spooked?), then the Fed has done a very smart thing to insulate the non-financial sector, the real-economy, if you will, from the ongoing vagaries of Wall Street banks and mutual fund complexes...



source: Fed's weekly CP release (h/t to CalcRisk) The "Currency" (in the chart title) is USD - it got cut off the chart, sorry.

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Outside the Box

EVERYONE CANNOT BE RIGHT

In other words, the entire value of the financial sector (not just banks) in the S&P 500 is around just 15%. If all banks went to zero tomorrow, the index would only fall 15% further ...

There are some prominent economists who believe that equity stakes in large banks are ... valuable. The market, interpreted one way, is saying something else, perhaps.

The VIX, the volatility measure on the S&P500 broad stock index, is around 55%, today. That says that the standard deviation of the S&P500 is 55%, annualized. Assuming a distribution, you reasonably interpret that to mean that the S&P could drop 55%, without 'extraordinary' circumstances.

Now, I'll tell you, that price is so high, it is higher than if the value of all the equity of all the banks in the index was worth nothing. In other words, the entire value of the financial sector (not just banks) in the S&P 500 is just 15%. If all banks went to zero tomorrow, the index would only fall 15% further ... that's way less than 55%, right? Both cannot be right.

What to do?

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BSDs UNITE

Sell covered calls, as big as you can, outside the financial sector ... If you are even more brave, sell puts. If you are just normal, just go long technology (or a diversified set of high-quality names). If you are creative, buy some high yield bonds. If you are a professional, pick some winners and buy them against the broad indexes. In other words, there are a lot of things to do.

The risk if you are wrong? As I see it, the stock market is already discounting a normal sized recession, plus or minus 4%. Your risk is really that the U.S. Economy collapses. Yes, there are extraordinary pressures on over-leveraged consumers and national finances are out-of-whack in a world that is contracting, but U.S. business balance sheets are in really good shape (as best I can tell). The chance that the financial system's equity is worth nothing is non-zero, but the chance that the entire financial complex ceases to function is slim, judged at this juncture.

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Guarantee for the Interbank Market?

REMOVING COUNTER-PARTY RISK TO CALIBRATE THE 'CREDIT CRUNCH'

Yes, good idea. But, as we've been (smugly) pointing out, think about what will happen if you are "wrong".

The implementation of the Treasury's new authority under TARP is weeks away, and rightly so. This means that, in the interim, the Fed could step up and say, "we'll carry the bag, paper over the problem, until the big medicine man comes", we'll guarantee the inter-bank market for these types of paper ... for a short, indefinite term, not less than 90 days.

Now, suppose the Fed did this, yet the inter-bank lending rates did not come down. Since credit / counter-party risk has been removed from the equation, the observed rates will be a measure of the true unwillingness to lend, a true measure of the "credit crunch".

Knowing that might help policy makers calibrate their next response(s), but such an outcome would not immediately reassure the markets (it might even spook them, given how some economists wing-flap). Together, that implies that the confidence-building benefits of such a clever move ought not to be oversold.

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Remarkable Day: AIG

THINK OF THE MESSAGE IT SENDS TO THE CHILDREN

You probably didn't watch or hear all of the hearings on the astounding AIG failure-cum-rescue.

Neither did I, but let me share the crowning morsel from the parts that I heard.

AIG management contracted a guy who was supposed to look at the stuff going on in the Financial Products area, the one that wrote some $400+ billion in off balance sheet products, reportedly (at notional value, I assume).

The head of the group thumbed his nose at him, so the guy resigned, because he could not do his job, the job that AIG had hired him to do.

Despite this conspicuous happening, complete with written, clarion warnings to all the right people inside and outside the firm about it, management apparently ... did nothing further, apart from refer the matter to legal.

Oh, everyone got their bonus, including the CEO (only about $5 million, though).

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The AIG Story

A villain is now appointed.

Forbes has the dope.

The hidden risks always multiply...

Innovation? You make the call:

By AIG's own description, about $379 billion of the $527 billion in AIG's default swap portfolio "represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation."

Regulatory capital relief? Ahhhh, the comedy!

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Wall Street Lays an Egg

Books will be written about his all too human failure ...

Anyone know why investment banks are failing?

Scan the papers / journals and you'll not find out.

As Paul Krugman says, "And as the unknown unknowns have turned into known unknowns, the system has been experiencing postmodern bank runs."

I tend to concur, but there is more than just a run mentality at work. That's a symptom. What is the cause? If there is a list of causes, what are they and in what proportion? [There will be Congressional hearings ...]

One has to consider that the problems lay off balance-sheet, in the derivatives that have (a) soured or (b) turned into "loans", because there is no liquid market in the underlying.

On the other hand, CNBC is reporting that Lehman had marks on the "mortgage portfolio" way too high, even on the weekend. So, where was the SEC, then, over the past nine months? How much was that, in relation to their other problems. What's more, if that is all that was true, then truly the Fed should have considered a "portfolio workout" loan.

AN ORDERLY DESCENT INTO AN UNWANTED OUTCOME

I cannot believe that AIG's book of derivatives could just be allowed to collapse. Those yelling "no taxpayer bailouts" have to consider that the reduced competition and the reduced ability to lay off and price risk has consequences too, that may or may not rival "moral hazard".

As for Fed action, their task is not to "save institutions" but, perhaps, to save those parts of institutions that are key to keep the markets orderly and functioning.

---

That means a very politically difficult decision, in the current politico-regulatory, ideologically-driven environment: they have to draw a line and it cannot be an "on" or "off", they may have to "partially save" some organizations. Since no one will agree just where or how to draw that line, it's a thankless task, as are most of the other regulatory aspects and last resort lender aspects of the Fed. What's worse, it may not be possible to "legally" pull off such a manoeuvre - it's like doing a collateral reorganization, perhaps, on the fly, rather than through a prolonged bankruptcy proceeding.

NOT JUST CAPITAL NEEDED?

Following Krugman's comments, one has to wonder if post-modern tools aren't needed.

Rather than trying to run around finding additional capital, perhaps the "solution" is to do a complex, multi-party unwind/netting of derivatives trades, to the extent that those contracts are the "problem" (and again, it's hard to know what the real problems are...).

In other words, replensh capital (taxpayer supported, if needed) for the direct loans that went "bad", like straight subprime securities, and implement a "forced unwind" for various derivatives contracts, to prevent or secure "domino" problems associated with counterparty failure, if any.

Even if the derivatives risks are all concentrated with a few players who made bad bets, it may not be judged best let those institutions fail and draw as best a "firewall" around them as possible, rather than to force a systemic "solution" on all participating institutions. Of course, that might "reward" foolish and weak players, but that shortcoming might be easier to "manage" than the alternative, which is a total and prolongued restructuring of the financial sector, with higher long-term capital costs for the economy ...

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