Tuesday, March 24, 2009

Timothy Geitnher

Geithner Bad Asset Program will DECREASE Long-Term US Banking Capital

Bill Gross from Pimco is saying he expects to make 'double digit' gains from the bad asset program. Pimco, Blackrock and others will the first in line for losses from this program along with the treasury. If they are 'gaining' somebody else must be losing and it cant be the FDIC/Fed because the private investors/treasury will be the first in line for losses. This leaves only one group left to lose: The Banks

Bernanke back in Sep/Oct was mentioning the hold-to-maturity value and the market value of the assets. He was essentially saying the run-off value of a bad asset was X and the market bid was X - Y, the disconnection happened because no one could leverup to buy these assets and there was some uncertainty to extreme losses in those assets.
Then Geithner came up with this plan in order to 'connect' these two values again. In my view, the connection will not totally occur.

Think about it, the hold-to-maturity value of a bank asset is something you cant know before the fact, as a result private investors will try to GUESS what this value is, due the risk aversion currently present, plus investment grade corporate bonds yielding 7.5% and junk bonds yielding 17% is likely investors will demand a DISCOUNT to their GUESS of what the hold-to-maturity value is, that is they will demand a risk premium, they will demand compensation for political risk(like not being able to walk way from a large non-recourse loan), liquidity risk, credit risk, congress risk(I understand there is a cheap put and cheap funding but in the risk averse market right now that is not enough to offset the risks). Now, if they get this risk premium and make 'double digit' returns then the banks necessarily need to lose. So if this plan succeeds, the banks by definition must have lost money/future earnings. There is no such thing as a free lunch

To put it more simply, if the banks were allowed to run off their books without suffering a run they would return X from their bad assets, by selling to the bad asset program they will get X - Y, Y being the money that will endup in Blackrock bonus packages

This means for every bad loan(which is not marked to market) a bank sells to the bad assets program the Net Present Value(the long-run value of an institution) will go down, all else being equal, they also will have to raise shares, hurting the stock. When it comes securities(which are marked to market) its a bit more tricky because it might be a good idea to take the loss since holding the security could force you to mark the asset to irrational ABX numbers. But still it will decrease the value of that bank long-run asset side value putting the bank is a bigger hole

Another simple example is, suppose you had a corporate bond fund in Jan 2008 with a bunch of junk bonds in it. Its March 2009 and you have liquidity issues. You are forced to sell securities at a market clearing price, its quite likely buyers of of a diversified set of junk bonds will likely make money right now even if a few of them default, that is because the yield on junk bonds are very high compared to the likely default rate(that would have to reach Great Depression scenarios to make the buyers lose money), so the 'earnings' that buyers got come out of your pocket, the long-term value of your bond fund went down.
This happens because the market right now is depressing the value of all types of assets, that is risk premiums(the compensation the buyer gets) are very high, this means being a seller of assets is a bad deal these days. This is a buyers market where you dont want to be a seller at the market clearing levels

So ignore the critics that say this is a hidden way to give capital to banks, its not. It does just the opposite, its puts banks in bigger balance sheet holes

Therefore the Geithner plan is a hope private common stock capital will save the day once the banks are a bit cleaner in their balance sheets, it does this at the cost of making banks sell assets below their run-off values and decreasing their long-term capital(they get more insolvent). The hope is that if private common stock capital comes in, recaps the banks making them very solvent then banks will lend again and as an GROUP the US Banking system will increase its Net Present Value as the economy will grow again. Its a bold plan(particulary given that Congress does not want to give more funds for banks) but at this point I'm not quite sure if it will work

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