Posted on 03/26/2009 11:13:07 PM PDT by CutePuppy
So is that it? Is the downturn over? After bouncing off of 6500, or more than half its peak value, and with Citigroup briefly breaking $1, the Dow Jones Industrial Average has rallied back more than 1200 points. So, is it safe to go back in the water? Best to figure out what went wrong first -- what I like to call a bear-raid extraordinaire.
The Dow clearly got a boost from Treasury Secretary Tim Geithner's new and improved plan, announced on Monday, to rid our banks of those nasty toxic assets. The idea is to form a "Public-Private Investment Fund" to buy up $500 billion to $1 trillion worth of bad assets -- mostly mortgage backed securities (MBSs) and collateralized debt obligations (CDOs).
While it's true that private interests can conceptually help establish the right market price for these assets, the reality is Mr. Geithner's public-private scheme won't work. Why? Because the pricing paradox remains -- private parties won't overpay, yet banks believe these assets are extremely undervalued by the market. As Edward Yingling, president of the American Bankers Association, said recently on CNBC, "You have to go into the securities, examine the securities, examine the cash flow. I've seen it done, and the market is so far below what they're really worth."
The Treasury can't just keep throwing money at the problem, but needs instead to figure out what's really been going on -- the aforementioned bear-raid extraordinaire that's crushed Citigroup and Bank of America and General Electric, among others. Only then can Mr. Geithner craft a real plan to fight back.
In a typical bear raid, traders short a target stock -- i.e., borrow shares and then sell them, hoping to cover or replace them at a cheaper price. Once short, traders then spread bad news, amplify it, even make it up if they have to, to get a stock to drop so they can cover their short.
This bear raid was different. Wall Street is short-term financed, mostly through overnight and repurchasing agreements, which was fine when banks were just doing IPOs and trading stocks. But as they began to own things for their own account (MBSs, CDOs) there emerged a huge mismatch between the duration of their holdings (10- and 30-year mortgages and the derivatives based on them) and their overnight funding. When this happens a bear can ride in, undercut a bank's short-term funding, and force it to sell a long-term holding.
Since these derivatives were so weird, if you wanted to count them as part of your reserves, regulators demanded that you buy insurance against the derivatives defaulting. And everyone did. The "default insurance" was in the form of credit default swaps (CDSs), often from AIG's now infamous Financial Products unit. Never mind that AIG never bothered reserving for potential payouts or ever had to put up collateral because of its own AAA rating. The whole exercise was stupid, akin to buying insurance from the captain of the Titanic, who put the premiums in the ship's safe and collected a tidy bonus for his efforts.
Because these derivatives were part of the banks' reserve calculations, if you could knock down their value, mark-to-market accounting would force the banks to take more write-offs and scramble for capital to replace it. Remember that Citigroup went so far as to set up off-balance-sheet vehicles to own this stuff. So Wall Street got stuck holding the hot potato making them vulnerable to a bear raid.
You can't just manipulate a $62 trillion market for derivatives. So what did the bears do? They looked and found an asymmetry to exploit in those same credit default swaps. If you bid up the price of swaps, because markets are all linked, the higher likelihood (or at least the perception based on swap prices) of derivative defaults would cause the value of these CDO derivatives to drop, thus triggering banks and financial companies to write off losses and their stocks to plummet.
General Electric CEO Jeff Immelt famously complained that "by spending 25 million bucks in a handful of transactions in an unregulated market" traders in credit default swaps could tank major companies. "I just don't think we should treat credit default swaps as like the Delphic Oracle of any kind," he continued. "It's the most easily manipulated and broadly manipulated market that there is."
Complain all you want, it worked. In early March, Citigroup hit $1 and Bank of America dropped to $3 and GE bottomed at $6.66 from $36 not much more than a year ago. Same for Lloyds Banking Group in the U.K. dropping from 400 to 40. Citi CEO Vikram Pandit recently announced that the bank was profitable in January and February. (How couldn't they be? With short-term rates close to zero, any loan could be profitable). Never mind they still had squished CDOs, it was enough to get some of the pressure off, for now.
Oddly, with the new Treasury plan, these same bear raiders are still incentivized to manipulate the price of swaps to depress toxic derivative prices, especially so with the government's help to get hedge funds to turn around and buy them. Perversely, they may get rewarded for their own shenanigans.
This week's Treasury announcement of private buyers isn't going to magically change the depressed prices of these toxic derivatives. The Treasury needs to fight fire with fire. If I were Mr. Geithner, I'd pull off a bull run -- i.e., pile into the CDS market and sell as many swaps as I could, the opposite of a bear raid. If the bears are buying, I'd be selling, using the same asymmetry against them. Sensing the deep pockets of Uncle Sam, the bears will back off. Worst case, the Fed is on the hook for defaults, which they are anyway!
