by Calculated Risk on 9/24/2008 02:56:00 AM

From the Fed:

Today, the Federal Reserve, the Reserve Bank of Australia, the Danmarks Nationalbank, the Norges Bank, and the Sveriges Riksbank are announcing the establishment of temporary reciprocal currency arrangements (swap lines) to address elevated pressures in U.S. dollar short-term funding markets. These facilities, like those already in place with other central banks, are designed to improve liquidity conditions in global financial markets. Central banks continue to work together during this period of market stress and are prepared to take further steps as the need arises.

Federal Reserve Actions
The Federal Open Market Committee has authorized the establishment of new swap facilities with the Reserve Bank of Australia, the Sveriges Riksbank, the Danmarks Nationalbank, and the Norges Bank. These new facilities will support the provision of U.S. dollar liquidity in amounts of up to $10 billion each by the Reserve Bank of Australia and the Sveriges Riksbank and in amounts of up to $5 billion each by the Danmarks Nationalbank and the Norges Bank.

In sum, these new facilities represent a $30 billion addition to the $247 billion previously authorized temporary reciprocal currency arrangements with other central banks: European Central Bank ($110 billion), Bank of Japan ($60 billion), Bank of England ($40 billion), Swiss National Bank ($27 billion), and Bank of Canada ($10 billion).

These reciprocal currency arrangements have been authorized through January 30, 2009.

by Calculated Risk on 9/24/2008 01:07:00 AM

From the WSJ: FBI Investigates Four Firms at Heart of the Mess

The Federal Bureau of Investigation's preliminary inquiries are focusing on whether fraud helped cause some of the troubles at Fannie Mae, Freddie Mac, Lehman Brothers Holdings Inc. and American International Group Inc., according to senior law-enforcement officials.
...
Pressure is building for the FBI and regulators to hold top executives accountable for the crisis that has crippled the nation's finance sector. ... Investigators say that despite calls from some quarters to prosecute wealthy bankers who helped fuel the mortgage bubble, it is unclear what crimes they will find at the root of the exotic financial vehicles that have sickened banks around the world.

by Calculated Risk on 9/23/2008 09:44:00 PM

Update to make this clear: I never focused on Section 8 (oversight) of the Paulson Proposal because I felt this was obviously going to be changed. To be fair, sometimes people put an offensive clause in a proposed agreement as a negotiating ploy. I think Paulson learned that negotiating ploys don't go over very well with Senators!

From Paulson's proposal:

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.

Paulson today:



If Paulson really wants transparency, give us a website, updated daily, with the details of all transactions!

by Calculated Risk on 9/23/2008 09:08:00 PM

Predictions:

Bernanke and Paulson will enjoy tomorrow even less than today (testifying before the House Financial Services Committee at 2:30PM ET). The House is the key to passing any plan and I expect some fireworks.

Hopefully there will be some questions about pricing tomorrow, and maybe transparency (a website with all transactions!).

If you want to have an impact - call your Congressman - the vote will be closer in the House.

A plan will probably be passed within a week or so. The plan will probably include some type of contingent equity participation, and some oversight - and everyone will declare victory.

Goldman will buy some commercial banking assets by Friday. This is just a guess because of recent events: Goldman becoming a bank holding company, and Buffett investing in Goldman.

Emails: I've been swamped with emails this week and especially today. Many of the emails contained detailed questions or thoughtful alternative plans. I apologize that I'm unable to answer all the emails, and I sincerely appreciate the thoughts and questions. Best to all.

by Calculated Risk on 9/23/2008 06:11:00 PM

An interesting question is why do Bernanke and Paulson believe the Hold-to-Maturity price is higher than the current market price for MBS?

One possible explanation is market failure based on information asymmetry. Mark Thoma explores this question: "Hold to Maturity" versus "Fire Sale" Prices

Let me try to give a defense of paying above current market prices (in a devil's advocate sense). For markets to function according to competitive ideals, full information must be available to all market participants. When information is lacking, or when it is asymmetric, the outcome is inefficient relative to the full information outcome.

The nature of these assets - their opacity as it has come to be called - makes full information unavailable. I'm not sure how asymmetric information is, people holding the assets don't know themselves whether a particular asset might blow up and lose it's value or not, but there is some degree of asymmetric information in these markets (a standard lemons problem).

This is market failure due to lack of full information, and asymmetric information to the extent it does exist, is depressing prices.

