An Open Letter to Hank Paulson: Uncertainty & the Banks, What to do now

November 20, 2008 · Posted in Entertainment, Featured, Finance, Financial Crisis, People in the news, Political Issues, Politics, Social Issues, Society, Things to think about, Thoughts on the economy · 4 Comments 

Mr. Paulson:

The capital injections by the Treasury have not done anything to inspire confidence in the banking system by investors or to incentivize banks to start making new loans.

I recognize that it is too much to expect banks to run out and start expanding their balance sheets by writing new loans with so much uncertainty with respect to losses and impact on their capital.

Now that fears are spreading with respect to the commercial real estate market and the consumer loan market, the ability of banks to look at new business is further hampered.

We need to do something decisive and since so many are putting forth ideas, I want to put one out for your consideration.

The problem with the banking system is the continued uncertainty over asset values.  Due to the huge leverage of the banks a small decrease in asset values can blow through ALL of the capital in the banking system including the $125 billion given to the 7 largest banks and billions more given to the smaller banks.

As long as these assets are on their balance sheets, this situation remains unresolved and there is no place to go with these assets.  This is a cancer in the system and must be removed.

The U.S. Treasury is not moving forward with the TARP.  I think this is due to the complexity of the problem as well as the current environment in Congress and I understand your position.

But, with all due respect to you, I do not believe that you can wait and throw this off to the new Administration.

So, where do we go from here? 

I think the U.S. Treasury should convene the largest banks in the country, lock them in a room, with the following mandate:

1) The U.S. Treasury (UST) is going to capitalize a special purpose vehicle (SPV) – a new company – with $100 billion in cash.  UST will own the common stock of the SPV.

2) The banks (I use banks for ease, this could include insurance companies) – are going to contribute $1 trillion of assets to this vehicle with limits for each bank based on size.  The banks and UST will agree on what assets can be contributed and as a group the banks and UST will agree on the value of the assets to be contributed.

The assets that are allowed to be contributed will be broad asset classes, not one-off derivative deals and such.  Commercial mortgages, residential mortgages, consumer loans, large corporate and commercial loans (Shared National Credits, loans broadly held by banks) etc.

The $1 trillion of assets will not be contributed at “market value” nor will it be contributed at “par” value (the original value of the asset).  It will be contributed at a value that reflects the expected recovery of those assets over the life of the assets discounted back to the present (the “Intrinsic Value”).  

3) In addition to the $100 billion of capital injected into the vehicle by the U.S. Treasury the banks will make the following contributions:

a) For each $10 dollars of assets they contribute to the SPV they will contribute $1.00 of common stock.

Combining the $100 billion of cash and the $100 billion of common stock contributed by the participating banks the SPV will end up with $200 billion of capital, which should increase with the stock price of the banks.

b) In addition, the banks will place in escrow $1.00 of common stock for each $10.00 of assets contributed to the SPV.

The stock placed in escrow will be issued to the U.S. Treasury or liquidated at some future date to compensate the U.S. Treasury for any losses from its investment in the SPV and a minimum preferred return.  To the extent recoveries on the SPV exceed the intrinsic value estimate, this is the UST profit on the enterprise and the banks recover the shares placed in escrow.  The shares placed in the SPV are, again, part of the value to the UST from this endeavor.

3) The banks will receive a senior note equal to the value of the assets contributed to the SPC, paying interest at a rate which is equal to the yield on the collective assets of the SPV less operating costs.  The banks will also bear responsibility for providing knowledgeable employees – at their cost – to the SPV to manage these assets.  The SPV will have a Board comprised of respected individuals on a bipartisan basis.

The value in this idea is two fold:

First, by the banks getting a lot of these assets off their balance sheets they reduce the uncertainty in the system which should allow the stock market to re-value the equity based on the core business and not the “unknowns” associated with these assets.

Second, the security which the banks take back from the SPV will be worth more than the value of the loans on their balance sheet.  Consider this hypothetical example:

1) The banks contribute assets, collectively priced by the market at 50% of the par value of the security;

2) A conservative analysis (5% drop in GDP next year and 1.5% growth thereafter, or something like this) suggests that the intrinsic value of the assets is actually 70% of par;

3) The banks contribute these class of securities to the SPV for $1 trillion at the determined 70% “intrinsic value” (the face value contributed will exceed $1 trillion, but the value is greater than the mark to market value);

4) Now let’s say the actual recovery on these securities is $800 billion, the banks hold a senior security on this asset and thus would have first recourse to the $800 billion;

5) The SPV would however have the $100 billion of UST capital and $100 billion (at current market prices) of a portfolio of bank stocks to satisfy the SPV obligations to the banks.

