Saturday, October 04, 2008
Amid the usual on-air drivel of various co-anchors and guests which has been gushing for the past week, Caruso Cabrera asked the question, paraphrased, below
'If there's such profit opportunity in buying these assets that the taxpayer should fund doing so, why aren't private investors doing so already?'
Santelli immediately chimed in with his agreement. I think they are right.
We've seen the reports on private equity funds being amassed for eventual purchase of these mortgage-backed instruments. We've seen the Merrill Lynch deal with the Texas investment group for 22 cents on the dollar, with recourse.
But if no significant purchases are being made by those who don't have unlimited credit, why should taxpayers believe that Treasury purchases of the same securities will be profitable?
Even Bill Seidman, one-time head of the RTC, allowed that, if skilled private investors were buying and managing these portfolios, money might be made. But not in government hands.
To me, that's a very important missing signal. If savvy private investors don't feel they know enough about the value of these instruments, regardless of mark to market issues, about which they, and the Federal government, do not need to be concerned, why should we believe that Treasury knows at what prices its purchases will yield profit, while simultaneously recapitalizing the current owners of those securities.
As I wrote here last week, If the Federal government is aiming to rescue banks, it can't pay low prices. If it's aiming to profit, it can't pay high prices.
Which will it be? If private investors aren't even bidding low prices, or banks aren't hitting those bids, that tells you something about how unprofitable this expensive plunge by Treasury into structured securities is likely to become.
Friday, October 03, 2008
Thursday, October 02, 2008
Wednesday, October 01, 2008
Among my favorite, later posts on the topic are these, here, here, here and here. In that first linked post, I wrote,
"You see, this entire financial services debacle is unique because it involves tradeable instruments. Whole loans could be valued at par so long as they were performing. But once magically transformed via financial engineering into CDOs and their ilk, market price became the dominating valuation metric. And, as I and others have noted for some time now, markets for structured instruments can vanish in an instant. Thus, zero price.
There is no ability for anyone to know how much is a sufficient writedown of an asset with no trading market, except 100%. And who wants to do that?
Yes, financials are still reeling. And it won't stop until all the CDOs are basically written off. Totally.
Or, short of that, a vibrant market suddenly erupts all at once as a few hedge funds and private equity groups, like Paulson's ,written about in yesterday's Journal, swoop in and briefly create a market in the instruments for pennies on the dollar.
The holders will get to value the instruments, though probably at lower values than they wished. But above zero.
As I've written elsewhere, these private firms will then enjoy a spectacular rise in value of these structured instruments which are mostly still performing assets.
But for publicly-held companies, there's absolutely no reason for any investor to take a chance on what has become a blind pool of assets which are valued based upon non-existent markets for complex instruments."
I wrote those passages assuming that mark-to-market regulations would not be modified.
Why another post on this? In today's edition of the Wall Street Journal, three of my favorite writers- two of them distinguished economists- write about the current financial sector debacle.
Holman Jenkins, Jr., spotlights mark-to-market accounting in his editorial, as does Brian Wesbury, in his piece. Nobel Laureate Edmund Phelps does not mention it, but, instead, in his piece entitled "We Need To Recapitalize the Banks," weighs various government interventionist proposals to remedy the current situation.
Taking Phelps' article's title as a perspective, one may think of the current financial sector mess as having four possible solutions, ranked below from simplest and least expensive, to most complex and expensive:
1. Per this post, scrap the current mark-to-market regulations and, instead, allow use of net present valuation for performing instruments. Remove the requirement that lower, 'fire sale' current values pertaining to 'non-active' trading markets be used in lieu of 'hold-to-maturity' values for performing assets.
2. Congress authorizes Treasury to sell default insurance on structured finance instruments, thus allowing banks to value the assets at economic value on their balance sheets.
3. Congress authorizes Treasury to invest directly in US commercial banks, taking warrants as a sweetener, so that taxpayers will benefit when the equity values of the banks recover. Capital is rebuilt, with taxpayers afforded some protection.
4. Paulson's plan of simply using $700B of taxpayer funds to buy distressed structured finance securities from bank balance sheets, at undetermined prices.
Jenkins and Wesbury both are in agreement with me on this issue. They believe that the first solution is sufficient to effectively recapitalize banks by allowing them to value structured financial instruments on their balance sheets at long-term, economic values which will not require massive writedowns.
To be honest, I feel very comfortable in such intellectual company. Wesbury wrote,
"So what is to blame for the "worst financial crisis since the Great Depression"?
The answer seems simple. Mark-to-market accounting rules have turned a large problem into a humongous one. A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values.
