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.

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

Goldman Sachs: General, count me in

The FDIC announced their final rules on the so-called Temporary Liquidity Guarantee Program, or TLGP (Pronounced "Teelgup"). This is the program that was designed to allow banks to issue FDIC insured debt, ensuring that they'd be able to roll over any debt coming due in the coming months.

The key change in the final rules is that the guarantee will now be timely principal and interest. Under the original rules it would be possible for an investment in a failed bank to get tied up in bankruptcy court, and while the FDIC would eventually pay you, there was no assurance as to exactly when.

Already Goldman Sachs says they will be bringing FDIC insured debt as early as Monday, and I'd expect an avalanche of banks to come with new issues in the next few weeks.

This debt will now carry a full faith and credit guarantee for as long as three years (6/30/12 to be exact). Note that similar debt has been issued in Europe, most notably Barclays who did the first deal in the U.K. That deal was priced at swaps +25. I expect U.S. debt to come wider. To me, its got to trade in context of Agency bonds, which are more like swaps +50, Treasuries +165.

There are three interesting wrinkles here. First, the FDIC bank debt will be explicitly guaranteed, while Fannie and Freddie are not. However, I'm hearing the FDIC stuff will have a 20% risk weighting for banks. That's equal to Agencies currently, but there has been talk that the Agencies will be reduced to 10%.

Finally, there will be extensive supply of the FDIC stuff over the next month or so, whereas the Agencies have done very little term issuance. So given the market's poor liquidity, I'd expect the new FDIC issues to have a new issue concession, and therefore price wider than Agencies.

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.

Clumsy and Random Thoughts

• It is feeling very panicky right now, in that the market is moving suddenly and without proximate reasons. Unfortunately, the panic is legitimate. No one knows what a GSE bailout will look like.
• But you shouldn't conclude that a bailout would be difficult. Read this post. I stand by everything I said then.
• There are also rumors that PIMCO and SAC were not trading with Lehman. Both PIMCO and SAC have denied the rumor. Worth noting that PIMCO was one of the first to stop trading with Bear Stearns. Anyway, neither has reason to deny the rumor other than that the rumor isn't true.
• The more panicky things get, the more likely we get a relief rally after bank earnings are out. Odds are good that it will be a mixed bag, with some banks looking particularly ugly (Wachovia this morning warned of a huge loss) and others will be bad but not that bad. I mean, take a look at short interest on the NYSE...

• That being said, I don't think we can get a sustained rally (in credit or equities) until the market thinks it knows the outcome of both bank capital raising and home price declines. Now that will happen before housing has actually bottomed, because the market will look forward and conclude the worst is behind us.
• So I'm still vastly underweight credit generally and financials specifically. I've cut duration in an attempt to play a post-bank rally, but I'm just too chicken shit to buy a bunch of bank paper here.

Moral Hazard: I dunno... I can imagine quite a bit

In reading my post from Monday on mortgage bailouts, one commenter mentioned moral hazard. I feel like this is becoming an over-used term, and I'd like to state Accrued Interest's official position on the subject.

According to the most authoritative source I could find (Wikipedia)...

"Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions."

Any time risk has shifted in any way from one party to another there is potential for moral hazard. Someone who has health insurance that pays for all prescriptions probably winds up using more prescription drugs. That's one example of moral hazard.

In the case of a bailout, it is usually not the bailout itself, but the implication of the bailout. Its the precedent set that is problematic. So for example, when a rich kid crashes Daddy's car into the neighbor's tree, and Daddy just buys another one, the kid makes an assumption about the future. He assumes that Daddy will keep bailing him out of jams.

So let's look at two simplified examples of a housing-related bailout. In one corner, let's say that banks are forced to write down all upside down mortgages by 20% and in exchange, the government agrees to take all subsequent losses on the loans. The banks who made bad loans suffer a good deal from this, but perhaps not as much as they would have otherwise. This isn't exactly Daddy buying them a new car. More like Daddy paying for the damage the kid did, but making him ride the bus to school from then on. We can debate whether those are adequate consequences or not, but certainly the banks didn't expect to take a 20% loss on those loans when they first made them.

The same goes for bond holders. They suffer losses much greater than they anticipated when they bought the bond. Maybe not as large as might have otherwise been, but still large.

The borrowers who took out loans they knew they couldn't afford get completely bailed out here. Maybe they don't get a new car, but Daddy's repairs the old one and things continue as they had before. The borrower gets something for nothing.

Now compare that with some program that encourages people to buy foreclosed homes in a big way. What you've done is alter the demand curve for homes by making them both more affordable for end buyers and making a buy to rent investment more attractive.

In this case, the borrower is probably no better off. S/he was already foreclosed upon. He really doesn't care what happens to his house after that. The bank is clearly better off, because they get a better price on their REO portfolio. Investors too. Both have their loss severity reduced.

But all the guilty parties wind up suffering a fair amount under such a plan. In other words, every one involved regrets their actions.

Now let's take a step back. We know that the government is going to interfere in the housing market. No matter what is done, there will be moral hazard involved. I'd like to see moral hazard limited by making sure that all involved in the mortgage lending process suffer to a significant degree. We want everyone involved to be saying (sarcastically) to themselves "This is some rescue!"

What we don't want is for either the lender or the lendee to say, "That wasn't such a chore now was it?" We don't want one party to bear all the risk, nor to have the government take away all the pain from any one group of participants.

You can reduce the supply of foreclosed properties either by preventing the foreclosure or by having someone buy the foreclosed properties. Any program which prevents foreclosures is benefiting the lendee at either the lender or the tax payer's expense. By encouraging investors to buy foreclosed properties, you are giving the primary benefits to an uninvolved third party.

I think that translates to less moral hazard.