by Calculated Risk on 9/21/2008 10:11:00 PM

From the Fed:

The Federal Reserve Board on Sunday approved, pending a statutory five-day antitrust waiting period, the applications of Goldman Sachs and Morgan Stanley to become bank holding companies.

To provide increased liquidity support to these firms as they transition to managing their funding within a bank holding company structure, the Federal Reserve Board authorized the Federal Reserve Bank of New York to extend credit to the U.S. broker-dealer subsidiaries of Goldman Sachs and Morgan Stanley against all types of collateral that may be pledged at the Federal Reserve's primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility (PDCF); the Federal Reserve has also made these collateral arrangements available to the broker-dealer subsidiary of Merrill Lynch. In addition, the Board also authorized the Federal Reserve Bank of New York to extend credit to the London-based broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch against collateral that would be eligible to be pledged at the PDCF.

This means more oversight and a changing business model.

by Calculated Risk on 9/21/2008 06:45:00 PM

From the WSJ: Australia Suspends All Short Sales

The Australian Securities and Investments Commission banned short selling on all listed shares in Australia, following moves by other countries to prevent short sales of financial stocks.

Also from Bloomberg: SEC Pushes Hedge Fund Oath in Manipulation Probe

Udpate: Dutch ban 'naked' short selling for 3 months

And in Taiwan: Taiwan reimposes short-selling ban on 150 stocks

These seem like stories from long ago, in those early days of finance when people didn't really understand markets and government officials went on misguided witch hunts.

by Calculated Risk on 9/21/2008 04:38:00 PM

The primary goal of the Paulson Plan is to get the banks to lend again - or "unclog the system" as Secretary Paulson put it. Secondary goals are to "protect the taxpayer" and hopefully minimize moral hazard.

Will the plan achieve the primary goal? I think the answer is yes. By removing these troubled assets from the balance sheets of the financial institutions, the banks will able to lend again without lingering doubts about their solvency and viability. At first glance, the size of the plan seems sufficient.

UPDATE: This assumes some sort of recapitalization of the banks while they deleverage too. Something that isn't in the plan ...

It is almost guaranteed that there will be unintended and unanticipated consequences, but the plan will probably achieve the primary goal. And making sure the banks continue to lend will minimize the impact of the credit crisis on the general economy.

Unfortunately the Plan fails to address the secondary goals.

By definition the Government will pay more for these troubled assets than private investors (or the banks would just sell the assets to investors). The question is: will the government pay more than the intrinsic value of these assets? (intrinsic value in this sense would be the amount the government eventually receives for these assets).

This intrinsic value is unknown right now because we don't know how far house prices will decline (and the value of MBS is related to house prices), and we don't know how much the Government will pay for these assets.

Under an optimistic scenario perhaps the government might pay close to the intrinsic value for the MBS, and the taxpayers would lose little or nothing. A more pessimistic scenario would suggest that the government would lose something on every transaction - and because of the structure of the plan, this might cost the taxpayers $700 billion.

Note: This doesn't imply each asset is worthless. Imagine you start with $100. You buy an asset for $100, and sell it for 30% less - you lost $30. Now you invest the $70 and lose 30% again, and on and on. Even though you only lost 30% on each transaction, you eventually lose the entire $100 - this is possible with the structure of this plan.

So the plan does nothing to protect taxpayers or minimize moral hazard. This is fixable by adding some sort of options or warrants for preferred shares and / or senior debt that could be tied to the losses for each institution. If the government loses money buying MBS from a particular institution, then - after several years - that institution could reimburse the taxpayers or the shareholders suffer significant dilution.

And a final suggestion: In an effort for transparency, I'd like to see a website that listed each transaction purchased by the government. This could list the details of the asset, the PAR value, the selling institution, the underlying characteristics, the originators of the loans, the price the government paid (and eventual sold the asset for) and any other relevant detail.

by Anonymous on 9/21/2008 02:58:00 PM

This is purported to be from a member of Congress, regarding the TARP authorization. I cannot independently verify that, but like Fox Mulder I want to believe:

Paulsen and congressional Republicans, or the few that will actually vote for this (most will be unwilling to take responsibility for the consequences of their policies), have said that there can't be any "add ons," or addition provisions. [Frank expletive]. I don't really want to trigger a world wide depression (that's not hyperbole, that's a distinct possibility), but I'm not voting for a blank check for $700 billion for those [serious obscenity].

Nancy said she wanted to include the second "stimulus" package that the Bush Administration and congressional Republicans have blocked. I don't want to trade a $700 billion dollar giveaway to the most unsympathetic human beings on the planet for a few [adjectival exuberance] bridges. I want reforms of the industry, and I want it to be as punitive as possible.

