Be Wary of Policy by Stock Market Response
It was neither a surprise nor a disappointment that the stock market fell yesterday as it reacted to Treasury Secretary Geithner's latest bailout announcement. Stock prices reflect the value of expected future profits -- cash flows after all vendors and creditors have been repaid. If the government had stepped in with (yet) another (even more absurdly generous) plan to relieve shareholders of their obligations to those creditors at taxpayer expense, then naturally stock prices would rally. So we an at least be thankful that we didn't see that.
For a more colorful take on these ideas, here is Steven Pearlstein in The Washington Post:
Not enough clarity, they complained. Still no light at the end of the tunnel, bemoaned others. Like spoiled, petulant children, they demonstrated their dissatisfaction by driving stock prices down another 5 percent.
By now, I hope you've learned enough not to be taken in by the self-serving floor patter. These guys won't be happy until the government agrees to relieve them of every last one of their lousy loans and investments at inflated prices, recapitalize every major bank and brokerage and insurance company on sweetheart terms and restore them to the glory days, so they can once again earn inflated profits and obscene pay packages by screwing over their customers and their shareholders.
For the Wall Street wise guys, bailout politics is just another game to be played, another market to be manipulated, another set of risks to be arbitraged.
Read the whole thing.
Timothy Geithner's Bank Rescue Plan can be a Big Bang
There is no such thing as hard to priced toxic assets if there is loss compensation agreement from bank which sells the toxic assets, and the bank has financial ability to make the compensation, plus government guarantee of timely interest and principal repayment if the bank default. The toxic assets can also be sold at price equals the present value of expected value of cash flow of the toxic assets, with the government guarantee.
For example, the Public-private Investment Fund purchases toxic mortgage backed securities at cost of $500 billion, and finds expected cash flow of the toxic assets worth $300 billion one year later, and have the loss compensation agreement from banks that banks will compensate $200 billion, plus interest, to the Fund. The Fund, or the taxpayers, will not lose any money in the purchase arrangement, and earn interest on the principal invested in the toxic assets. The banks sell the toxic assets at high price, but realize the actual loss based on the actual write-off rate of the mortgages, and do not suffer from selling toxic assets at distressed or unreasonable low prices. The Public-private Investment Fund injects $500 billion into the banking system and induces initial credit flow of $500 billion in the process. This is a win-win situation for the government, the purchasers of toxic debt securities, the banks, the taxpayers, and the economy.
Government can ensure taxpayers will not lose any money in offering guarantee of the banks' financial ability to make compensation to purchasers of toxic assets, by charging insurance premium to cover the risk, reserving the right to raise premium in the future when the default risk of the toxic assets increase, requiring the bank to place collaterals of 5% of the value of sold toxic assets at central bank, by AAA rated securities, and adjusts the amount of collaterals in accordance with the risk of default in the toxic assets. Hence, government can ensure the banks selling toxic assets with government guarantee can have financial ability to make compensation by controlling the amount of toxic assets sale, risk premium, amount of collaterals required, and will not lose any taxpayers' money in offering the guarantee. The stress test to be done by the Treasury Department and Federal Reserve can ensure that only banks with financial ability to honor the loss compensation agreement to be eligible for the sale of toxic assets.
If Government has doubt in the financial ability of a bank to honor the loss compensation agreement in selling the toxic assets, government does not need to bother consideration of purchase of toxic assets from this bank, as the financial ability and management of this bank is not up to standard. Takeover, merger with other bank, or resale of this bank will be the most appropriate way in this situation.
Most banks should have financial ability to make compensation to purchasers of toxic assets, if these toxic assets can be sold at the present value of expected cash flow from the toxic assets, and the banks have capital asset ratio meeting regulatory requirement before the sale.
The effective way to sell the toxic assets at the banks' estimated present value is to sell AAA rated asset-backed securities by collateralization of the cash flow from the toxic assets, with the banks' guarantee to timely interest and principal repayment, and the guarantee from government when the banks selling these asset-backed securities failed to honor their commitment. There will only be two tranches in this bank and government guarantee asset-backed securities, the senior tranche of AAA rated securities are for sale to investors, and the lower tranche of non-investment grade securities with face value of $1 retained by the selling bank. When a bank intends to sell toxic assets at the price of $30 billion, which is the present value of expected cash flow of the toxic assets perceived by the bank, the bank can issue AAA rated asset-backed securities by collateralization of the cash flow of these toxic assets, and sells them at $30 billion with bank guarantee, and government guarantee, of timely interest and principal repayment of the the asset-backed securities. The bank retains the lower tranche of securities with face value of $1, and this lower tranche can have the right to receive the remaining balance of cash flow from the asset pools, if the cash flow generated from the assets worth more than $30 billion. If the cash flow generated from the asset pool worth $32 billion, the bank retains the right to the $2 billion of cash flow in excess of the $30 billion sale price. If the cash flow generated from the asset pool worth $29 billion after 2 years, the bank will compensate $1 billion to the purchasers for their loss in principal, plus interest based on the coupon rate of the asset-backed securities. As the money for compensation will be smaller than the proceeds from sale of toxic assets, most banks should have financial ability to meet the compensation requirement, unless the banks are seriously insolvent and are unable to meet their financial obligations before the sale of such toxic assets.
