PPIP: Maybe you'd like it back in your cell?

The big question surrounding the toxic asset plan is will banks sell? I've put a little pencil to paper here and come up with some actual numbers.

First of all, I expect the Legacy Securities Program will work wonderfully. Sellers will flock to it like Jawas to a stray astromech droid. This program is aimed at securities which have been severely impaired from both a credit and liquidity perspective. CLOs, RMBS, ABS, CMBS, etc. The program should succeed in turning these programs into just credit impaired. In effect, it will separate the red ones with the bad motivators from the blue ones in prime condition. That will be key to an eventual economic recovery. It should foster a healthy new issue market for RMBS, ABS and CMBS (don't know that CLOs can come back), which will help get the velocity of money back to a more normal level.

Obviously having ready buyers able to earn impressive ROEs should improve the value of the underlying assets. Financial institutions have already marked these securities to market, an improvement in the actual value of the instruments ought to result in an improvement of balance sheets. This will particularly benefit financials who invested primarily at the top of the asset-backed capital structure. It will also benefit those that hold more risk in securities (such as brokerages Goldman Sachs and Morgan Stanley and possibly some P&C insurers) and less those that hold risk in loans (such as almost all banks). Even there, much of Goldman and Morgan's risks are tied to the equity markets, not to debt markets. Same goes for life insurance, generally speaking.

That brings us to the with the Treasury's Legacy Loan Program. I expect this to go over like the exotic twi'lek dancer's routine in Jabba's palace. The plan will indeed increase the theoretical price at which banks could sell loans. That's fine, but its short help. Loans haven't been marked to market. Instead, they are held at book value less an allowance for expected loss.

I've done some deep dives on bank residential loan portfolios. Getting detailed data is a challenge, but basically I tried to figure out what percentage of the bank's current portfolio is "challenged." High CLTV, bad geographics, low FICO, etc. You can make a relatively safe assumption that most of the loss reserve is pledged to those kinds of loans. Anyway, I can't find any big banks that are holding, say home equity loans at less than 90% of face. Unless the Legacy Loan Program winds up buying assets at $90 or more, banks won't sell.

So will the PPIF's pay $90? I doubt it. Take home equity loans as an example. Start with the following assumptions:

• PPIFs get loans at 1mo-LIBOR +50bps. Its hard to say exactly what the cost of funds might be, but worth noting that FDIC paper trades around L+20.
• 6-1 leverage, which is the max allowed under the program. I think its reasonable that non-delinquent, prime loans would get the max leverage.
• Assume the loans float at Prime-flat.
• Assume the loans are 1-2 years old, and will repay over the course of 6 years. To make it easy I'm going to assume equal payments per month.
• The pool of loans will suffer 10% cumulative losses, all of which occur in the first two years. I won't write down the losses as they occur, simply take away the interest. That's consistent with a hold-to-maturity IRR calculation.
• Finally, and perhaps most importantly, I'm assuming that the PPIF equity investors are targeting an IRR of 20%.

The result? $82.5.

That price will render it impossible for most banks to sell. For example, based on Bank of America's recent earnings presentation, it has something like $250 billion of prime, non-delinquent home equity loans with 90%+ LTV. I'd call this the kind of stuff that isn't exactly toxic, but selling could improve BAC's risk exposure significantly. Say they effectively have a $90 mark on these. If they sell at $82, they'd suffer an 8% loss versus their capital, or $20 billion. BAC has core equity capital of $48 billion. You do the math.

I don't expect commercial loans to be much better. Now a lot of commercial stuff has large loan loss reserves, and therefore sales would more easily be accretive to capital. But commercial loans are also present an information asymmetry problem. You can put a zillion residential loans into a pool and get some semblance of diversification. You can then look at average stats and get some idea of the make-up of the loans: geo diversification, average FICO, etc. A bank that is selling a commercial loan is telling you they don't want that commercial loan anymore.

This isn't to say the toxic asset plan will have no positive impact, but it is likely to be more indirect than investors are currently hoping. The best chance banks have for decreasing their residential loan portfolios is a revived securitization market, which is the primary aim of the TALF. Banks may be more willing to sell a portion of their home equity loans as a senior security, with the bank retaining a subordinate position. In that case, the bank might retain the upside while still freeing up some capital. In addition, a revived securitization market would give the market confidence that banks have enough liquidity to hold their loan portfolios to maturity.

It will also help banks who have made larger writedowns, especially those that made acquisitions. At the time of acquisition, the bank has to write down the loan to fair market value. In the case of J.P. Morgan's acquisition of WaMu, or Wells Fargo's acquisition of Wachovia, there would be no motivation to under-estimate the FMV decline. Those banks could therefore enjoy improved capital positions from certain sales.

