The Dark Bailout

Galbraith on financial manias

Around this time last year, I quoted Galbraith’s ‘A Short History of Financial Euphoria’. Here it is again:

All crisis have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.

The Paulson subsidy – a little rant

From Bernanke’s mouth:

If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

First, banks will have a basis for valuing those assets and will not have to use fire sale prices. Their capital will not be unreasonably marked down

I’m starting to think that Paulson and company should pay exactly no more than the market price for the mortgage securities that nobody else wants. To say that the market for these products has completely disappeared isn’t quite right, it’s just that these securities are deemed almost worthless by most market participants. That is the market price. A deep, deep discount. There is still hundred of billions of investment money out there in the form of hedge funds and sovereign wealth funds and if these mortgage related products are a screaming buy then we would see them being bought up. The price reflects the risk. It’s simple. I agree that the assets will probably yield a profit over the long-run but that’s a highly speculative decision that the Treasury has no place making.

If the banks are seizing up due to fear because they have these dodgy, almost worthless assets on their books then the Treasury can take them and put them in the Hanky Panky fund, but why muddy the waters further by paying an elevated price and giving the banks billions in form of a disguised subsidy? The fact that paying the market price leaves the banks severely undercapitalised is a separate issue and it should be addressed separately for reasons of transparency and safeguarding the public purse. The government could provide loans-for-equity or seek another solution that addresses the funding problem. If they simply pay over the odds for the mortgage securities, all this additional money would simply be a subsidy transfer from the public to the banks. Not good. Not good one bit. Somebody step up and save capitalism from itself!

Capitalism takes a sabbatical – Rosenberg

A few interesting quotes from a research note titled ‘Capitalism takes a sabbatical’ by arch pessimist David Rosenberg, head of economics at Merrill Lynch:

…. It must be noted that what the government is doing today with (TARP) is much bigger and more complex than RTC was back in 1989. What Mr. Paulson wants to establish is a “good bank, bad bank” much like RTC, but RTC sold off assets from banks that had folded, not assets from the living zombies. The assets sold in the open market were not opaque CDO’s but “real” stuff like buildings, cars, planes and art. This time around, banks are going to be forced to mark down their assets to market values – and the government is about to set up a process to discover what those prices are. Estimating the total losses was far less complicated back then. And it was a regional problem, not a national or even global dilemma. What Paulson is really doing is digging into the 1930s playbook – the Federal Reconstruction Finance Corporation; as well at the Home Owner Loan Corporation (since the Democrats are very likely going to want to modify the mortgages they end up taking into the government’s books to avoid a further uptrend in foreclosures).

… The elusive bottom Keep in mind, for all the bottom pickers out there, that after the RTC was established in 1989 it took a year for the stock market to bottom, two years for the economy to bottom, and three years for the housing market to bottom. And recall that after the FSA in Japan was unveiled in 1997 the stock market didn’t bottom for another five years and it’s an open question as whether the economy ever did manage to stage a sustainable recovery. In the Swedish case of the early 1990s, even with an effective government solution, the process of extinguishing the bad debts via government intervention was painful – the equity market incurred a 28-month long bear market that saw Sweden’s major index decline 45% from peak to trough and the economy undergo a 20-month recession that saw domestic demand contract by 2-1/2%.

… Once we get through this upcoming period of consolidation and insolvency of the weak banks, the industry is going to come under greater regulatory oversight which will constrain leverage, off-balance sheet activities and future earnings growth. And, of course, we have history to tell us that what led the market down in the bear phase – in this case, financials and consumer cyclicals – never go on to lead in the next bull market.

I wonder if there is any survivorship bias in the phrase…

‘It is always darkest just before the dawn.’