As coupon rate of the asset-backed securities will be higher than the discount rate of Federal Reserve, or the inter-bank rate, which are the cost of funding for banks, banks should retain the right, and exercise this right to make compensation to the purchasers for their loss of principal at the time of non-performance of the loans in concern, i.e. at the time the loss of principal incurred due to foreclosures, delinquencies of the borrowers in the asset pool, to minimize the coupon interest payment to the purchasers for non-performing loans.
Banks selling toxic assets this way can minimize their risk in mark-to-market losses from the toxic assets, and can write off the losses based on actual rate of losses from foreclosures, delinquencies, defaults from losses of the non-performing loans of the toxic assets, rather than writedown based on the distressed market prices of toxic assets.
If the toxic assets are sold to private investors, government will not lose any money in offering the guarantee for the sale of banks' toxic assets if the guarantee are implemented in a proper manner. If government needs to purchase the toxic assets from banks, the loss compensation agreement from banks can ensure taxpayers will not lose any money as government will only purchase toxic assets from banks which have financial ability to honor the loss compensation.
If the Financial Stability Plan and the Public-private Investment Fund are implemented effectively, $1 to 2 trillion of toxic assets of banks can be converted into good assets and be purchased by the fund and private investors.
Private investors and the government can invest $50 billion into the Public-private Investment Fund, and borrow 450 billion from Federal Reserve's Term Asset-Backed Securities Loan Facilities, to purchase the bank-government guaranteed asset-backed securities which are collateralized by the cash flow from toxic assets of banks. If the coupon rate of the asset-backed securities is 4.5%, and the Fed's lending rate will be 0.25%, the investment fund will earn interest income of $21.375 billion (=$500 billion x 4.5% - $450 billion x 0.25%), an annual return of 42.75% from initial investment of $50 billion. Federal Reserve will ensure that the purchased asset-backed securities will be held as collaterals to ensure full repayment of the loans to this investment fund.
Treasury can engineer the banks to participate the bank rescue plan, by using 50% of the proceeds from sale of toxic assets to purchase the bank-government guaranteed asset-backed securities. This can be viewed as a show of confidence by the banking sectors in the bank-government guaranteed asset-backed securities, and their continuous support in holding asset-backed securities with loans made by the banks, and to be market makers for these asset-backed securities, to ensure proper liquidity of the secondary market of these securities. As government guaranteed asset-backed securities can have price stability and liquidity in the secondary market, these securities will become liquid with stable price performance.
The purchase of such securities by using 50% of the proceeds from sale of toxic assets by banks will be up to $500 billion. (=$500 billion x 50% + 125 + 62.5 + 31.25 + ... ). Hence, the initial investment of $50 billion can purchase up to $1 trillion of toxic assets from banks. The remaining 50% of proceeds from sale of toxic assets will be available for making other loans to the economy.
Based on this arrangement, the Treasury can purchase $2 trillion of toxic assets from banks, by initial investment from public and private investment of $100 billion.
The $450 billion loans by Federal Reserve can be financed by printing money. This increase in money supply will be temporary, and will not be permanent increase to cause significant inflationary effect. If the Public-Private Investment Fund sell $100 billion of asset-backed securities to other investors to lock in the profit, the Fund will repay $90 billion of loans to Federal Reserve, and the increase in money supply will be reduced from $450 billion to $360 billion. Hence, this increase in money supply will be temporary and the Federal Reserve can ensure money supply can be reduced accordingly when the Public-Private Investment Fund sells the portfolio of the banks' toxic assets.
This increase in money supply will not cause depreciation of US dollars, as banks selling the toxic assets via this program will be required to submit a plan of using the proceeds from the sale, and capital outflow by banks after sale of toxic assets will not be allowed by the Treasury.
Hence, Timothy Geithner can have good chance of success in implementation of his bank rescue plan, and the financial situation of most banks will be in better shape than many economists' expectation, if most banks are able to sell their toxic assets at values based on present value of expected cash flow of toxic assets, rather than the distressed market prices of these assets.