Treasury’s Financial Stability Plan: Will It Work?

Wednesday, February 11th, 2009

By RGE Monitor

On February 10 Treasury Secretary Timothy Geithner presented the administration’s Financial Stability Plan to deal with the financial system’s toxic asset overhang and ease, if not reverse, the ongoing decline in bank lending to households and corporations. Out of the three broad options available - including nationalization, ‘good / bad bank’, backstop guarantee on ring-fenced toxic assets - the administration plan offers elements of all three.

The first program involves a mandatory ‘stress test’ for all banks with $100bn-plus assets which should also shed some clarity on the individual banks exposures and valuations of toxic assets. The Treasury’s Capital Assistance Program stands ready with preferred shares / warrants injections where needed, only this time with clear lending requirements and strict limits on dividends, stock repurchases and acquisitions next to a $500,000 compensation cap.

Any capital investments made by Treasury under the CAP will be placed in the Financial Stability Trust. However, it is still unclear what the options are for institutions that are severely undercapitalized or that fail to attract public capital on a recurring basis (see e.g. Bank of America, Citigroup after the 2^nd bailout.) The program aims at ensuring full transparency disclosing all relevant information on capital recipients: www.FinancialStability.gov.

The second program, the Public-Private Investment Fund (PPP), aims at setting up a new lending/guarantee facility by leveraging an initial private capital commitment with government funds to an initial scale of up to $500 billion (can be expanded to max. $1 trillion.) The aim is to involve private capital on a large scale that sits currently on the sidelines while also allowing private market forces to determine the price for currently troubled and illiquid assets.

A similar experiment was tried before with the private sector sponsored M-LEC vehicle that ultimately proved unviable due to asymmetric toxic asset exposures of participating banks and due to still unresolved asset valuation issues. Commentators agree that for a similar plan to work this time, the government will have to assume a potentially substantial downside in order to induce otherwise unwilling investors to participate in view of the size of potential losses.

As we noted before, the size of the entire shadow banking system lacking liquidity is $10 trillion of which $6 trillion are assets held in the U.S. Not all of these assets will turn bad but at RGE we expect total losses on these shadow banking assets plus traditional loan losses to reach $3.6 trillion (of which $1.8 trillion borne by U.S. banks.)

One practical example is the Federal Reserve’s Maiden Lane portfolio of toxic Bear Stearns assets. If that performance is any guide, the upside left in these toxic assets might in reality be more limited than previously assumed. Cumberland Advisors reports that this particular portfolio has lost over 10% of its value, and losses are mounting. Indeed, the authors see ‘no prospect for a profit on this portfolio.

Renowned distressed debt experts such as Edward Altman and Martin Fridson note that the best time to invest in distressed debt is when default rates peak. Mind that high-yield default rates are set to rise to 15-20% sometime in 2010 from currently 4-5% due to very bad credit quality at the outset of the cycle.

The third program put forth by Secretary Geithner is an expanded version of the previously $200bn Federal Reserve Term Asset Backed Securities Loan Facility (TALF) program aimed at unclogging the markets for auto, student and other consumer loans. That initiative may expand to as much as $1 trillion, using $100 billion from the Treasury’s rescue funds, and include aid for commercial real estate markets.

Geithner points out that securitization created about 40% of the demand for new loans extended to consumers, students, and auto buyers. The decline of securitized lending to the tune of $1.2 trillion between 2006 and 2008 leaves a hole that needs to be filled if a severe lending contraction should be prevented.

Nouriel Roubini argues that, ultimately, nationalization may be a more market friendly solution of a banking crisis: it creates the biggest hit for common and preferred shareholders of clearly insolvent institutions and - possibly - even the unsecured creditors in case the bank insolvency is too large; it provides a fair upside to the tax-payer. Moreover, it bypasses the asset valuation issue as any overpayment goes back into taxpayers pockets. “With the government starting stress tests to figure out which institutions are so massively undercapitalized that they need to be taken over by the FDIC the administration is putting in place the steps for the eventual and necessary takeover of the insolvent banks.” This might well explain some of the negative market reaction.

The Treasury has stressed that while the ongoing price correction will stimulate home demand, there is a need to reduce foreclosures, which otherwise adding to the excess overhang of homes pose the risk of price over-correction, pushing more homeowners into negative equity. The Treasury plans to announce a Housing Program in the next few weeks to help refinance mortgages and contain foreclosures by reducing monthly payments for homeowners.

The program will be financed by using $50 billion from the remaining TARP funds. To increase lender participation, the plan makes it compulsory for banks using government funds under the Financial Stability Plan to participate in foreclosure mitigation. In order to stimulate home demand and help the current homeowners refinance, the Treasury and Fed will continue with their November 2008 plans to use $600 billion to buy MBSs and debt of the GSEs using and reduce mortgage rates to the 4-4.5% range. More importantly, the plan will increase flexibility to modify loans under the Hope Now and FHA Programs started in 2007-08 to help increase participation and foreclosure prevention.