With the pressure of default assumptions easing, prices of CDOs should rise, which not only gives breathing room to banks, but may actually get these derivatives to a price where banks would be willing to sell them, replacing toxic assets in their reserves with cash or short term Treasurys, which ought to stimulate lending.
So are hedge funds villains? Not especially. The bear raid probably saved us five to 10 years' of bank earning disappointments as they worked off these bad loans. Those that mismatched duration set themselves up to be clawed. Under cover of a Treasury bull run, banks should raise whatever capital they can and dump as many bad loans before the bear raiders come back. Let the bears find others to feast on, like autos, cellular, cable and California.
That's the standard philosophy, but in reality, the existence of so many major market bubbles has pretty much disproved it. There is another side of this coin - since logically "smart" shortselling would (and does) tend to occur near the supposed top of the market, the short squeezes actually move the market higher and create larger and longer tops than anyone expects, with more money moving from the sidelines into the market, not the other way around. You often hear short sellers warning about the "market's irrational exuberance" years before the parabolic ascent and crash occur - that's a lot of money thrown at the market just when it's most expensive to do so and when "this time it's different" euphoria just starts to set in and people throw money at the market. In other words, The market can stay irrational longer than you can stay solvent. - John Maynard Keynes.
Bears and Bulls get mauled because short selling often extends and prolongs the market (or stock's) top, and what could have resulted in reasonable and quiet deflation of the market often results in a crash that is significantly harder and destroys more of the capital than otherwise would.
Something to think about... And, no, I am not in favor of "banning" short selling, or derivatives etc. They are just useful financial tools and can be used conservatively or aggressively, without all the damage that all too often we see they can and have been used to cause. To paraphrase, "financial instruments don't destroy capital; people, who are abusing them, do". We should see to it that they cannot. The same way we do not ban aviation or car travel, but try and take measures to prevent them from being used as guided missiles or weapons of mass destruction.
Here's a scenario:
"Megabank" had $100 billion (par value) of toxic assets.
Over time, they wrote down $5 billion on those assets and they now sit on the balance sheet at $95 bllion (marked at 95).
The FDIC holds an auction for those toxic assets.
Megabank either directly (or indirectly through a third party in order to obfuscate) bids the whole $95 billion.
The FDIC guarantees a loan for 80% of the auction price - $95 billion x 80% = approx. $75 billion.
The US Treasury puts up 1/2 of the remaining equity needed - $20 billion x 50% = $10 billion.
MegaBank puts up the remaining equity that is needed - $10 billion (they might even use TARP bailout money to fund it - wouldn't that be ironic).
Now, here's where it gets interesting. Megabank KNEW going in that the toxic assets were actually only worth 50 cents on the dollar (I'm being EXTREMELY generous with that number).
Megabank faced a write-down of an additional $45 billion on their toxic assets if they were forced to price them accurately.
Instead, Megabank now has cash instead of toxic assets, and only had to put up $10 billion in equity to get it.
Megabank fully intends to let the deal go south since everything is set up as a non-recourse loan. The MOST that they stand to lose is their equity - $10 billion. So what - that's better than the $45 billion that they were staring in the face.
Meanwhile, the US Treasury (taxpayer) also loses its equity - $10 billion.
The 80% loan goes into default and the FDIC has to cover. The original loan was $75 billion. The true price of the toxic assets is $50 billion, for a $25 billion loss (taxpayer).
Therefore, between the US Treasury and the FDIC loan guarantee, the US taxpayer ends up losing $35 billion dollars on the deal.
Megabank only loses $10 billion - and maybe even less if they take out CDS contracts on the whole deal.
When you said, "their own debt", I thought you meant bonds they issued, not bad bonds they bought from someone else.
Comparing blaming "manipulators" (notice, not "speculators", which would be trite and unfair) of the market (and providing specfic examples of how it's done) is not the same as comparing themn to "Jews" (as in Merchant of Venice and Nazi Germany and other places at other times). As a matter of fact, when the mob on Capitol Hill singled out AIG people who received "bonuses" it made me think of them being used as "Jews". And when the ACORN mob started riding a bus around those AIG employees' houses, it made me think how close are we to Kristallnacht or pogroms?
Re "short selling forced writedowns quickly rather than being papered over for 5 to 10 years," I'd much prefer the latter since it would only affect and orderly deflate the value of banks (along with their assets on the books) instead of creating a major crisis and massive destruction of capital and near destruction of capitalist financial system (which may yet happen, depending on how much "change" our new government "hopes" to inflict on us)
Good comments on OPM and most governments' (not just ours) "solutions" that extend and prolong the problems that market itself would solve (with enough temporary liquidity, necessary to quell panics).
The problem with socialism is that you eventually run out of other people's money.
To cure the British disease with socialism was like trying to cure leukaemia with leeches.
- Margaret Thatcher
DemRats equivalent of the Reichstag fire.
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