Mark-to-market accounting causes so much mayhem because it forces financial firms to treat all potential losses as if they were cash losses. Even if the firm does not sell at the excessively low price, and even if the net present value of current cash flows of these assets is above the market price, the firm must run the loss through its capital account. If the loss is large enough, then the firm can find itself in violation of capital requirements. This, in turn, makes it vulnerable to closure, nationalization or forced sale.
Because the government has been so aggressive with the use of these capital regulations, private capital has been scared away. Just about the only transactions taking place in the subprime marketplace have been sales to private equity firms that do not have to mark assets to market prices. Their investors agree to commit capital for the long haul, and because they are able to bend the current holders of these assets over the knee of the accounting rules they get prices that virtually guarantee a huge profit.
Despite all this evidence, the government has yet to provide relief from mark-to-market accounting. However, the Financial Accounting Standards Board will meet today to discuss potential changes. One thing it ought to consider is that the Treasury plan tips its hat to the problem by acknowledging that its goal is to put a floor under distressed security prices. Warren Buffet understood this and invested in Goldman Sachs before the law had passed, but with full expectation that it would. Other investors will follow. There is no shortage of liquidity in the world.
Nor would relaxing mark-to-market rules temporarily in the U.S. -- let's say for three years, for troubled assets issued between 2003 and 2007 -- undermine our standing internationally, as some allege. If a $700 billion bailout fund and the takeover of Fannie Mae, Freddie Mac and AIG have not already undermined foreign confidence, then nothing will. On the same day the bailout bill failed in the U.S. House of Representatives, the dollar soared."
In his remarks, Wesbury sees the same scenario I did earlier this year. Without a reform of mark-to-market accounting, only private equity will be capable of holding structured financial assets which have no actively-traded market. And they will make a killing, buying for pennies on the dollar and recovering the full economic value over time.
Wesbury ends his piece as follows,
"Once private investors know they cannot be taken out by accounting rules and illiquid markets, their cash will flow freely. And if the real issue is to find a proposal that will help fix the problems in our financial markets urgently, then the current Treasury plan fails the test. Because of government bureaucracy and legal issues, the first purchases by the Treasury plan will not be made for at least two weeks and possibly four weeks. Mark-to-market accounting changes could start the healing overnight and prevent the U.S. from moving further away from free-market capitalism."
It's a brilliant insight, as he notes that, until mark-to-market is suspended or modified, private investors won't touch bank equities, because they know the government if forcing those institutions to incur punitive valuations.
Holman Jenkins, similarly, writes,
"The Paulson plan's defeat on Monday was not the end of the world, and may not even be lasting. But it does invite us to revisit the sideshow of mark-to-market accounting.
Even as this agnostic column was giving birth to itself, the SEC's chief accountant released a new "interpretation" late yesterday meant to relax these vexatious rules. The Dow jumped 485 points. Were investors reacting to the SEC announcement -- or hope of the Paulson plan being revived in Congress? Perhaps they concluded that the two are one in the same.
Now recall that accounting is a language of abstraction. In the normal case of a public company, whatever method it uses to value its assets, it merely provides a benchmark for investors to make their own judgments. Nobody takes accounting values as the final word.
Banks, though, are subject to regulatory capital standards and therefore can be rendered insolvent overnight based on an accounting writedown. At the moment, many banks are clinging to "market" values for loans that are higher than probable fire-sale values, and doing so on tenuous grounds. In kibitzing over the Paulson plan, indeed, one knotty question was how Treasury could buy such loans at a price "fair to taxpayers" without propelling the sellers into federal receivership.
Because of all this, the regulatory state finds itself in a somewhat absurd position -- its own rules could render many financial institutions insolvent in a manner inconvenient to the state.
But usefulness is not what we're talking about here -- we're talking about a regulatory trap for equity, created as an unintended consequence of a well-meaning accounting rule. Short sellers see this trap and try to exploit it. Uninsured lenders and depositors see it and worry about not getting paid back. That fear is why banks have all but stopped lending to each other -- and why Henry Paulson launched his plan, and why the SEC made its move yesterday.
Accounting straddles the real and unreal, so it's hard to guess how much difference getting rid of mark-to-market might really make. The only way to find out is to try.
A mere accounting rule change won't reduce foreclosures or raise home prices -- then again, if spared drastic writedowns, banks might be more willing to lend, raising home prices and reducing foreclosures.
A mere accounting rule can't alter the underlying economics of a lending business -- then again, no longer worried about insolvency-by-accountant, investors might discover new confidence to inject capital and improve the underlying economics of a lending business.