Efforts to stimulate demand reducing mortgage rates and offering tax incentives will be largely ineffective as they are a small factor in determining home demand relative to factors such as tighter lending standards, changing dynamics for households - job and income loss, wealth erosion, rising savings rate, and low expectations of income or asset appreciation. These factors will constrain home demand in the short run while potential buyers await further price correction and banks don’t see the viability in offering a mortgage for a house whose value is expected to fall.

As a result, the government needs to focus on the supply side of the market by refinancing at-risk mortgages and preventing foreclosures that will only add to the existing overhang of houses. Moreover, government’s loan modification program should reduce mortgage principal rather than just reducing the mortgage rate or extending the loan maturity, which has been the case in past government programs. Unless the problem of insolvency among a large number of households is addressed, default on modified mortgages will continue.

Also, given the large number of homeowners with negative home equity, the program will need much larger funds - over $600 billion to $1 trillion though the actual cost might be much less, since the government will receive a share from future home appreciation. Monetary incentives for servicers are also low and ineffective.

Even the number of homeowners the program plans to target, 1.5-2 million is a very small fraction of the over 12 million homeowners with negative equity. In fact, several Democrats are pushing a legislation to allow bankruptcy judges to change mortgage terms that would allow lenders to reduce the mortgage principal for primary homes and bring down monthly payments. To increase participation, they support offering monetary incentives for servicers while lenders will be entitled to a share if the homeowner sells the house and also have the government share any losses on the modified mortgage.

As we have argued before at RGE Monitor, looking at the shortcomings of past government programs such as the Hope Now, Housing Retention and FDIC programs, the new program should be mandatory for lenders in order to increase participation. The government will also need to share the cost of modifying the loan, by matching the principal or the interest rate cut in a proportionate or less than proportionate amount. By guaranteeing the loans, the government will be the senior debt holder. The new interest rate should be based on the risk assessment of the borrower and all three parties - homeowner, lenders and servicers, and the government should share the cost of modification. However, determining the extent of principal reduction based on the true value of the house, and dealing with second lien mortgages and the diverging interests of mortgage servicers will be challenging.

Under the new guidelines for compensation issued by the Treasury, firms receiving federal aid will be subject to shareholder say on pay and will be required to cap executive compensation at $500,000 with any additional compensation given out in restricted stocks which can be cashed only after the government has been repaid or the bank has satisfied repayment obligations, and met lending and stability standards. Moreover, bonuses and compensation for other top executives will also be reduced. The Treasury requires disclosure of the compensation structure and strategy, and expenditure on luxury items.

While government intervention is warranted, the compensation reform does little to align risks with rewards. Large shares of the compensation can and will still be given out in restricted stocks including compensation for several traders and funds managers who are not under the lenses of the current plan. Government measures also give a green signal to those who have already received large compensation and severance packages at the troubled banks.

More importantly, the measures might act a disincentive in attracting credible executive talent to these troubled institutions in the future who can help deal with the bank losses and overhaul. Wall Street compensation is determined in a competitive market with CEOs joining a firm offering the most attractive pay packages and perks. Many banks are already reluctant to seek capital injection from the Treasury or are contemplating to payback past borrowings in order to avoid government scrutiny over their compensation packages.

To reduce excessive risk-taking in the short-run, compensation, bonuses and even severance packages should be based on the long-term performance of the employee relative to the risk undertaken with large part of the payments given out in restricted stocks that can be redeemed over a longer period of time.

Source: RGE Monitor, February 11, 2009.

Tags: Administration Plan, Backstop, Bailout, Bank Of America, Capital Assistance Program, Capital Commitment, Capital Investments, Financial Stability, Government Funds, Illiquid Assets, Nationalization, Overhang, Preferred Shares, Private Capital, Private Investment Fund, Private Market, Stress Test, Strict Limits, Timothy Geithner, Treasury Secretary
Posted in Credit Markets, Markets | No Comments »

Finally, the plan…sort of

Wednesday, February 11th, 2009

I am spending the next few days in Europe on a short business trip. First stop is Dublin where the temperature is icy, the mood is dour, property prices are plunging, the queues for jobless claims are five hours long, the soon-to-be-unemployed are holding protest strikes, and the banks are on the edge of a financial precipice. Yes, it may be a movie with different actors, but the plot is the same as in many other countries.

Meanwhile in the US, Treasury Secretary Timothy Geithner yesterday disappointed the markets with the lack of detail on the administration’s Financial Stability Plan. After all, he did say a few days ago (paraphrasing): ” We are not going to put out the details of our plan until we get it right.” (Please click here for RGE Monitor’s discussion on whether the plan will work.)

