Washington Fiddles as Global Deflation Rages
Location: New York
Author: IRA Staff
Date: Wednesday, March 25, 2009
Raise your glass to the hard working people
Let's drink to the uncounted heads
Let's think of the wavering millions
Who need leaders but get gamblers instead
"Salt of the Earth"
The Rolling Stones
In the latest post on our Picking Nits blog, "Idle Fs: Asset-Rich
Operationally Stressed Banks," IRA CEO Dennis Santiago comments on the
long-term business model trends visible in the 2008 FDIC data, including
disturbing evidence that a number of banks have effectively shut down
lending operations. As their portfolios run off, these banks must shrink
both in terms of assets and core revenues.
Here is the prepared statement by IRA co-founder Chris Whalen for today's
hearing before the Senate Banking Committee, "Modernizing Bank Supervision
and Regulation." Riding on the Acela at 6:00AM this morning, we could not
help but recall those times we appeared before Chairman Henry B. Gonzalez
(D-TX) to discuss some of the very issues that trouble the global markets
today. Below follow thoughts and observations on the Geithner/Summers
public/private proposal to address toxic assets, at least as we understand
it.
The managers of the private hedge and equity funds would put up 10-20% of
the amount of the cost of the assets. Fed would fund the balance at
sub-market rates, while the Fed and ultimately the taxpayer would assume the
risk of any losses. And the investors look to get most of the profits. You
can change the assumptions regarding asset performance or pay out rates, but
if asset performance is as officialdom anticipates, then this plan is a
monumental give away to the Sell Side dealers. Remember neither the managers
nor the private investors are bearing any downside risk. Indeed, the
Geithner Plan III represents a very cheap call option on the toxic asset
pile.
As economist Dick Alford told The IRA: "The structure as described in the
press is nothing more than the Fed, FDIC and Treasury providing some asset
managers with calls on the upside--max loss equal to 3% of assets? When was
the Fed or the FDIC authorized to sell or give away call options? I suppose
that they will try to sell this as a non-recourse loan, but it isn't. It is
an option… The investors would in effect be left with sub-market financing
and ownership of much of the upside potential. The implied rates of return
to the private side are staggering, especially given the absence of any
downside risk."
Proponents argue that this plan will allow for "price discovery," but that
kind of depends on the price you want to discover. The value of the "priced
discovery" is very limited in the world of Washington, in part because the
big banks refuse to admit that the true, economic value of many toxic assets
is around $0.30 on the $1. Thus the price discovered will be a price
premised upon no downside risk and guaranteed sub-market funding, all
designed to help the bond holders of these banks avoid a haircut. If this is
what Secretary Geithner calls a market based solution, then we may as well
nationalize all the banks, flush private property rights and declare The
Jubilee.
More troubling, the perception in officialdom is that many toxic assets that
have been marked down dramatically ($0.20-0.40 on the $1) will continue to
perform, and will thus continue to make timely payments. Secretary Geithner
and Fed Chairman Ben Bernanke seem to believe that the economic value of
these assets would, in "normal" market conditions, be upwards of $0.80 on
the $1 of value. Thus we seemingly have a $0.50 per dollar difference
between the theoretical price in the Geithner/Bernanke world and the $0.30
per $1 valuation in the markets today.
Illustrating the popular view that the financial crisis is "only" an
accounting issue, an observer named "sourcethree" posted this comment on The
Big Picture last week: "The change in the rules wouldn't have influenced the
eventual outcome at Lehman, Bear, etc. because those firms did have too much
in the way of real toxic assets that still would have overwhelmed whatever
'benefit' this evolution in the m2m rule would have meant to them… but it
would help all banks more clearly define those assets that are toxic vs.
those that are simply feeling the crunch of overwhelming
selling/non-existent demand for non-credit reasons. Bank of New York is an
example of what you're looking for - last quarter, they marked down their
Alt-A MBS by $1.2 billion - they said even under their worst case scenario,
the losses over time from these securities would only be $200 million - they
even had a third party do a similar test and they came up with the same
result - so, the difference here for just the last quarter was $1 billion
and added to their already $6 billion in unrealized losses from prior
quarters. Even if you doubt their assumptions used in their 'worst-case'
scenario, the difference between the POTENTIAL credit impairment and the m2m
loss they were forced to record was a factor of 6 TIMES."
But as we told the clients of IRA's Advisory Service last week, whatever
relief that financial institutions and other residents of the
hold-to-maturity world believe that they will receive through the
modification of fair-value accounting and other official dispensation, they
will lose through deteriorating economic fundamentals and falling cash flows
supporting these assets as 2009 unfolds.
Or for those colleagues in the insurance world who thought they dodged the
OTTI bullet propelled by fair value accounting rules, look for another
projectile right behind it driven by economic factors, namely persistent
deflation. As our friend Tom Zimmerman said during the last "Deflating
Bubble" session hosted by AEI and PRMIA, subprime loss experience has
peaked, prime residential loss rates are going to peak later in 2009 and
commercial exposures will see loss rates peak in 2010. This Zombie Dance
Party is just warming up.
The surprise facing Geithner, Bernanke et al is that by Q3, the true
economic deterioration in many toxic assets will be clear for all to see.
That $0.30 per $1 of face value bid that Treasury could hit today will be
$0.15 per $1 of face value or less. The funds available today to deal with
the financial crisis will be further dissipated. The opportunity cost to the
Treasury of the Geithner/Bernanke do nothing approach to toxic assets will
be enormous.
Speaking of poor fundamentals, when AIG released information about the
amounts and recipients of roughly $100 billion of its government loans from
September to December 2008, almost utterly unreported was the fact that the
staid, boring, heavily regulated insurance businesses managed to run up
losses on securities lending requiring $44 billion of government support.
By way of contrast, the credit derivatives widely blamed for bringing down
the world's financial system were consuming $27 billion of support;
municipal investment agreements (essentially, deposits) made by
municipalities with AIG Financial Products took another $12 billion, and
maturing debt took $13 billion. We wonder, just which unit of AIG lent the
securities? What did AIG purchase with the proceeds of the securities loan?
Could it be that the big story at AIG is the unsoundness of the insurer, not
the credit default swaps? Why the misdirected coverage?
Our guess is that we are seeing an unholy alliance of insurance and bank
regulators, who would rather point the finger at unregulated credit
derivatives and support more regulation as the answer to everything. And
don't forget the public officials who don't want people to wonder whether
other staid, boring insurance companies that don't do credit derivatives
might still have huge problems in their core portfolios. Since securities
lending lacks the glamor of M&A or international "Master of the Universe"
trading, the media is easily distracted.
After all, analysts have been sounding the alarm on AIG for many years, but
it is difficult for the truth to penetrate Wall Street's managed version of
reality. As we noted in our statement to the SBC, our friend Tim Freestone
identified possible instability in the AIG business as early as 2001. AIG
threatened to sue Freestone when he published his findings, which were
documented at the time by the Economist magazine.
The Economist and Freestone stood their ground and Hank Greenberg and his
lawyers eventually went away, but the markets took little notice. Notables
such as Henry Kissinger questioned the Economist story and said "I just want
you to know that Hank Greenberg has more integrity than any person I have
ever known in my life."
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