A very good read on why the Paulson Put is flawed

The Freakonomics blog links to a two page pdf comment piece, titled ‘Why Paulson is Wrong‘. Good stuff indeed. Here are some choice cuts:

‘If banks and financial institutions find it difficult to recapitalize (i.e., issue new equity) it is because the private sector is uncertain about the value of the assets they have in their portfolio and does not want to overpay. Would the government be better in valuing those assets? No. In a negotiation between a government official and banker with a bonus at risk, who will have more clout in determining the price? The Paulson RTC will buy toxic assets at inflated prices thereby creating a charitable institution that provides welfare to the rich—at the taxpayers’ expense. If this subsidy is large enough, it will succeed in stopping the crisis. But, again, at what price? The answer: Billions of dollars in taxpayer money and, even worse, the violation of the fundamental capitalist principle that she who reaps the gains also bears the losses. Remember that in the Savings and Loan crisis, the government had to bail out those institutions because the deposits were federally insured. But in this case the government does not have do bail out the debtholders of Bear Sterns, AIG, or any of the other financial institutions that will benefit from the Paulson RTC.’

‘As during the Great Depression and in many debt restructurings, it makes sense in the current contingency to mandate a partial debt forgiveness or a debt-for-equity swap in the financial sector. It has the benefit of being a well-tested strategy in the private sector and it leaves the taxpayers out of the picture. But if it is so simple, why no expert has mentioned it?’

‘Forcing a debt-for-equity swap or a debt forgiveness would be no greater a violation of private property rights than a massive bailout, but it faces much stronger political opposition. The appeal of the Paulson solution is that it taxes the many and benefits the few. Since the many (we, the taxpayers) are dispersed, we cannot put up a good fight in Capitol Hill; while the financial industry is well represented at all the levels. It is enough to say that for 6 of the last 13 years, the Secretary of Treasury was a Goldman Sachs alumnus. But, as financial experts, this silence is also our responsibility. Just as it is difficult to find a doctor willing to testify against another doctor in a malpractice suit, no matter how egregious the case, finance experts in both political parties are too friendly to the industry they study and work in.’

‘The decisions that will be made this weekend matter not just to the prospects of the U.S. economy in the year to come; they will shape the type of capitalism we will live in for the next fifty years. Do we want to live in a system where profits are private, but losses are socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded? For somebody like me who believes strongly in the free market system, the most serious risk of the current situation is that the interest of few financiers will undermine the fundamental workings of the capitalist system. The time has come to save capitalism from the capitalists.’

‘The time has come to save capitalism from the capitalists.

The Paulson Put

A cynic may say it merely adds to list of factors that incentivise banks to take too much risk:

- Skewed risk taking by individual traders – they share in the upside rewards of their successful trades and can they make millions in good years. However, these guys don’t put up their own money when things go bad and they start printing losses. In a worse case scenario the trader will get laid off.

- The old Greenspan Put – Is a crisis looming on the horizon? Don’t worry, the Fed is there to save the day by relaxing monetary policy. This may generate excess liquidity and merely shift the problem to a later date but we’ll deal with that later … by repeating the process over and over.

- The Paulson Put – The grand daddy of puts. Low interest rates no longer working? Banking system gummed up with so much crap collected over a decade or more of excessive risk taking? Don’t worry, just run ‘Paulson’s Financial System Anti-Virus’ software to extract and quarantine the crappy loans, and then press ‘Ctrl, Alt + Delete’ on the entire financial system.

BadBeat poker prop shop and trading the markets

If you were unsure about the similarities between poker and trading, take a look at this interesting article about a metals trading prop shop in London that has started a business backing on-line poker players. Here are some quotes from the piece:

Although online poker sites do not announce what proportion of their customers actually win money, professionals estimate that about 95 per cent of players lose.

Daily loss limits are seen as the cornerstone to developing profitable players. Losing your daily loss limit three times means you move down to playing with half that amount until the gods smile on you again.

The hours a player puts in are also vital to making money. Over time, good players will beat bad players, but luck is a factor. “The one thing employing people to play has highlighted is how little most player play,” says Conroy. “Considering it’s a game of skill and luck, you need to put the time in for the skill to show through.”