The Bad Bank: We're only going to have one shot at this

I've written several times about the Bad Bank plan. I believe its critical to restoring confidence in our financial system, and while I don't expect it to "fix" the recession, I do think its a necessary ingredient to the U.S. economy finally moving forward. I've made some loose proposals in the past about how the Bad Bank could work, but after continued thought, I'm proposing an even more detailed idea. Again, this is in the spirit of exchanging ideas, I'd love to hear your comments.

I'll start with some assumptions.

• Banks and other financial institutions have two flavors of problem assets: loans which are not marked to market and securities which are.
• The point of the Bad Bank is to improve bank balance sheets both in terms of reduced leverage as well as visibility.
• Buying assets at so-called "market" levels does not serve the above purpose.
• While protecting tax payers is obviously important, creating a Bad Bank which doesn't materially improve financial conditions is a waste of time and money.

Note that because loans and securities are being accounted for differently, it creates a material difference in how much the Bad Bank must pay to actually improve a bank's balance sheet. More on this later.

We start by hiring four asset managers. Say its PIMCO, Blackrock, Fidelity, and Accrued Interest (of course! Its my damn plan). Each would be given $100 billion to manage, and would also be given access to a Fed-based credit line of $200 billion each. The loans would be TALF-style, no re-margining, term loans that can be repaid at any time. Each firm would be paid a hedge-fund style fee, i.e., with a performance-based element.

For securities, banks and other financial institutions (I'd open it up to pretty much anyone) there would be weekly auctions. On Monday, firms would submit the securities they'd like to sell. There would be some kind of limit on how much any one bank could put out for the bid on any given week just to keep it manageable. The four firms would then be required to put some kind of bid on each item on Friday. No passing. No more of this "there is no market" stuff.

The sellers would be permitted to put a reserve price, but on no more than half of the bonds offered for sale. What wouldn't be helpful is for firms to put their entire liquidity portfolio out for the bid and then pull everything back after getting a price. That wouldn't improve transparency at all.

The price though won't come in cash, but in stock. More on this later.

Now for the really tricky part. Loans. I'm talking your old-fashioned bank-held whole loans. Mrs. Smith's mortgage. Those are not marked to market, and thus are currently held at par less some reserve for loan losses. Bank of America, for example, only has a 3.5% allowance for losses on their home equity portfolio. As mentioned above, unless these assets are purchased near book value, there's no point in buying them at all.

So here is my radical solution. The Bad Bank buys all non-delinquent residential loans at full face value.

Now wait, don't get too angry just yet. Banks who wish to sell residential whole loans to the Bad Bank must build pools of loans that meet certain criterea. This would be relatively easy for residential loans. For example, if Bank of America wants to sell $100 billion in home equity loans to the Bad Bank, they can't just sell the $100 billion of ugliest shit they have. There would be min/max average FICO, OLTV, average loan size, etc. required. We wouldn't have to make these restrictions overly stringent, but it would assure that the Bad Bank wouldn't wind up with just toxic waste.

Commercial loans and delinquent residential loans would go through the same bidding process as securities. This probably means that banks won't be selling many of these loans, but that's OK. We don't need to completely bleach bank balance sheets, just a good rinse off will do.

As I said above, banks wouldn't get cash, at least not in whole. They'd get stock. Remember that banks aren't suffering for a lack of cash. Banks have some $673 billion in excess reserves...

What they lack is certainty and transparency. So the government buys securities and commercial loans at whatever the bid-determined price is in exchange for stock in the Aggregator Bank. For loans, the bank would get 75% of the face value of their loans in shares and 25% in a subordinated residual.

The principal value of the common stock of the Aggregator Bank would be fully guaranteed by the Treasury. It would pay a dividend equal to all interest on all securities as well as 75% of the interest from whole loans. The other 25% would be retained and potentially paid back to the original bank (the subordinated interest holder), assuming the loan portfolio as a whole met some pre-determined performance standard.

Notice that if the selling bank realizes reasonable performance on their loans, then they are no worse off for having participated in the program. This incentives "good" banks to participate, thus freeing up loanable funds. If loan performance is poor, then the Aggregator Bank retains the excess interest and principal to mitigate tax payer losses.

Notice that this plan doesn't involve any real cash outlay. The Aggregator is trading stock for assets, with the government standing behind the Aggregator's stock. Over time, the government should hold an IPO of the Aggregator's shares, with banks permitted to sell their shares for cash at whatever price the market will bear. Over time, share buy backs would be held with principal returned from the loans. At some point there would have to be some sort of closing transaction as eventually the entire loan portfolio would have paid off.

