by Calculated Risk on 9/20/2008 03:34:00 PM

Update: While I was writing, Dr. Krugman wrote: No deal. Definitely worth reading!

The underlying problem is that house prices are still too high and no one knows how much further prices will fall. The value of the troubled assets is dependent on future house prices (note: house prices are the key factor for foreclosures and loss severity). Some people don't seem to understand house prices will continue to fall, from the NY Times: But Will It Work? (hat tip Yal)

“It’s easy to forget amid all the fancy stuff — credit derivatives, swaps — that the root cause of all this is declining house prices. If you can reverse that, then people start coming out of their foxholes and start putting their money in places they have been too afraid to put it.”
Alan S. Blinder, Princeton economist, and former vice chairman of the Federal Reserve Board of Governors, Sept 20, 2008

This plan isn't intended to reverse the house price trend - and it shouldn't be intended for that purpose. The Paulson plan is intended to keep the banks lending to credit worthy borrowers. Other goals are to minimize the burden for taxpayers, and minimize moral hazard - but the primary goal is to keep the banks lending to minimize the impact of the credit crisis on the economy.

There are private investors willing to buy these troubled assets right now, but the banks do not want to sell at those prices. Why? Some banks believe the assets are worth more than the current bids (it all depends on future house prices, and different banks and investors have different projections). And many banks are unwilling to accept the current bids because the banks would then be insolvent. See Professor Krugman's: Doubts about the rescue and Uneasy feelings. Also, even solvent banks would probably have to recapitalize (dilute shareholders) or reduce lending if they sold at current bid prices.

So how does the Treasury plan help? It isn't clear yet. The first goal should be transparency of the troubled assets. What do the banks own, and what are the assets really worth? Transparency is surprisingly difficult: each RMBS and CDOs - even within the same asset class and origination year - can have significantly different values depending on the orginator and other factors. If the Treasury conducts a reverse dutch auction on a broad asset class, they will probably end up with certain New Century and Bear Stearns deals that are basically worthless.

To facilitate price discovery, it would probably be better to bid for individual mortgages from RMBS pools, but analyzing each mortgage would be a monumental task. We definitely do not want the Treasury to buy RMBS and CDOs at anywhere near the value on the bank's books. Buying at those prices would help keep the banks lending, but it would also severely impact the taxpayers, it would be a transfer of wealth from the many to the few, and it would also encourage future excessive risk taking.

So determining price will be difficult. And what happens if a price can be determined? How does this help keep the banks lending?

As I noted when the plan was announced, buying impaired assets at a steep discount reduces regulatory capital as losses are realized, and therefore will lead to less lending unless the banks are recapitalized.

Perhaps with a clean balance sheet, the banks can attract private capital (with significant dilution of current shareholders). Or perhaps something similar to the Depression era Reconstruction Finance Corporation (RFC) can be part of the plan to invest capital in the banks.

If an investment from the Government is required anyway, why bother buying the impaired assets?

This suggests a different approach: First, a recognition phase with complete transparency. Have private investors bid on some assets to establish market prices (some portion should be sold to the private investors to encourage bids), and then let the banks argue for their own valuations. Based on an analysis of these valuations, have the Treasury make an RFC type investment in the bank with a convertible debenture that would count as regulatory capital. This capital infusion would keep the banks lending (the primary goal) and the amount required would be far less than the amount needed to buy the troubled assets.

If a bank can pay off the debentures with interest - possibly because the assets perform as the bank expects, or perhaps by bringing in private capital - then there would be no dilution from the debentures. Otherwise the debentures convert into preferred shares and significantly dilute the shareholders - and then the government can sell the shares on the public market. Ideally the debtholders would take a haircut too (before the taxpayers), but that is probably too complicated. This alternative would keep the banks lending, minimize the cost to the taxpayers, and reduce moral hazard.