In this case, I don't think the information is asymmetric because both buyer and seller are aware of the characteristics of the MBS. There is uncertainty regarding future house prices (and MBS performance is related to house prices), but that isn't a market failure.

Professor Thoma also links to Professor Kling: Hold-to-Maturity Pricing

Suppose that you owe $110,000 on your mortgage, due in one payment a year from now. The "hold to maturity price" is that $110,000, discounted back to the present. At an interest rate of 10 percent, the price is $100,000.....NOT!

The fair price depends on the probability that you will default. If there is a 50 percent chance that you will default, the fair price is more like $50,000.

The probability that you will default depends on the distribution of possible paths of future home prices. Along paths of falling home prices, defaults are much more likely than along paths of stable or rising prices.

It's hard to know how home prices will behave, but right now if I were pricing the risk (something I used to do for a living, unlike the key decision-makers in this bailout), I would include a lot of paths where prices go down. That would make the "hold-to-maturity" prices of the mortgage securities, properly calculated, pretty low in many cases.

First, this analysis assumes 100% loss severity in the event of default. If there is a 50% chance of default, half the time the mortgage will be worth $110K discounted back to the present. But if the borrower defaults, the value will not be zero since there is a recovery value on most mortgages. Kling apparently assumes a loss severity of 100% in the event of default (perhaps he was thinking of a 2nd mortgage), but a more normal severity would be around 50% or $55K discounted back to the present. So in this example, and using a 10% discount rate, the mortgage would be worth $100K * 0.5 + $50K * 0.5 or $75K at present.

But I think this might provide a clue to the pricing disparity: because of the uncertainty in future house prices (and MBS performance) potential buyers are probably using a higher discount rate than Bernanke / Paulson. Typically the higher the standard deviation of the potential outcomes (higher risk), the higher the discount rate. So even if investors view the future price the same as Bernanke/Paulson, they might view the NPV as much lower. In addition, the cost of capital is higher for private investors - also impacting their discount rate.

Perhaps Bernanke / Paulson believe that aggregating assets will lower the risk. Usually when you aggregate assets, the overall volatility decreases. This is almost always true for holding a group of stock (the beta on the S&P 500 is lower than the beta on most stocks in the S&P 500). But if the assets are all impacted by one parameter - in this case future house prices - aggregating assets does not lower the risk.

This would make a great question for Bernanke tomorrow. Why does he believe the Hold-to-Maturity price is higher than the current market price? Is this because of some market failure? Or because of different discount rates? Or some other reason?

by Calculated Risk on 9/23/2008 05:55:00 PM

Just headlines from MarketWatch:

Goldman to sell $5 bln preferred stock to Berkshire Hathaway

Berkshire also to get $5 bln in Goldman common warrants

A Buffett rumor that is true!

by Calculated Risk on 9/23/2008 04:37:00 PM

Wells Fargo Jumbo 30 year fixed mortgage rates are now at 9.0% (9.176% APR). (hat tip patrick.net)

Click on graph for larger image in new window.

This will really hurt the markets with house prices above the conforming loan limit. Here are the conforming loan limits by County from Fannie Mae (excel file).

by Calculated Risk on 9/23/2008 04:22:00 PM

From FinancialWeek.com: Goldman eyes IndyMac to build bank network

We plan to build our banking business organically and by buying retail deposits and bank assets in the wholesale market, not through opening branches,” a Goldman Sachs spokesman said.

“For example, the FDIC is selling IndyMac assets and those might be the sort of thing we’d be interested in looking at.”

by Calculated Risk on 9/23/2008 01:38:00 PM

From Reuters: Bernanke's comments on asset auction process

I believe that under the Treasury program, auctions and other mechanisms could be devised that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets. If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

[B]anks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down.

Originally I expected the plan to have two components: 1) buy troubled assets from institutions, and 2) an RFC type recapitalization plan. However the plan did not include the recapitalization provision, so the clear intent is to pay premium prices (to current market prices) for troubled assets to recapitalize the institutions (with no equity participation for taxpayers).

Bernanke and Paulson are clearly arguing the current market prices are wrong - that they are "fire sale prices".

Krugman has more: Getting real — and letting the cat out of the bag

[T]he key question is what price Treasury pays for the assets. And here we have Bernanke effectively saying that it’s going to pay above-market prices — prices that allegedly reflect “hold-to-maturity” value, but still more than private investors are willing to pay.
...
[T]he plan only helps the financial situation if Treasury pays prices well above market — that is, if it is in effect injecting capital into financial firms, at taxpayers’ expense.