Now I know what the complaints will be. Tax payers take most of the risk and don't have a lot of upside. True. Problem is that in order to actually fix the problem, tax payers have to take most of the risk. You can't erase risk from the system, only redistribute it. If you want less risky banks, then tax payers have to front the risk. Honestly with my plan, tax payers take on less risk that simply handing cash over to banks, which is what we've been doing so far.

In fact, I fear its a misplaced desire to "protect" tax payers which will ultimately cause the Bad Bank to fail. If the Bad Bank only buys good loans or only buys bad loans at punitive levels, it won't help the situation.

TARP II: Find a way into the detention block!

Details are emerging about the new financial rescue package. Some of the items the Wall Street Journal has reported sound far more market-friendly than what I had feared.

The centerpiece is the bad bank. While not exactly what I talked about last week, this bad bank will be funded with private sector money. Its daring, but if it can work, then I think it will achieve some of the goals I laid out in that post. A privately funded bad bank should involve less government intervention than would otherwise be.

Another key element will be a FDIC-insured covered bond program. I talked about creating a government-backed covered bond program backed by some limited government guarantee. Now it looks like it will be a reality. Basically banks will be able to issue FDIC-insured debt with maturities as long as 10-years as long as that debt is backed by loans. I'd expect this to be restricted to new loans, because the idea is to get credit flowing again.

Remember that covered bonds differ from securitizations in that the debt is an obligation of the issuing bank no matter what. So even if the loans which "cover" the bond go into default, the bank still has to pay. With a securitization, the bank sells all its risk to investors in the securitization. From a moral hazard perspective, the beauty of the covered bond program is that the risk stays with the bank who originated the loans. The FDIC (i.e. tax payers) are only on the hook in the event that the bank goes under. And we're already on the hook for that!

From a "fix" the economy perspective, the covered bond program gives banks a guaranteed profit as long as it can underwrite good loans. The bank's cost of funds for 10-year FDIC insured covered bonds would be about 4.5% (my own estimate, maybe lower). How easy is it to make loans well north of 4.5%? By implementing this program, the government is telling banks not to worry about their funding sources, just worry about lending the money to worthy borrowers.

The last piece of this bailout that I think will really matter is the TALF. Similar to the covered bond program, the TALF will guarantee profits to banks and other financial institutions as long as they can make good loans. Combined with the covered bond program, this should eliminate the hoarding of cash at banks.

The real trick is how the government is going to incent private investors into the bad bank. I think that if the government guaranteed some percentage of the initial purchase value, private investors would come in. I'm not sure how high this number has to be, but there is a number.

Bad Bank/Worse Bank

So what do we think of Geithner's Bad Bank idea? Is this the solution that will finally fix the economy? Will this mark a Bottom (tm)?

First of all, the universal bad bank idea is much better than how the TARP is currently being utilized, namely equity injections into private banks. When you have the government actually owning private companies, it opens up any number of Pandora's boxes. Already the government is trying to influence how banks operate by forcing them to lend out TARP injections. That's a terrible precedent.

On the other hand, if the government simply buys certain assets from banks, that could be the end of it. Congress could attach certain rules and regulations surrounding the asset purchases, for example, forcing banks to agree to executive pay restrictions. But once the purchases have happened, that could be the end of it.

If you want to some day return to real capitalism, then we need to figure a way to get through the current crisis. But we also need to do it in such a way that government interference in private business is minimized. As long as government owns banks, that isn't happening.

How should the purchases of bad assets be handled?

I'd like to see it done something like this. We form a new company, call it LoanCo. The Federal Government capitalizes LoanCo with some amount of money, say $500 billion. LoanCo agrees to hold weekly reverse auctions. Each auction is held with specific types of mortgages or mortgage securities. For example, one week might be OptionARMs with a certain FICO range, original loan size range, vintage year and interest rate. The next week would be a different set of characteristics.

Each bank would offer to sell their block of loans at some price, expressed as a percentage of original loan amount. LoanCo would have a pre-determined total amount they will be buying. The purchases would occur at the lowest price that "cleared" the market. Essentially, banks would be giving LoanCo limit sell orders. Bank of America might say they'd sell some set of loans at 60% of par or better. If LoanCo gets all the loans they want by paying 30%, then B of A is left out in the cold. If LoanCo winds up paying 70%, then B of A simply gets better execution.