No accounting rule is worth $700 billion. Then again, the essence of the Paulson plan was to raise the value of bank assets to help banks escape the regulatory equity trap. Does that mean we can change an accounting rule and save Congress from having to appropriate $700 billion?
Let's find out."
The third writer, Phelps, didn't mention mark-to-market explicitly. Instead, he revisited macroeconomics, and ended up simply judging default insurance to be, to him, not necessarily better than purchasing the assets. I don't agree.
Phelps reviews several other alternatives, including the Paulson plan, and prefers simply injecting capital into banks, in exchange for warrants.
But Phelps provides the important overview of the real issue- how to most efficiently, effectively and, then, quickly recapitalize banks.
And if this can be done via accounting rule modifications, that would be the route that trumps the other three. On all dimensions.
Tuesday, September 30, 2008
For example, Glass-Steagall has, in a sense, been re-instituted in a de facto manner. No large, publicly-held investment bank exists anymore, nor will one likely again for at least a few decades.
The integrated commercial banks which absorbed Bears Stearns, Merrill Lynch and parts of Lehman are unlikely to ever operate those remnants with the leverage or innovation- for better or worse- as they were in the past.
FDIC and SIPC insurance provides some measure of safety for depositors in those institutions that were absent before the original Glass-Steagall bill of the 1930s.
The emergence of three gigantic financial 'utilities'- Chase, Citigroup and BofA- marks the evolution of financial services, after a period of expansive innovation, to a quasi-governmental oligopoly.
John Bogle, the farsighted founder of the Vanguard Group, has stated for years that, as a sector, financial services cannot add value, per se, and certainly not at a rate greater than the long term growth of the economy. He's right.
Thus, as I wrote here, after a nearly 50-year period in which private investment banks sold themselves at peak prices to the public, the sector had taken on too much risk and caused so much counterparty risk as to result in the seizure of credit flows among large financial service players.
Excess capacity has been removed. Excessively risky activities such as securitizing mortgages and selling credit default swaps have been curtailed.
And all this before any Congressional action.
At this point, a very minimal solution from Congress would provide the needed respite for publicly-held banks. The Republican House idea of using Federally-sold credit default insurance for structured finance instruments, backed by mortgages of dubious, or unknown quality, would effectively solve the counterparty risk debacle now affecting financial markets.
I don't know why Paulson and his team either failed to conceive of that brilliant idea, or dismissed it. In no way is it necessary for the Federal government to purchase structured finance paper in the amount of some $700B. All that is required is to cause that paper to be valued on bank balance sheets at their longer term, economic, 'hold to maturity' value, rather than the near-zero value they have in current, non-actively traded markets.
Perhaps the 107 point drop in the S&P reflects the market's concern over the basic lack of understanding of this issue in Washington. Because, as Ben Graham noted some 50 years ago, it's unlikely that the real, tangible value of US business assets in the S&P500 fell by over a trillion dollars yesterday.
Monday, September 29, 2008
Mostly, however, it was a one-on-one match between Gasparino and the always-hapless, under-brained Liesman.
I'm no long term fan of Gasparino. He used to verbally bully the esteemed Wall Street Journal editor Alan Murray.
But this morning, I found myself in complete agreement with Charlie. He correctly noted that, prior to the House Republicans standing up and demanding to be heard in the negotiations on the Washington financial sector rescue legislation, it was largely a Democrat/Liberal Republican venture.
Forget John Harwood, CNBC's ultra-liberal apologist. He has no credibility, nor any shred of objectivity left. Leave it to Gasparino to point out that Paulson is a fairly liberal, East Coast Republican, and he chose to deal directly with only Democrats on the Hill- Barney Frank and Chris Dodd.
Given that those two are largely responsible for the GSE train wreck, it's arguable that Paulson made a serious error in his tactical approach.
Gasparino noted that, until the House Republicans slowed down the rush to take taxpayer funds, nobody even considered a simple, innovative idea like government-issued insurance that would actually make money initially, rather than ladle out most of $700B.
In response, Liesman and Quick squawked about how they thought it was a bi-partisan bill, and everybody said so. That Paulson initiated it, so it must be bi-partisan. Liesman further blathered something like,
'Sure, take more time to craft the bill, and let a few more banks go bust.'
Further proof that Liesman is incapable of any valuable thoughts on his own, but is a conduit for accepted wisdom from any liberal he can cite.
I don't know whether to laugh or cry. How thick must those two be? Any slam-dunk legislation was always going to be railroaded by Dodd and Frank. It took a lot of courage for Boehner, for whom I also typically have little use, to protest the bums rush being orchestrated by Congressional Democrats and non-conservative administration officials.