What possible justification can there be for doing this without acquiring an equity stake?

No equity stake, no deal.

One thing is clear - something we all guessed correctly - is that the intention of the plan is to pay premium prices for troubled assets to recapitalize the banks. It’s still not clear how the price mechanism will work, and unfortunately Paulson and Bernanke are unable to describe how this will work.

Except Paulson did say they would hire “really good asset managers” to determine the price. A little sarcasm: I suppose these are asset managers that have been shorting financials for the last couple of years (hat tip Seminole).

by Calculated Risk on 9/23/2008 01:08:00 PM

From the Independent: Hedge funds suffer mass redemptions

Hedge funds could have an unprecedented level of cash pulled out by investors this quarter, according to insiders, just as they faced millions of pounds of losses from last week's shock regulation of short selling.
...
The redemptions seem to have started in earnest, although currently the evidence is mainly anecdotal. One UK hedge fund manager confided that last week had the highest number of investors rushing to withdraw funds that he has known. The industry will know for sure whether it is a drip or a deluge when the data providers release their statistics for the third quarter, next month. One market analyst said: "I know even the good hedge funds have been suffering withdrawals recently. Investors are very nervous."

Roubini predicted that the next phase would be hedge fund withdrawals:

“The next stage will be a run on thousands of highly leveraged hedge funds. After a brief lock-up period, investors in such funds can redeem their investments on a quarterly basis; thus a bank-like run on hedge funds is highly possible. Hundreds of smaller, younger funds that have taken excessive risks with high leverage and are poorly managed may collapse. A massive shake-out of the bloated hedge fund industry is likely in the next two years.”

If this report is accurate, kudos (again) to Roubini!

by Calculated Risk on 9/23/2008 11:51:00 AM

A few quotes from Secretary Paulson's Testimony:

"I believe we need oversight. We need protection. We need transparency. I want it. We all want it."
...
"I am convinced that this bold approach will cost American families far less than the alternative - a continuing series of financial institution failures and frozen credit markets unable to fund everyday needs and economic expansion."
...
"I'm frustrated. The taxpayer is on the hook. The taxpayer is already on the hook. The taxpayer is already going to suffer the consequences if things don't work they way they should work. ...The best protection for the taxpayer is to have this work."

by Calculated Risk on 9/23/2008 09:58:00 AM

From the Financial Times: Pressure mounts for WaMu sale

Washington Mutual was under mounting pressure from regulators yesterday to reach a deal with prospective buyers that would put the beleaguered US bank in stronger hands.

The Office of Thrift Supervision was pushing for a speedy solution, said people familiar with the talks.

If no outright buyer emerges in the coming days, the regulator could push to broker a deal that would split WaMu between several banks. The consortium would share WaMu's attractive deposit base and retail branch network, and would also share the bank's troubled mortgage portfolio.

Another possibility is that the interested banks will let the FDIC close WaMu, the FDIC will take the toxic mortgage portfolio, and then the banks will buy the attractive assets from the FDIC.

by Calculated Risk on 9/23/2008 08:49:00 AM

Here is the text of Fed Chairman Ben Bernanke's testimony before the Senate Banking Committee today:

Chairman Dodd, Senator Shelby, and members of the Committee, I appreciate this opportunity to discuss recent developments in financial markets and the economy. As you know, the U.S. economy continues to confront substantial challenges, including a weakening labor market and elevated inflation. Notably, stresses in financial markets have been high and have recently intensified significantly. If financial conditions fail to improve for a protracted period, the implications for the broader economy could be quite adverse.

The downturn in the housing market has been a key factor underlying both the strained condition of financial markets and the slowdown of the broader economy. In the financial sphere, falling home prices and rising mortgage delinquencies have led to major losses at many financial institutions, losses only partially replaced by the raising of new capital. Investor concerns about financial institutions increased over the summer, as mortgage-related assets deteriorated further and economic activity weakened. Among the firms under the greatest pressure were Fannie Mae and Freddie Mac, Lehman Brothers, and, more recently, American International Group (AIG). As investors lost confidence in them, these companies saw their access to liquidity and capital markets increasingly impaired and their stock prices drop sharply.