But rather than get cash for the bad assets, the selling bank gets stock in LoanCo. All interest received by LoanCo is initially retained, but all principal is immediately returned to shareholders. The government guarantees half of the principal in these loans. In exchange, the government keeps all interest payments until LoanCo starts winding down and keeps any principal payments over the initial purchase price. So for example, if a loan was sold to the government at $60 but they eventually recover $80, taxpayers keep the $20.

(Note there is a somewhat similar plan being proffered in today's WSJ. Robert Pozen's idea is similar to mine in many ways, but I like mine better).

The advantage of my system is that banks would get capital relief, as LoanCo stock has a guaranteed value of at least $0.50 cents on the dollar. It would also make investors in banks feel more confident, knowing that the value of distressed mortgage assets can't be any worse than half of its current value.

This would also create a somewhat market-based price for the "bad" assets, at least more so than creating some model to determine a price. There is a good chance that LoanCo would suffer from selection bias. Banks would have to submit loans with certain criteria, but they would clearly pick the "worst" loans that fit that criteria. But in the scheme of things, this shouldn't be a deal breaker.

The downside of this plan is that banks get very little in fresh cash, only certainty as to the downside on their assets. But I argue that's not all bad. If we just give banks cash, they are essentially allowed to grow earnings on the backs of taxpayers. By issuing stock, the banks get the capital certainty they need, but have to figure out how to grow earnings on their own.

And I argue that banks will start lending once the fear of another round of bank runs diminishes. The margins on new loans should be excellent. I don't think we need to dole out free cash in order to incent banks to lend.

And the best part about LoanCo is that its clearly a one-time deal. The moral hazard and long-term government intervention problem is limited.

TALF: Quicker, easier, more seductive

The Fed has expanded the Term Asset-Backed Loan Facility (TALF), which AI first discussed here. Here is the quick recap of the facility.

1) Fed will loan funds for purchase of recently issued ABS. This was clarified to mean ABS issued after January 1, 2009 made up of loans no older than October 2007. The ABS must be rated AAA, and be made up of student loans, auto loans, small business loans, or credit cards.

2) Loans will be non-recourse and not marked-to-market. The borrower will not have to deal with margin calls due to price declines.

3) The loan term will be up to 3-years, originally was only 1 year. That is extremely positive for the potential success of this program. See below.

4) The loan rate will be set at "yield spreads higher than in more normal market conditions but lower than in the highly illiquid market conditions that have prevailed during the recent credit market turmoil." In other words, lower than the rate paid on the asset.

So what has the Fed done here? Created an easy arbitrage. All investors have to do is do accurate credit work, and this is a guaranteed profit. Note that the 3-year term seals this thing. 3-years is basically the entire life span of most eligible collateral, so it eliminates the last thing an investor needed to worry about. Given a 1-year term, investors would have worried that the end of 1-year, new financing might not be available. But by the end of 3-years, the asset will be all but gone.

Also through this facility, the Fed can really control consumer lending rates. The rate on newly issued AAA ABS will be stuck at a level slightly higher than the Fed's lending rate. Banks which are currently hoarding cash will fall over themselves to buy ABS and pledge them into this facility.

Now don't read this as especially bullish for the overall economy. I still see this as a facility intended to aide in quantitative easing, and not a "fix" for the recession. Or put another way, a means of preventing the economy from getting still worse. But as far as ABS go? Should get that market rolling again.

We need? What about you need?

The Fed's new Term ABS Loan Facility (TALF) announced this week could be a significant step in improving credit availability. While many of the details of the program are not yet known, there is already several take aways.

First, this looks and smells a lot like a back-door way of reviving some of the TARP's original concept. Consider what we already know about the program. Eligible collateral for the TALF will basically include AAA-rated bonds within the major non-housing ABS sectors: auto loans, student loans, credit cards, and SBA loans. TALF loans will have a one-year term and will be non-recourse to the borrower. The facility appears to be oriented toward banks and insurance companies, but may actually be available to anyone. TALF loans "will no be subject to mark-to-market or re-margining" which is a critical part of the program.

Now put these criteria together and consider the effect. A bank may originate loans of the above types, then get funding from the Fed at an attractive rate. There is no need to worry about the funding being taken away suddenly because of changing haircuts, nor is there any worry about interim marks impacting economic results. The originator does have an incentive to make a good loan, since the Fed is going to require some haircut. But as long as the originator can make good loans, the eventual profit will be the differential between the lending rate and the Fed borrowing rate.

Let's look at a real life example. COMET 2008-A6 A6 is a credit card ABS issued in May. The original deal spread was +110bps over 1-month LIBOR with a 2.4 year average life. Currently bonds of this type are trading with a spread of around 600bps, which makes the dollar price of this bond around $89.