Just my two cents as we wait for more details ... Best to all.

by Calculated Risk on 9/19/2008 07:36:00 PM

Here is the proposal so far: (hat tip Michael)

LEGISLATIVE PROPOSAL FOR TREASURY AUTHORITY
TO PURCHASE MORTGAGE-RELATED ASSETS


Section 1. Short Title.

This Act may be cited as ____________________.

Sec. 2. Purchases of Mortgage-Related Assets.

(a) Authority to Purchase.--The Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.

(b) Necessary Actions.--The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this Act, including, without limitation:

(1) appointing such employees as may be required to carry out the authorities in this Act and defining their duties;

(2) entering into contracts, including contracts for services authorized by section 3109 of title 5, United States Code, without regard to any other provision of law regarding public contracts;

(3) designating financial institutions as financial agents of the Government, and they shall perform all such reasonable duties related to this Act as financial agents of the Government as may be required of them;

(4) establishing vehicles that are authorized, subject to supervision by the Secretary, to purchase mortgage-related assets and issue obligations; and

(5) issuing such regulations and other guidance as may be necessary or appropriate to define terms or carry out the authorities of this Act.

Sec. 3. Considerations.

In exercising the authorities granted in this Act, the Secretary shall take into consideration means for--

(1) providing stability or preventing disruption to the financial markets or banking system; and

(2) protecting the taxpayer.

Sec. 4. Reports to Congress.

Within three months of the first exercise of the authority granted in section 2(a), and semiannually thereafter, the Secretary shall report to the Committees on the Budget, Financial Services, and Ways and Means of the House of Representatives and the Committees on the Budget, Finance, and Banking, Housing, and Urban Affairs of the Senate with respect to the authorities exercised under this Act and the considerations required by section 3.

Sec. 5. Rights; Management; Sale of Mortgage-Related Assets.

(a) Exercise of Rights.--The Secretary may, at any time, exercise any rights received in connection with mortgage-related assets purchased under this Act.

(b) Management of Mortgage-Related Assets.--The Secretary shall have authority to manage mortgage-related assets purchased under this Act, including revenues and portfolio risks therefrom.

(c) Sale of Mortgage-Related Assets.--The Secretary may, at any time, upon terms and conditions and at prices determined by the Secretary, sell, or enter into securities loans, repurchase transactions or other financial transactions in regard to, any mortgage-related asset purchased under this Act.

(d) Application of Sunset to Mortgage-Related Assets.--The authority of the Secretary to hold any mortgage-related asset purchased under this Act before the termination date in section 9, or to purchase or fund the purchase of a mortgage-related asset under a commitment entered into before the termination date in section 9, is not subject to the provisions of section 9.

Sec. 6. Maximum Amount of Authorized Purchases.

The Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time

Sec. 7. Funding.

For the purpose of the authorities granted in this Act, and for the costs of administering those authorities, the Secretary may use the proceeds of the sale of any securities issued under chapter 31 of title 31, United States Code, and the purposes for which securities may be issued under chapter 31 of title 31, United States Code, are extended to include actions authorized by this Act, including the payment of administrative expenses. Any funds expended for actions authorized by this Act, including the payment of administrative expenses, shall be deemed appropriated at the time of such expenditure.

Sec. 8. Review.

Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.

Sec. 9. Termination of Authority.

The authorities under this Act, with the exception of authorities granted in sections 2(b)(5), 5 and 7, shall terminate two years from the date of enactment of this Act.

Sec. 10. Increase in Statutory Limit on the Public Debt.

Subsection (b) of section 3101 of title 31, United States Code, is amended by striking out the dollar limitation contained in such subsection and inserting in lieu thereof $11,315,000,000,000.

Sec. 11. Credit Reform.

The costs of purchases of mortgage-related assets made under section 2(a) of this Act shall be determined as provided under the Federal Credit Reform Act of 1990, as applicable.

Sec. 12. Definitions.

For purposes of this section, the following definitions shall apply:

(1) Mortgage-Related Assets.--The term “mortgage-related assets” means residential or commercial mortgages and any securities, obligations, or other instruments that are based on or related to such mortgages, that in each case was originated or issued on or before September 17, 2008.