Henry Waxman has suggested corporate government reforms, including CEO compensation, as the price for this. Some members have publicly suggested allowing modification of mortgages in bankruptcy, and the House Judiciary Committee staff is also very interested in that. That's a real possibility.

We may strip out all the gives to industry in the predatory mortgage lending bill that the House passed last November, which hasn't budged in the Senate, and include that in the bill. There are other ideas on the table but they are going to be tough to work out before next week.

I also find myself drawn to provisions that would serve no useful purpose except to insult the industry, like requiring the CEOs, CFOs and the chair of the board of any entity that sells mortgage related securities to the Treasury Department to certify that they have completed an approved course in credit counseling. That is now required of consumers filing bankruptcy to make sure they feel properly humiliated for being head over heels in debt, although most lost control of their finances because of a serious illness in the family. That would just be petty and childish, and completely in character for me.

I'm open to other ideas, and I am looking for volunteers who want to hold the [colorful noun] so I can beat the crap out of them.

I've been an advocate of bankruptcy cram-downs for ages, so no argument there. What I really really like is the idea of subjecting CEOs to the same petty humiliation everyone else gets treated to. I suggest that for every separate asset these CEOs sell to the government, they be required to write a Hardship Letter over a 1010 warning (that's a reference to the statute forbidding lying in order to get a loan) explaining why they acquired or originated this asset to begin with, what's really wrong with it in detail, what they have learned from this experience, and what steps they are taking to make sure it never happens again. Furthermore, the Treasury Department will empanel a committee of the oldest, most traditional, and bitterest mortgage loan underwriters--preferably those downsized to make way for automated underwriting systems--to review these letters and opine on their acceptability.

I'm sure you all will have other suggestions.

by Calculated Risk on 9/21/2008 10:33:00 AM

Here is a paragraph from the Treasury Fact Sheet released last night:

Asset and Institutional Eligibility for the Program. To qualify for the program, assets must have been originated or issued on or before September 17, 2008. Participating financial institutions must have significant operations in the U.S., unless the Secretary makes a determination, in consultation with the Chairman of the Federal Reserve, that broader eligibility is necessary to effectively stabilize financial markets.

So this bailout covers any securities issued on or before last week! Why would we be bailing out activity from this year? Or even after Feb 2007 when the subprime crisis woke everyone up? I'd argue for an even earlier date ...

But the second sentence is even more surprising: eligibility has been changed from "financial institution having its headquarters in the United States" to "significant operations in the U.S." - and even "broader eligibility" if Paulson so decides.

According to this fact sheet, under the Paulson Plan, U.S. taxpayers may bailout foreign financial institutions and even foreign governments.

Update: Paulson confirms on TV, via Reuters: Paulson: Foreign banks can use U.S. rescue plan

Treasury Secretary Henry Paulson said Sunday that foreign banks will be able to unload bad financial assets under a $700 billion U.S. proposal aimed at restoring order during a devastating financial crisis.

"Yes, and they should. Because ... if a financial institution has business operations in the United States, hires people in the United States, if they are clogged with illiquid assets, they have the same impact on the American people as any other institution," Paulson said on ABC television's "This Week with George Stephanopolous."

by Calculated Risk on 9/20/2008 08:23:00 PM

From David Herszenhorn at the NY Times: $700 Billion Is Sought for Wall Street in Massive Bailout

The ultimate price tag of the bailout is virtually impossible to know, in part because of the possibility that taxpayers could profit from the effort, especially if the market stabilizes and real estate prices rise.
emphasis added

I hope you laughed. I did. A little gallows humor.

And, yes the cost is still unknown, but there is no way that the taxpayers will profit. My initial estimate is that the direct costs of the Paulson plan will be $700 billion to taxpayers. That is about double the cost of the S&L crisis (compared to GDP).

Why $700 billion?

The plan only limits the Treasury to "$700,000,000,000 outstanding at any one time", so the total purchases can exceed $700 billion. In fact, every time the Treasury sells some securities, they will probably plow the net proceeds back into more troubled assets until the entire $700 billion is gone.

Think of a drunk gambler at a slot machine. He starts with $100 and slowly loses. Every now and then he wins some money, but he keeps putting the coins back into the slot until he has lost everything. That is how this plan will work.

Unless there is a dramatic changes, there will be no upside participation in the financial companies for taxpayers, and the taxpayers will recapitalize the banks by, in Krugman's words, "having taxpayers pay premium prices for lousy assets".

Note: I believe a Reverse Dutch Auction is inappropriate for these assets (it won't lower the price much). This is because these auctions only work when the sellers have very similar goods to sell. In this case, if the asset class is defined broadly, then the characteristics will vary too widely been assets, and the Treasury will just end up buying the worst available assets.

And, if the asset class is defined narrowly, there won't be enough sellers for a reverse Dutch Auction to work.

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!