Analyzing asset-backed bonds gets complicated because bond holders get monthly principal and interest payments. But in simple terms, the bond is yielding LIBOR +600bps. If the Fed is willing to lend at LIBOR +50 or 100bps, banks will quickly gobble up high quality ABS paper. As a result, the yield spread on this kind of ABS will contract until its closer to the Fed's lending rate. If the COMET bond were to go from LIBOR +600 to LIBOR +300, the bond's price would appreciate by 5.5 points.

There would be two important knock-on effects. First, it would create a price floor for similar ABS which isn't pledged into a Fed facility, alleviating mark-to-market problems banks are currently facing. Second, it will allow for new origination in ABS, which will help rejuvenate consumer credit.

The primary beneficiary will be the ABS securities itself. Next would probably be the bigger holders of ABS paper, which include banks and P&C insurers. Companies involved in securitization will also benefit: credit card issuers like Capital One and student lenders like Sallie Mae. There is already talk that this program could be extended to Commercial MBS, which would benefit REITs tremendously.

Disclosure: Long certain ABS as well as Sallie Mae

Asset-backed securities and the future of consumer lending

So... no buying of mortgages from banks in the TARP. What are they doing?

On the same day they pulled the rug from under our banking system, Treasury announced they would be "exploring" programs to improve liquidity in the AAA-rated asset-backed security (ABS) market. Although securitization has in many ways been a big part of the problem, revival of the ABS market would make a big difference.

Remember the covered bond idea? Its a structure used extensively in Europe where a bank pledges a pool of mortgage loans to "cover" a piece of debt. In theory, the bank enjoys a lower interest rate on such debt because it is both a general obligation of the bank as well as "covered" by the mortgage loans.

In July, the Treasury proposed covered bonds as an alternative to the traditional securitization markets. It never really got going in large part because the corporate bond market continued to deteriorate, and thus was not receptive to new products. But the idea was sensible enough. Covered bonds better align the bank's incentives with the investor, because the bank remains on the hook for the debt no matter what. This is in contrast to a straight securitization, the bank off loads all the risk to investors.

From a macro-economic perspective, a vibrant covered bond market would have allowed banks to lend knowing there was a ready source of cash. Banks will not lend until they are confident in their sources of cash. If the covered bond idea is dead, for now anyway, perhaps the ABS market can pick up the slack.

Historically, ABS have typically been backed by consumer loans, including credit cards, auto loans, home equity, and student loans. ABS were typically structured with a senior/subordinate credit enhancement, meaning that certain tranches of the deal would take losses first and only once those tranches were wiped out would other tranches take a hit.

Of course, there have been numerous problems with the ratings agencies allowing too little in subordination in certain deals. But there is nothing inherently wrong with the senior/sub concept. In fact, if its kept as a simple sequential loss structure, analyzing the credit of an ABS deal becomes relatively straight forward: its just losses versus available subordination. Sounds a hell of a lot more transparent than trying to decode a bank's balance sheet!

So what if the ABS market could be revived? Lenders who could not access the unsecured debt markets could access the ABS markets, raising loanable funds. If the lender also kept a sizeable residual on the deal, the result would be similar to the covered bond idea.

Many companies would benefit directly from an improved ABS market. Credit card issuers, such as American Express, Citigroup, and Capital One. Student lenders such as Sallie Mae. Even the autos would benefit, although obviously the GM and Ford situation is much deeper, Toyota and Honda would also benefit.

It wouldn't solve all our problems. I still wish they were buying mortgage assets. But this is better than nothing.

AI to Paulson: A Jedi must have the deepest commitment

Hank... Hank... you've got to be kidding me. Its clear to you that buying illiquid mortgages "is not the most effective" way to use the TARP. Seriously. Can some one please let Secretary Paulson know that mortgages are, in fact, the crux of the problem. Why do we have a problem with banks lending to each other? Because no one trusts anyone else's balance sheet. Because the mark-to-market price of mortgage assets just keeps falling.

Let's talk about the reality here. This doesn't represent a shift in strategy by Paulson. Banks have forced his hand.

There was whispers for a week or two that banks didn't want to participate in the TARP asset purchases. As individuals, they can't see the incentive. Its a classic free-rider problem. All banks would benefit if all banks participated, but each bank looking at its own situation individually isn't incented. Or more accurately, it isn't clear whether a bank would benefit individually or not, and given all the strings attached to participation in the TARP, banks are passing.

So where does this leave us? Worse. Undoubtedly worse.