The Federal Reserve believes that, whenever possible, such difficulties should be addressed through private-sector arrangements–for example, by raising new equity capital, by negotiations leading to a merger or acquisition, or by an orderly wind-down. Government assistance should be given with the greatest of reluctance and only when the stability of the financial system, and, consequently, the health of the broader economy, is at risk. In the cases of Fannie Mae and Freddie Mac, however, capital raises of sufficient size appeared infeasible and the size and government-sponsored status of the two companies precluded a merger with or acquisition by another company. To avoid unacceptably large dislocations in the financial sector, the housing market, and the economy as a whole, the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship, and the Treasury used its authority, granted by the Congress in July, to make available financial support to the two firms. The Federal Reserve, with which FHFA consulted on the conservatorship decision as specified in the July legislation, supported these steps as necessary and appropriate. We have seen benefits of this action in the form of lower mortgage rates, which should help the housing market. The Federal Reserve and the Treasury attempted to identify private-sector approaches to avoid the imminent failures of AIG and Lehman Brothers, but none was forthcoming. In the case of AIG, the Federal Reserve, with the support of the Treasury, provided an emergency credit line to facilitate an orderly resolution. The Federal Reserve took this action because it judged that, in light of the prevailing market conditions and the size and composition of AIG’s obligations, a disorderly failure of AIG would have severely threatened global financial stability and, consequently, the performance of the U.S. economy. To mitigate concerns that this action would exacerbate moral hazard and encourage inappropriate risk-taking in the future, the Federal Reserve ensured that the terms of the credit extended to AIG imposed significant costs and constraints on the firm’s owners, managers, and creditors. The chief executive officer has been replaced. The collateral for the loan is the company itself, together with its subsidiaries. (Insurance policyholders and holders of AIG investment products are, however, fully protected.) Interest will accrue on the outstanding balance of the loan at a rate of three-month Libor plus 850 basis points, implying a current interest rate over 11 percent. In addition, the U.S. government will receive equity participation rights corresponding to a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders, among other things.

In the case of Lehman Brothers, a major investment bank, the Federal Reserve and the Treasury declined to commit public funds to support the institution. The failure of Lehman posed risks. But the troubles at Lehman had been well known for some time, and investors clearly recognized–as evidenced, for example, by the high cost of insuring Lehman’s debt in the market for credit default swaps–that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precautionary measures. While perhaps manageable in itself, Lehman’s default was combined with the unexpectedly rapid collapse of AIG, which together contributed to the development last week of extraordinarily turbulent conditions in global financial markets. These conditions caused equity prices to fall sharply, the cost of short-term credit–where available–to spike upward, and liquidity to dry up in many markets. Losses at a large money market mutual fund sparked extensive withdrawals from a number of such funds. A marked increase in the demand for safe assets–a flight to quality–sent the yield on Treasury bills down to a few hundredths of a percent. By further reducing asset values and potentially restricting the flow of credit to households and businesses, these developments pose a direct threat to economic growth. The Federal Reserve took a number of actions to increase liquidity and stabilize markets. Notably, to address dollar funding pressures worldwide, we announced a significant expansion of reciprocal currency arrangements with foreign central banks, including an approximate doubling of the existing swap lines with the European Central Bank and the Swiss National Bank and the authorization of new swap facilities with the Bank of Japan, the Bank of England, and the Bank of Canada. We will continue to work closely with colleagues at other central banks to address ongoing liquidity pressures. The Federal Reserve also announced initiatives to assist money market mutual funds facing heavy redemptions and to increase liquidity in short-term credit markets.

Despite the efforts of the Federal Reserve, the Treasury, and other agencies, global financial markets remain under extraordinary stress. Action by the Congress is urgently required to stabilize the situation and avert what otherwise could be very serious consequences for our financial markets and for our economy. In this regard, the Federal Reserve supports the Treasury’s proposal to buy illiquid assets from financial institutions. Purchasing impaired assets will create liquidity and promote price discovery in the markets for these assets, while reducing investor uncertainty about the current value and prospects of financial institutions. More generally, removing these assets from institutions’ balance sheets will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth.