I was stunned with how savvy and observant Gasparino is in this situation.
With lightning speed, the OTS sold WaMu to Chase, while Wachovia, one of the five largest banks, and seemingly healthy only last year, desperately seeks a buyer to keep it from insolvency.
So, let's review the past month or so.
Treasury finally seized the badly-run, bloated and badly-designed Fannie Mae and Freddie Mac, after their ability to raise capital to continue operations became doubtful. Then Lehman Brothers was allowed to fail when its capital-raising abilities fell short of its needs.
AIG was taken over with 80% ownership by Treasury, to avoid a Chapter 11 filing which would have thrown into doubt the firm's insurance and asset management's units ability to function normally.
Merrill Lynch sold itself to BofA just shy of also being forced to go Chapter 11, due to capital shortfalls and it being the next logical target, after Lehman's exit.
A week later, Goldman Sachs and Morgan Stanley both applied for Federal bank charters, completing the exit of the last large, publicly-held investment banks from the US financial services sector.
Does it not appear that, with Schumpeterian certainty, excess capacity among the weakest, worst-managed financial service competitors is being removed without massive, excess Federal intervention?
I don't count Fannie and Freddie because, to be honest, these two mistakes were Congressional piggy banks to start with. Their excesses were purely Congressionally-sourced, so their takeover is, if anything, merely a recognition of the reality that they were an organizational fiction when considered 'publicly-held.'
AIG was a takeover, to be sure. I do not fully understand why the insurance and asset management units were not bundled together and spun into a separate unit, allowing the other, riskier part to fail. Probably a matter of time available to avoid various debt covenant defaults.
Since insurance in America is a state-regulated business, there was no pre-existing Federal authority to handle the AIG mess.
Still, seen from a distance, because of the nature of short-term lending, counterparty risk management, and confidence, the rapid consolidation of this over-capacity sector was really not all that surprising. Unlike sectors such as energy, metals, or transportation, which consolidate over months or years, financial services tends to consolidate due to some institutions' failures, and, thus, happens much more rapidly.
Does this still require a Federal outlay of hundreds of billions of dollars?
I'm actually not so sure. The consolidation of Merrill Lynch, WaMu and Wachovia will already remove quite a bit of excess capacity, while also allowing some significant bad-asset writedowns. In just a week, the size of publicly-held, face-value held CDOs have plummeted. And will fall by more when Wachovia is bought.
What's left to worry about? The badly-run investment banks are gone. The remaining two- one well-run, the other mediocre- are temporarily independent commercial banks, pending their sale to banks with actual branch networks. The remaining large US banks are healthier than the ones that have gone under.
It's fairly comical that Citigroup could be seen as a potential rescuer of Wachovia. With so many lingering, serious problems of its own, Citigroup would only be adding to its inability to create value for its shareholders.
As I am writing this paragraph, at 8:30AM, the news on the wire is that Citigroup is, indeed, buying Wachovia's retail banking operations. Wells Fargo dropped out of the running. Citigroup has its writedowns capped at $42B, with the FDIC apparently on the hook for anything north of that, in consideration for Citigroup agreeing to raise more capital.
Thus, in just a few weeks, my friend B's 1996 prediction of the evolution of US financial services to a point at which only 3 commercial bank 'utilities' would exist has come true. Citigroup, Chase and Bank of America, the original three money center banks with international networks, are, at least in name, the survivors.
The first of two nearby Yahoo-sourced price charts for the past three months for Chase, Citigroup, BofA and the S&P500 Index show the old money center institutions gaining as the riskier financial services players have exited the scene.
As I am writing this section, my friend B emailed me with the press release on the Citi-Wachovia purchase, noting,
"The inevitable agglomeration accelerates. The separation of the bank market into the three major components is becoming more stark, yet the proper business models and their regulatory, etc. environment have not been resolved. We run the risk of the financial utilities becoming government entities. They will most likely behave that way regardless of whether they remain private or not. Innovation departs "Wall Street", which has quite a while ago become more a symbol than a location for innovation, and moves to the ether and its various nodes around the globe."
As B predicts, these banks will behave like government-run institutions, if they don't actually have the Treasury as a major shareholder.
B is an extremely smart financial services veteran with a PhD in finance.
He correctly predicted, over a decade ago, that this agglomeration would occur, resulting in hulking, musclebound financial utilities which are incapable of being managed to outperform the equity markets. In effect, he prophesied, they will be the repository for 'safe' banking businesses- deposit taking, basic lending and transaction processing.
Financial innovation, such as it will exist, has departed to private equity firms and, to some extent, their organizational brother, the hedge fund.