We'll still get through this, but now you have to figure that home prices will bottom well in advance of the general economy. Why? Consider a possible progression:

1) Home prices bottom. Put whatever time frame on this that you'd like. I actually think it could happen sooner than many expect, but I digress.

2) Home lending is relatively robust for borrowers with good credit (It must be, or home prices wouldn't have bottomed!), but this is solely because the GSEs are there to securitize these loans. If the government is actively supporting the ABS markets, then credit card, auto and student lending markets will be performing OK as well.

3) But actual bank capital will remain challenged. By the time home prices bottom, banks will have taken more losses on foreclosures and commercial loans. And beyond the TARP, most banks will not have been able to raise significant outside equity capital.

4) So commercial lending will become very rare indeed until such time as banks have rebuilt their capital base. Therefore new business formation, acquisitions, capital projects, all will become difficult if not impossible.

What kind of economy does that leave us with? A long recession that's what. Recessions are caused by misallocated economic resources. Some businesses need to downsize or be eliminated, and those resources need to be allocated elsewhere. The recession is the pain that occurs in between.

But resource reallocation takes capital. And if banks won't lend, its going to take a long time indeed for that reallocation to occur.

I'm taking an awful risk here... this had better work...

Is the TARP working? Are rate cuts working? Stimulus package? Is the TSLF working? What about the GSE conservatorship? Is that going to work? What about my lucky rabbits foot?


Pundits love to debate whether any given program will "work" or not. But in these debates, the participants tend to talk past each other. Take the capital injections made through the TARP. One side can argue that this scheme is "working" because of falling LIBOR and CDS spreads on banks. The other side can claim that this program does nothing to address the root problem (foreclosures) and will not allow the U.S. to avoid recession.


Of course, they're both right. And hence this is a boring and frankly unproductive debate.


Most of the programs and plans currently enacted (my rabbit's foot aside) are aimed not at preventing a recession. That ship has sailed. To see what I mean, think about the basics of the business cycle.


Recessions tend to be the result of some misallocation of resources within the economy. Since reallocating resources takes time, there is an inevitable period where the economy operates at less than full capacity. The greater the adjustment needed, the deeper and longer the recession.


In the period leading up to this recession, we had a overinvestment in housing. Even if nothing else had happened, the adjustment in housing probably would have resulted in a recession. Loans were made that shouldn't have been made. Houses were built that shouldn't have been built. We need to clear the excess investment (houses).


However, we also had a financial economy which had become reliant on low volatility and continuous access to liquidity. After the failure of Bear Stearns, Wall Street was forced to decrease their leverage positions. Continuously falling marks, especially on housing assets, only increased their need for additional equity. This added to the already painful economic adjustment underway.


The came September. The rapid failure of the GSEs, Lehman, AIG, Washington Mutual and Wachovia changed everything. The urgency for firms to deleverage was dialed up to 11. In addition, common forms of debt financing, including securitization, have completely dried up. Most firms can fund their activities using other forms of financing, but it will be expensive and potentially painful to make the transition.

So now we need to adjust to a large number of foreclosures, a deleveraging financial system, and a rapidly changing funding structure. That is a recipe for a deep and long recession.

There is nothing the Fed or anyone else can do to prevent this process from occurring.

But the Fed and Treasury can help to ease the transition. Programs like the commercial paper funding facility can help firms that relied on asset-backed commercial paper to transition to other secured funding. Offering FDIC insurance on new bank debt allows banks to roll-over maturing debt, buying them time to deleverage through normal cash flow.

But these programs cannot, will not, and I content were never intended to "fix" the financial system. We will get through this, but we need more time.

As an investor, if you continue to think in terms of "solutions" from the government, you are missing the point. Even putting my libertarian ideology aside, the government cannot "solve" a misallocation of resources. The best thing it can do is provide liquidity to make the transition as painless as possible.

So in thinking about whether some scheme is going to "work" or not, think in terms of avoiding unnecessary economic adjustments. Think in terms of easing the transition. Don't think in terms of avoiding a recession or reversing the steep losses in the stock market. Nothing can stop that now.

We feared the worst

The question is, of course, now what? First, what’s happening in the bond market.

Treasury bonds, which were down around ½ point all day are now flat. I am very surprised, as it seems like the most obvious impact of the TARP is that Treasury issuance will rise significantly. I do not like the Treasury market here at all. I am also surprised the dollar remained stronger. For what its worth, I'm not shocked the stock market sold off.

Credit spreads, at least in CDS, were mixed. Goldman, GE Capital, American Express, all about 40bps tighter. Interestingly Merrill Lynch is about 30bps tighter while Bank of America is unchanged, indicating an increasing odds on the merger being completed. Currently BofA is around +165 and Merrill is around +400, so there is plenty of room there. The CDX was 2bps wider.