How much money do you need to play poker? …when it comes to bankroll, most people don’t have enough. The principle is never go broke. Being well bank-rolled means you never play with ‘scared money’. BadBeat’s John Conroy believes most players (probably 80 per cent) are under bank-rolled. They’re also playing at higher stakes than they should. To play $5-$10 no-limit hold ‘em efficiently you’ll need $40,000 to avoid running out of money after a month’s bad run, with a daily loss limit of $2,500.

In poker, a ‘bad beat’ is when you lose a pot against the odds – a strong hand beaten by a lucky one. The response? You just have to play more hands.

Source – ‘Dealer’s Choice’, FT Weekend Magazine, Septemeber 20/21 2008

Thank you comrades Bush, Bernanke and Paulson

The action of the US government may have saved the world from another Great Depression but we are still in for a world of hurt with a painful slowdown expected in the real economy.

Here are a few points that come to mind:

- Here’s how I see the history and present: The man on the street wants a house. Dodgy lending practices result in the build up of billions of stupidly risky mortgages. Banks package up these mortgages into large blocks and sell them off, often to each other. Like a quart of milk that has been ignored and left at the back of the fridge, the mortgages start to give off a bit of a stink as the housing market turns down. While stale milk can poured down the sink, no one can make the dodgy mortgage risk can’t disappear. At best, it can be moved around the system. The banks are stuck with the rump of duff mortgages and they start screaming to be saved. The government steps in and bails out the banks to ’save the world’ by hoovering up all the dodgy debt into one large fund. So who does the all this toxic risk now sit with? The answer will be the taxpayer. It’s almost gone full circle and worked it’s way back the man on street. Strange world. Here’s a nice quote from Robert Reich’s blog: ‘watch your wallets. The tab here could be very high. If everything goes extremely well, markets move upward, and the risky loans become far less risky, it’s possible that taxpayers (that is, the Treasury) might actually make money. But if the bottom falls out, American taxpayers could be on the hook for trillions of dollars. What then? The federal debt soars. What then? Interest rates go out of sight. What then? Foreigners lend us less money. What then? We’re cooked.’

- The political and ideological ramifications of the bail out are huge.

- We can’t short the bank’s anymore but can we short the US government? It doesn’t have shares but there is traded debt and a currency. Let’s just say I’m a teeny bit worried about the dollar now. I would expect the USD to at least become a bit more sensitive to the housing data.

- Will the US government allow all this toxic debt to be moved to their balance sheet without penalising the banks? I hope not. Robert Reich’s opinion is that ‘the process should resemble chapter 11 under bankruptcy. Any big financial institution that wants to clear its books can opt in. But the price for opting in is this: Investors in these institutions lose the value of their equity. Executives lose the value of their options, and their pay (and the pay of their directors) is sharply limited. All the money from the fire sale goes to making creditors as whole as possible.’ I agree that they need to feel some pain.

- In the UK the government blatantly overrode competition rules to allow a merger between HBOS and Lloyds TSB. This was rushed through so HBOS could be saved from being run in to the ground by market forces. I wonder if there was a better way to deal with what happened. A couple of worries I have include the potential for future anti-competitive market abuse that results from this behemoth, and the idea about saving a company that is deemed ‘too big to fail’ by letting it become way too big to be allowed to ever fail.

- Short UK banks and long US banks may have made a good trade given that our government is not planning a Resolution Trust UK Edition. We are just like a mini-US when it comes to the housing bubble, with some metrics looking quite a bit worse.

- Tomorrow will be the first time that I will be buying the Financial Times paper edition in over a year.

Climbing over the Financial Times subscriber wall

Just thought I’d share this tip to access any article in FT.com:

Copy and paste the title of the FT article in Google and hit ‘Search’. 9 times out of 10 the first search result link is the right one – clicking on the link through Google bypasses the subscriber wall. This has worked for me for as long as I can remember.