At this juncture, in light of the fast-moving developments in financial markets, it is essential to deal with the crisis at hand. Certainly, the shortcomings and weaknesses of our financial markets and regulatory system must be addressed if we are to avoid a repetition of what has transpired in our financial markets over the past year. However, the development of a comprehensive proposal for reform would require careful and extensive analysis that would be difficult to compress into a short legislative timeframe now available. Looking forward, the Federal Reserve is committed to working closely with the Congress, the Administration, other federal regulators, and other stakeholders in developing a stronger, more resilient, and better regulated financial system.

by Calculated Risk on 9/22/2008 10:05:00 PM

From Reuters: Fed eases minority bank investor guidelines

Key changes in the guidelines include allowing an investor to buy up to a 15 percent voting stake instead of the previous 9.9 percent limit. Investors can also buy up to 33 percent total equity interest, including voting and non-voting shares, instead of the 25 percent prior limit.

This will allow private equity companies to own a larger share of a bank without being designated a "bank holding company" and falling under the supervision of the Federal Reserve.

This is not a huge change, but those that remember the S&L crisis are a little nervous. In 1982, the Garn-St Germian bill allowed S&Ls to have just one owner, and this led to developers buying S&L and lending to their development companies at attractive rates (note: there were many other provisions to the bill that probably contributed to the S&L crisis). There is the same concern here with the new Fed guidelines - that private equity firms will lend to their other businesses excessively.

by Calculated Risk on 9/22/2008 08:14:00 PM

The WSJ reports: Stronger Oversight Gets Nod in Talks

The administration agreed to allow tougher oversight over the cleanup and provide fresh assistance to homeowners facing foreclosure, two Democratic priorities. In addition, negotiators neared agreement on allowing the government to take equity stakes in companies that participate in the rescue, a measure Treasury had wanted to avoid.

But differences remain on two big items: possible limits on executive compensation at firms taking advantage of the bailout; and changes to bankruptcy law that would let judges adjust the terms of mortgages.

It's hard to call the executive compensation provision a "big item", and the cram-downs have been a sticking point for some time. This is actually getting pretty close.

by Calculated Risk on 9/22/2008 06:48:00 PM

Several years ago I predicted that the National Debt would reach $10 trillion by the time President Bush left office. For a short period (thanks to the housing bubble), it looked like the deficit would be less than I projected.

Back in March, with the housing bust starting to hit government revenues, it started looking like the $10 trillion projection had a chance.

So here is an update: The current National debt is $9.727 trillion (see TreasuryDirect) as of Sept 19, 2008. That leaves the debt about $273 billion short of my projection with 4 months to go.

Last year, from Sept 19, 2007 to Jan 20, 2008, the debt increased $185 billion. That is not quite a fast enough pace to make $10 Trillion by next January. But the debt is accumulating much faster this year.

Over the last month, the National Debt has increased $112 billion compared to $34 billion for the same period last year. At this rate, the National Debt will blow by $10 trillion before Bush leaves office.

Add in the Paulson plan, and it's not even going to be close.

by Calculated Risk on 9/22/2008 04:03:00 PM

Headline Only: Treasury Says No Deal With Democrats on Government Taking Equity Stake in Financial Firms

by Calculated Risk on 9/22/2008 03:14:00 PM

From Bloomberg: Paulson, Lawmakers Agree on Equity Stake for Debt, Frank Says (hat tip Bob_in_MA)

``We got a lot of advice from people in the financial community that they should also be able to take some equity, and we agreed and the secretary has agreed with that,'' Frank, a Democrat from Massachusetts, told reporters today in Washington.

Update: From the WSJ: Democrats Craft Bailout Plans To Include Compensation Limits

The Bush administration has conceded several changes to its rescue plan for the troubled banking industry, including agreeing to compensation limits for bank chief executives taking part in the plan and the need for more help for homeowners facing foreclosure, a leading House Democrat said Monday.

Chairman of the House Financial Services Committee Rep. Barney Frank said the Treasury also agreed to Democrats' idea that the federal government should receive warrants to take an equity stake in financial firms in exchange for the government purchasing toxic assets from them.

That was quick. I guess another 300+ points down day on the DOW is scaring a few people.

by Calculated Risk on 9/22/2008 02:42:00 PM

From MarketWatch: Crude futures set for biggest daily price leap ever

Crude futures leaped as much as $25 per barrel, or 24.3%, shortly before the New York close Monday, to tap a high of $130 per barrel.

Wow.

by Calculated Risk on 9/22/2008 01:18:00 PM

From Politico: (hat tip Professor Krugman)

I'm still reading through the plan, but this is definitely a step in the right direction. In the Dodd plan, taxpayers will receive contingent shares, and there is substantially more oversight.