Citi and Wells Fargo both a little wider. I would bet on Citigroup prevailing in the Wachovia thing. Citigroup has apparently been the only thing standing between here and a run on Wachovia since Monday. I think the FDIC wants to reward banks who are “first responders” on failed banks. Allowing Wells Fargo to step in now would create a bad precedent. The FDIC does not want to see other banks hesitate to step in to buy deposits in future bank failures.

Swap spreads were also tighter. 2-year swaps were 13bps tighter, while 10-year swaps were 5 tighter. I do not know exactly what to make of it, but the 13bps move in 2-year swaps is consistent with recent volatility, but the 10-year is an outsized move.

Agency spreads moved in context of swaps. MBS spreads were unchanged after being significantly tighter through most of the day. Still like MBS and agencies over corporates here.

Fed funds futures have now priced 100% chance of either a 50bps or 75bps cut at the October meeting. I think other liquidity measures, like extending liquidity to ABCP or some such, would be more effective. But I’m not going to fight the Fed if they want to cut. The play is to bet on the curve steepening and dollar weakening.

I am remaining defensive in credit. I would say I am closer to buying finance paper than industrial paper, though not buying either at the moment. The bailout and all the Fed’s liquidity measures are much more likely to help large financials to survive, but nothing is going to stop the coming recession. But I need to see some better trading volume before even considering any corporate bond trade here.

Why Main Street should support this rescue

You know its bad when my wife, who under normal circumstances immediately dozes off when I start talking economics, is checking finance blogs looking for news on the credit markets. She is getting into heated arguments with friends over the bail out legislation. And to top it off, she's made a request that I explain to non-finance people why they should support a massive bailout of Wall Street. So here is my case. Hopefully regular readers as well as people far removed from finance will find this stimulating if not convincing.

First let's think about how modern lending works. Pick any type of loan: student loan, car loan, credit card, home mortgage, small business loan, etc. Any time a loan is made, whether its to pay for meal with your credit card or to pay for tuition, someone actually has to come up with the cash to lend to you.

Where do lenders come up with this cash? Primarily three places.

1. Deposits.
2. Borrowing from investors or from other banks.
3. Securitization. This means that the loan isn't held by the lender, but sold to investors.

Lenders don't want to use deposits to make loans right now, because there is serious risk of depositors suddenly demanding their cash. Remember that banks don't ever actually have enough cash to give all their depositors their money on any given day. So when depositors are nervous, banks are nervous.

Normally if too many depositors happened to take money out (not in a panic, but just by happenstance) the bank would simply borrow cash from another bank. That's nearly impossible right now. Banks are generally unwilling to lend to each other. Banks can still borrow from the Federal Reserve, but they are so desperate for cash right now that they are accepting any interest rate, and the Fed is finding it nearly impossible to control short-term interest rates. Today banks took overnight loans from the Fed at 7%, 3 1/2 times the target rate set by the Fed. This is historically unprecedented.

Banks also cannot sell loans to investors. Even loans that are backed by governmental guarantees, like certain student loans, are not sellable in the current environment. Forget about automobile loans or business loans.

So if banks and other lenders cannot get cash, they cannot lend it. So what? Isn't our society doing too much borrowing as it is? Maybe, but let's consider the consequences of a world with no lending.

First of all, there would be no housing market. Very few people can buy a house with cash. Housing prices would continue to fall for many years. The result would be that people would almost universally live in rented housing. Wealthy land lords would own all the housing in America, and would reap all the profits from rentals.

Second, there would be no secondary education. Like housing, the vast majority of people need loans to get a college education. Granted, colleges would probably pare back on the quality of the education offered in an attempt to lower their costs. Even so, it would likely be that only wealthy people could afford college. The income gap in our society would increase as a result.

It would also be extremely difficult for average people to start a new business. Most businesses require start-up capital, most of which is normally borrowed. In addition, many small businesses need working capital, which allows the business to make payroll while waiting for accounts receivable to come in. So here again, only the wealthy would be able to start new businesses.

How will this bailout help? Mostly by creating a outlet for banks to sell "troubled" loans. What constitutes "troubled" isn't yet known. But suffice to say the Treasury will mostly be buying mortgage loans that probably shouldn't have been made in the first place. The price paid to the bank will be less than face value, thus the bank will suffer losses. Hopefully enough of these loans will recover their full value that tax payers do not suffer large losses.

