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Commentary

TARP Costs And Shareholder Interest: Big Big Downside?

So Paulson’s announced the Troubled Asset Relief Program (TARP):

First, to provide critical additional funding to our mortgage markets, the GSEs Fannie Mae and Freddie Mac will increase their purchases of mortgage-backed securities (MBS). These two enterprises must carry out their mission to support the mortgage market.

Second, to increase the availability of capital for new home loans, Treasury will expand the MBS purchase program we announced earlier this month. This will complement the capital provided by the GSEs and will help facilitate mortgage availability and affordability.

These two steps will provide some initial support to mortgage assets, but they are not enough. Many of the illiquid assets clogging our system today do not meet the regulatory requirements to be eligible for purchase by the GSEs or by the Treasury program.

I look forward to working with Congress to pass necessary legislation to remove these troubled assets from our financial system. When we get through this difficult period, which we will, our next task must be to improve the financial regulatory structure so that these past excesses do not recur.

So first, they’ll expand the operations of Fannie/Freddie to buy more MBS. But Fannie/Freddie are in conservatorship so they have no need to maximize profit. Will they then do some wink-wink business and buy the MBS from other banks at much higher prices than they might have otherwise paid? Of course given the market’s at a standstill there is no point thinking of a “fair” price. Still, anything that’s way above index prices should raise question marks.

Next the Treasury themselves buy MBS. Again, lots of wink-wink potential, and this government is going out soon.

Last and most important. Something owned by the taxpayers will buy the toxic waste. That stuff won’t ever be bought by Freddie or Fannie or Treasury. Including, but not limited to:

  • Jumbo loans (>$400k?)
  • No-doc or stated income based loans
  • Negative amortization loans or those with high resets that qualify as seriously subprime.
  • low or no downpayment (FNM/FRE require 20%)

The toxic waste that Paulson describes is entirely these kind of loans. They’re bad because no one wants them, they’re either very likely to be in foreclosure or are already in there, and worse the cash flow has literally dried up. Many of these are sitting at the bottom of the heap in highly rated tranches of CDOs and CDO-squared derivatives. Yet others are being held by banks as “mark-to-model” because there are no transactions and no one knows what the value of these really are.

An entity that will buy these loans, funded by the US Taxpayer, is interesting. It will take these loans off the books of hedge funds, banks and other investors. That’s going to help because while these are “assets” they are increasingly becoming “liabilities” – the effort required to value them and the panic created by falling prices is costing more than the four cents or so they get to the dollar if they tried to sell.

But selling these loans creates two major problems:

  • Losses must be booked. Loans in higher rated CDO tranches may be worth less today once the CDO is unwound, and there may not be any compensation because these are panic situations. Loans that were “marked to model” will suddenly get marked to reality because they are sold at a real price. Often, if not always, this price is lower than the model price. This and the fact that an increase in liquidity will most likely fuel supply rather than demand, will keep prices low – and the low prices make the banks BOOK LOSSES on the transactions.

    It’s like buying a cell phone for Rs. 28,000 and walking to the market a month later, and seeing the price is 25,000. Your “mark to market” loss is Rs. 3,000 – or so you think. You might try to say “I can sucker someone for Rs. 26,000 perhaps” and mark-to-model instead and lose only 2,000. When you try to sell your phone, prices are further down and your phone is a second hand one – you get Rs. 12,000 only. A real loss of Rs. 16,000 versus the piddly stuff you had accounted for before.

  • This loss booking results in a loss of capital. Deleveraging apart, let’s assume that you can only leverage the same amount. Let’s say your bank’s current leverage is 10x. It had $1 million, and it could lend upto $10 million.

    The bank made a few subprime loans and with this new TARP managed to sell the toxic waste at say $9.5 million. (This is an overstatement. Toxic waste will sell at 100,000 or such)

    You’ve now lost 0.5 million – of your original capital of $1 million. Now you have 0.5 million left. Lever that 10x, and you’ve got $5 million to deploy. That’s half of what you had earlier. And if they tell you that you must delever to 5x, you have lost 75% of deployable capital.

Further, there are downgrades of Ambac and MBIA coming around. That will further hurt the system – because a very large amount of CDS written on these loans may be triggered, and the ability for Ambac/MBIA to raise capital will depend on their rating. A bankruptcy here can trigger massive losses through the financial system, including for bondholders.

I don’t even know what happens to CDS on the MBS/CDOs being unwound. That is a new picture that will emerge.

These are serious issues that can’t be sorted out by just buying out bad assets. Somehow fresh capital must be put back into the banks. The issue of fresh capital will all but wipe out current shareholders, obviously.

Shareholders must take the hit because shareholders have taken the risk. These stocks are trading at fairly high values – compared to what they must go to. Short selling was banned just before Paulson’s speech – and now I see why. If a bloke like me, sitting seven seas away from the financial mess in the US, can see what is coming – the traders out there will have a big frikking flashing light there – and will short all financials to hell and back. No wonder the shorting was banned, so the plan could be passed through congress, analysed to death and then hopefully when the ban expires, people will only short the REALLY bad stuff.

If you asked me, I would use this opportunity to take out some money from the banking system and into anything else – even cash. Definitely out of current or fixed deposits. Not for India (yet) but some of the foreign banks operate in India too (I have an account, which I shall move).

Gold is good. Money markets are probably worth it. But the US banking system is probably, as Congress was told, “we’re literally maybe days away from a complete meltdown of our financial system”.

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