(2) Secretary.--The term “Secretary” means the Secretary of the Treasury.

(3) United States.--The term “United States” means the States, territories, and possessions of the United States and the District of Columbia.

by Calculated Risk on 9/19/2008 07:36:00 PM

From the WSJ: U.S. Bailout Plan Calms Markets, But Struggle Looms Over Details

The most ambitious part of the government plan is to create a new entity to purchase impaired assets from financial firms. The process could work as a type of reverse auction, in which the government would buy from the institution that sells its assets for the lowest bid.

However, the government may find itself in a quandary: Does it pay more than fair-market value for hard-to-assess distressed assets, putting taxpayers on the hook for any losses? Or does it drive a hard bargain, buying for pennies on the dollar? The latter approach would further hurt financial institutions, since they would have to write down the losses and take additional hits to their balance sheets. The Treasury department ... hasn't commented on specifics about the plan...

One of the keys to moving forward is to bring transparency to the assets, and to mark them down appropriately. As the article notes, this will mean the banks will need to recapitalize with substantial dilution for shareholders.

Some details from the Lehman bankruptcy suggests asset prices are falling quickly:

On Friday, there were a number of changes to the terms of the sale to Barclays. The originally agreed total sale price of $1.75 billion could be lowered by $100 million to $200 million. The British bank will take on $47.4 billion in assets and $45.5 billion in liabilities, instead of $72 billion in assets and $68 billion in liabilities. The drop in the assets reflects the decline in the value of Lehman securities during the past week.

The purchase price was lowered because of lower appraisals of real estate in New Jersey.

The plan needs to bring transparency for these assets.

Also there are many competing proposals - I've received many emails with proposed plans - and it appears this plan is still being worked out.

by Calculated Risk on 9/19/2008 07:36:00 PM

From the FDIC: Failed Bank Information for Ameribank, Inc., Northfork, WV

Ameribank, Inc., was closed today by the Office of the Thrift Supervision and the Federal Deposit Insurance Corporation (FDIC) was named receiver. The FDIC entered into purchase and assumption agreements with Pioneer Community Bank, Inc., Iaeger, West Virginia, and The Citizens Savings Bank, Martins Ferry, Ohio to take over all of the deposits and certain assets of Ameribank, Inc., Northfork, West Virginia.

Ameribank has five branches located in West Virginia and three branches located in Ohio. Pioneer Community Bank, Inc., Iaeger, West Virginia will assume all deposits for the five branches located in West Virginia. The Citizens Savings Bank, Martins Ferry, Ohio will assume all deposits for the three branches located in Ohio.
...
As of June 30, 2008, Ameribank, Inc. had total assets of $115 million and total deposits of $102 million.
...
The cost of the transactions to the Deposit Insurance Fund is estimated to be $42 million. The failed bank had assets of $112.62 million, .033 percent of the $13.4 trillion in assets held by the 8,451 institutions insured by the FDIC. Ameribank, Inc. is the first bank to be closed in West Virginia since First National Bank of Keystone, Keystone, on September 1, 1999. This year, a total of twelve FDIC-insured banks have been closed.

Now it feels like a Friday!

by Calculated Risk on 9/19/2008 06:47:00 PM

From the NY Times: Congressional Leaders Stunned by Warnings

[A]s the Fed chairman, Ben S. Bernanke, laid out the potentially devastating ramifications of the financial crisis before congressional leaders on Thursday night, there was a stunned silence at first.
...
Senator Christopher J. Dodd [said] the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”
emphasis added

It's amazing how long it takes for some people to realize what is happening. There were plenty of warnings.

Oh well, it sounds like there will be more breaking news this weekend.

by Calculated Risk on 9/19/2008 05:40:00 PM

From the American Institute of Architects: More Negative Conditions for Architecture Billings Index

Click on graph for larger image in new window.