But its a mistake to assume that, as tax payers, we aren't already on the hook for this mess. Currently there is about $8.6 trillion in assets that the FDIC insures. The truth is that the FDIC is ultimately funded by tax payers. So as tax payers, we are already on the hook for bank's behavior. And for way more than $700 billion.

In addition, municipal governments are suffering greatly in this crisis. Not only are their facing the prospect of decreased property tax assessments, but the cost of funding municipal projects has skyrocketed recently. Today, 7-day floating rate municipal bonds are carrying interest rates above 8%, breaking all records. Who will ultimately pay for these extremely high interest rates? Tax payers.

I completely understand the visceral anger that many Americans feel about the situation we're in. I'm sick over the fact that its come to this. But this is what it's come to. We would be foolish, as Americans, to destroy our long-term economic prosperity just to satisfy our righteous anger with Wall Street.

If we don't do this bailout, Main Street will pay anyway, and pay much more dearly. So I would encourage you to write your Representative and tell him or her exactly that. You are angry at Wall Street, but you also want to see some justice for Main Street.

Fell free to e-mail this or send links as you'd like. I don't really care about getting credit.

What would ya like?

Does the TARP mark the death of capitalism? To some commentators, apparently it does. To be sure, this kind of massive government intervention is the last thing any real capitalist wants to see. But is what we have now any better? Let's think about why we like capitalism as a concept, then consider whether this market even remotely resembles capitalism.


Free markets are supposed to efficiently allocate resources. If there are too many pizza places in your town, but not enough auto mechanics, the free market is supposed to drive one of the pizza places under and encourage entry by an auto mechanic. While we may feel for the proprietor of the pizza joint, we know that in the long run, we're all better off when the market is allowed to move resources away from the pizza business.


But we don't want to see the pizza guy forced to close shop because of some external dictate. We want to see a vote held to decide whether we have too many pizza shops in town. We want all the pizza places to compete for business, with the better competitors enjoying strong profits. In fact, we don't even want to see the weaker competitors driven under. Ideally, the weaker competitors will improve their operations and become stronger competitors. But if not, then indeed one or more of the pizza restaurants will undoubtedly go under.


So what kind of world are we living in now?


Let's take a hypothetical investment bank. We'll call it Merrill Brothers (MB). MB became involved in underwriting a series of commercial real estate loans during 2006 and 2007. MB retained some subordinate interests in these loans, as management believed these projects were attractive investments.


Some of these were for condo deals, which is obviously not the best place to be now. Perhaps given the benefit of hindsight, MB wouldn't have entered into the condo deals at all. But it is what it is. MB's management needs to decide what to do about the loans now.


I think in a real capitalist economy, MB would be given the chance to live or die based on the actual performance of these loans. Why? When any bank makes a loan, their credit analysis is based on the perceived odds of the loan remaining current. The capitalist system should reward the banks that make good underwriting decisions based on this criteria.


But in today's market, MB would not be given that chance at all. In terms of mark to market, all credit-oriented securities have declined in value from 2007 to today. Obviously a loan for a condo project would have declined significantly in market value. Forget, for a moment, why these loans have declined in market price and/or whether that decline is reasonable. Let's just stick with the fact that the market price is lower than the original price.


Let's assume that MB's management absolutely loves their loan portfolio, but the market believes their loans are only worth $0.60/dollar. And many will question whether $60 is a good price. But if MB plans to simply hold the loan, what does the market price matter anyway? It really shouldn't. MB should have the chance to live and die by the economic reality of their lending decisions. Not the market's perceptions of those decisions.

Now perception becomes reality as the continuous negative headlines cause trading partners and lenders to back away from MB. In the end, MB either fails or runs to some better capitalized partner. But ultimately it isn't a capitalist ending at all.

Think of it like a poker hand. There are two queens and a 10 on the board, and you have a 10 in your hand. Your opponent is betting the hell out of it. Sure seems like he's got a third queen, and maybe the best play is to fold. But should the other players at the table step in and force you to fold? In a free market, you can bet, raise, or fold, no matter what other people say.

So now we're faced with to non-capitalist paths. On one hand, the current situation. On the other hand, a government bailout.

The bailout will create some semblance of confidence in financial institutions and their balance sheets. There will be some increase in lending capacity. There will be some end in sight for declining home prices.

If there is no bailout, then what? When do things improve? Does the commercial paper market shut down? Is it possible to leverage trading books? Can anything be securitized?

So as much as we all hate the idea of a government bailout, we really need to consider what kind of capitalism we think we're defending. I'd love to hear more about long-term solutions to our problems. But in the short-term, we have to stem the relentless waves of fear. Before its too late.