The US stock market indices plunged as investors gave a thumbs-down to the announcement, with the S&P 500 Index losing 4.9% and the Dow Jones Industrial Index 4.6%. All market sectors were in the red with Financials (-10.9%) leading the sell-off, with trading volume on the NYSE the highest since mid-December and advances beating declines by seven to one.

According to Lowry’s reports, Friday was a 90% up-day, only to be followed yesterday by a 90% down-day. “Panic on the upside, then panic on the downside - this is one dangerous market,” said venerable Richard Russell (Dow Theory Letters)..

Bill King (The King Report) commented as follows on the bank rescue package: “Geithner and Team Obama have been furiously polling private equity and Street titans to gauge their interest and participation thresholds in various bailout plans. Geithner’s lame plan implicitly indicates that few people wanted to participate in the leaked/proposed plans.

“Private investors know toxic paper remains incalculable with open-ended liability. The market understands that no bank bailout has been announced because there is no plan, barring an outright gift, that will fly with private investors. And an outright gift will infuriate taxpayers. Geithner asserted, ‘We will have to try things we’ve never tried before.’ You mean like telling the truth about the quantity and quality of toxic assets?”

Back to the stock market, key resistance and support levels for the major US indices are shown in the table below. All the indices are trading below the 50-day moving averages and the Industrials and Transport have also breached the December 1 lows. The critical November 20 lows are now within close reach and must hold in order to prevent considerable technical damage.

Where to now? As pointed out before, the primary trend is still bearish. The chart below shows the long-term trend of the S&P 500 Index (green line) together with a simple 12-month rate of change (ROC) indicator (red line) and the RSI oscillator (brown line). Although monthly indicators are of little help when it comes to market timing, they do come in handy for defining the primary trend. An ROC line below zero depicts bear trends as experienced in 1990, 1994, 2000 to 2003, and again since December 2007. Having said that, the levels of both the ROC and RSI are massively oversold.

At this juncture, short-term movements are almost impossible to predict, although 90% down-days are usually followed by two- to seven-day bounces. Seven out of the eight most recent 90% down-days were followed by rallies, according to Richard Russell. Having said that, my belief is that traders will simply have to wait for Mr Market to show his hand, especially as far as the November 20 lows are concerned.

And while we wait, I am trying to capture a leprechaun and find the “hidden treasure” on the Emerald Isle.

Tags: Bank Bailout, Bill King, Dow Jones, Dow Jones Industrial, Dow Jones Industrial Index, Dow Theory Letters, Financial Stability, Jobless Claims, Market Sectors, Obama, Outright Gift, Precipice, Private Investors, RGE Monitor, Richard Russell Dow Theory, Short Business, Stock Market Indices, Thresholds, Us Stock Market, Us Treasury Secretary
Posted in Markets, US Stocks | No Comments »

Hugh Hendry: Commodities Stocks to Remain Weak?

Tuesday, December 16th, 2008

Hugh Hendry, the eloquent and outspoken CIO, Eclectica Asset Management, in an appearance on CNBC’s PowerLunch (Dec. 10) shares his thoughts on agriculture commodities stocks such as Potash, and Syngenta.

Among other things, Hendry makes a forthright confession that he was wrong earlier this year to make the call to be long commodities stocks. He continues on to say that when he realized he was wrong, he promptly sold them too. Hendry runs a long-only Agriculture fund, as well as his primary hedge fund, and has been controversial in some of his choices to oppose his funds’  mandates at times in favour of cash or government securities.

His main quid pro quo is his caution that although commodity stocks  could revisit highs, we could be waiting as many as 10 years for it. Its a must watch.

In a 7-minute segment earlier the same day, Hendry discussed the idea that as the financial crisis deepens, civil liberties are curtailed by governments eager to put an end to falls in share prices and economies. This is an insightful discussion, a must-watch.

“The government has gone to war, it is an economic war. And in a war the government takes a larger and larger role in the society. That’s fine, you have to accept that,” Hendry said. “What is concerning is the erosion of civil liberties.”

The ban on short-selling financial securities in the UK is one example of erosion of civil liberties, another is a statement made in parliament last week which opens the way to silencing the press during financial crises.

The Treasury Select Committee said that it will look at the role of the media in financial stability and whether financial journalists “should operate under any form of reporting restrictions during banking crises”.

“We’re only a year into this and suddenly, already, our liberties are being brought back, brought in,” Hendry said.

Tags: 10 Years, Agriculture Commodities, Array, Asset Management, Caution, Choices, Civil Liberties, Cnbc, Commodity Stocks, Confession, Economic War, Erosion, Favour, Financial Crises, Financial Crisis, Financial Journalists, Financial Securities, Financial Stability, government securities, Hedge Fund, Hugh Hendry, Mandates, Minute Segment, Potash, Powerlunch, Role Of The Media, Share Prices, Syngenta, Treasury Select Committee
Posted in Commodities, Markets | No Comments »