While conditions have improved somewhat for three consecutive months, the Architecture Billings Index (ABI) continues to point to unfavorable conditions for the nonresidential construction market. As a leading economic indicator of construction activity, the ABI shows an approximate nine to twelve month lag time between architecture billings and construction spending. The American Institute of Architects (AIA) reported the August ABI rating was 47.6, up slightly from the 46.8 mark in July (any score above 50 indicates an increase in billings). emphasis added

The key here is that the index fell off a cliff in early 2008, and that there is "an approximate nine to twelve month lag time between architecture billings and construction spending". We should expect weaker non-residential structure investment in the second half of 2008 and throughout 2009.

by Calculated Risk on 9/19/2008 05:04:00 PM

From MarketWatch: Companies try to scramble aboard SEC lifeboat

Companies omitted include General Electric Co., American Express, Capital One, which all have huge financial-services businesses. ... A person familiar with the situation said [GE] has talked to the SEC about possibly being included on the list. American Express ... said it was just beginning to look into the possibility of being added.

CIT Group ... "made a formal request to be added to the list," spokesman Curtis Ritter said in an email to MarketWatch. ... Guaranty Financial Group Inc. said Friday that it should be added to the list too.

I'd be impressed if someone asked to get off the list.

by Calculated Risk on 9/19/2008 02:44:00 PM

Lost in the shuffle, Moody's announced last night: Moody's places Ambac and MBIA on review for possible downgrade (no link)

Moody's Investors Service has placed the Aa3 insurance financial strength rating of Ambac Assurance Corporation (Ambac) and the A2 insurance financial strength rating of MBIA Insurance Corporation (MBIA) on review for possible downgrade. Today's rating action follows Moody's announcement of an upward revision to cumulative loss projections for subprime RMBS exposures ...

From MarketWatch: Ambac, MBIA fall as Moody's warns it may cut again

by Calculated Risk on 9/19/2008 01:20:00 PM

From the California Employment Development Department: California’s Unemployment Rate Increases To 7.7 Percent (hat tip Harry)

California’s unemployment rate was 7.7 percent in August, up from a revised 7.4 percent in July, the state Employment Development Department (EDD) reported today. A year ago, in August 2007, California’s unemployment rate was 5.5 percent.

According to EDD’s monthly survey of employers, nonfarm payroll employment in California decreased by 7,700 jobs over the month, for a total of 15,109,000.
...
The number of people unemployed in California was 1,417,000 – up by 61,000 over the month, and up by 413,000 compared with August of last year.

The recession in California is getting worse, and rising unemployment will negatively impact the economy and the housing market, leading to lower house prices and more foreclosures - and probably more layoffs. A vicious cycle ...

by Calculated Risk on 9/19/2008 12:58:00 PM

Secretary Paulson said: "We're talking hundreds of billions."

The NY Times DealBook has other estimates: Putting a Price Tag on a Government Bailout

“It’s probably $500 [billion] to a trillion dollars, and that’s going to visit the taxpayers sooner or later,” [Sen. Richard Shelby] said. “It’s either going to be a debt charged to all of us or to all our children.”
...
Bloomberg News ... reported that the government is considering establishing an $800 billion fund to purchase so-called failed assets and a separate $400 billion pool at the Federal Deposit Insurance Corporation to insure investors in money-market funds.

However buying the assets isn't enough. These asset sales will lead to substantial write-downs, and that will reduce the regulatory capital at the banks.

So how do the banks recapitalize?

The hope is that by making the assets transparent, and selling off the toxic waste, that will rebuild confidence with investors. Maybe. But the U.S. Government might also have to help recapitalize the banks to keep them lending (like the Reconstruction Finance Corporation (RFC) did during the Depression). Either way, it appears the current shareholders face massive dilution.

Also - as an aside - when the banks make their assets transparent (should be a requirement for participation), we will discover if any executives misrepresented their assets and filed false reports with the SEC. That could be prosecuted under Sarbanes-Oxley, and perhaps a few executives spending time in jail might help with the moral hazard issues.