As a result of this structure, the SPV senior securities taken back by the banks would have a tremendous cushion to absorb losses and still be worth par value to the banks which participate.  The break-even recovery in this example is 56% on the original par or face values of the securities contributed.  This should provide considerable ability for the new SPV senior securities on the bank balance sheets to be valued at Par.  This will enhance the asset quality of the banks and likely allow them to mark up asset values on their balance sheets.  

This is how the UST gets the “bang for the buck” that you referenced when you said the TARP could not serve its purpose.

The banks would be healthier as a result of this structure and thus the stock they contribute as capital and to the escrow should be a good store of value.

THE KEY MERIT OF THIS IDEA IS THAT IT REPLACES ILLIQUID ASSETS WHICH NO ONE CAN VALUE WITH A SINGLE ASSET THAT HAS ADDITIONAL SUPPORT AND SHOULD THUS BE WORTH PAR.

The taxpayer is protected by the escrowed stock that the banks contributed to participate.  The escrowed securities first go to compensate the UST dollar for dollar on losses and then up to a preferred rate of return.  Any appreciation in the stocks is split with 50% staying with the UST and the rest returned to the banks.

Since no one will buy bank stocks right now – everyone, I mean everyone who has bought bank stocks in the last two years has been killed – this allows the banks to effectively RECAPITALIZE themselves with some assistance from the UST.

By getting a large part of the troubled assets off the balance sheets of the banks, placing it into a vehicle that is NOT PUBLIC (thus it can sit and hold these securities without concern for the “mark to market” accounting) and replacing those assets with a single security whose credit has been enhanced partly by the UST and partly by the banks themselves, you will dramatically reduce the uncertainty in the banking system.

The banks will still have some troubled assets which due to the unique characteristics of those assets are not appropriate for the SPV.  But the idea here is that by reducing the MAGNITUDE of the problems the banks are facing and enhancing the asset quality of the banks through this program you leave them in a better position to take the write-off on those assets or to work them out themselves.

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Conspiracy Theory and the New York Times

October 28, 2008 · Posted in Financial Crisis, Politics · 1 Comment 

A recent article in the New York Times ( http://www.nytimes.com/2008/10/25/business/25nocera.html ) purports to establish that the capital injections provided to the banking industry by the U.S. Treasury are being provided under false pretenses with the intent to reshape the industry as opposed to making loans to help reinvigorate the economy.

I am not taking issue with the facts presented in the story other than that the reporter highlights his lack of understanding of lending as a business and the relationship between the banking system and the economy.

The first thing to understand is that a healthy banking system is crucial to the functioning and growth of our economy.  With a healthy banking system (a well capitalized banking system), banks can make loans to companies whose future prospects and asset value support borrowing.

Banks will absolutely expand lending as conditions and their balance sheets permit.  They have every incentive in the world to do so.

To lend, just for the sake of lending, without regard for the financial condition of borrowers is exactly what got us into the current situation in the first place.

History provides a lesson for us on this point.  Following the collapse of the Japanese asset bubble in the 80’s/early 90’s the Japanese continued to make loans to support the system and prevent the market adjustments (however painful) required to correct the excesses.  As a result, the Japanese suffered a decade of economic stagnation and is still working off the consequences of its many failures to deal with the problems created during the bubble years.

The second thing to understand is that consolidating weaker banks is a normal and healthy part of the process of recovering from the economic calamity in which we find ourselves.

While the Treasury is theoretically making loans available to all banks, the fact is that many banks have proven – as a result of the weakened position in which they find themselves – that they are poor stewards of depositor, lender and shareholder capital.

Consider Washington Mutual.  Had the capital injection plan been approved by Congress earlier, would anyone really want to see the U.S. Government invest $25Bn into an institution that had so horribly managed its capital?  Is it not ultimately a good thing for the depositors of Washington Mutual (and the U.S. tax payer who backs those deposits through the FDIC) that it is now being managed by a company that while they certainly did not dodge the bullet of sub-prime entirely, at least they did not inflict on themselves a fatal wound?

This gets to my final point.  If we make loans to all banks – both good and bad stewards of capital – we, the tax payer, will make some good investments and many bad investments in banks that would be better off having been gobbled up by better management teams.  In the long run our economy will be better off as well.

Now, if on the other hand the Treasury made the loans available to only the “good” stewards, while letting the “bad” stewards of capital struggle with their problems the net impact on the economy in the long run would be muted.  The “good” stewards would have more money to lend.  Unfortunately, because many banks would be left to struggle the loan growth by the good banks would be offset to a great degree by contraction in the “bad” banks.

More importantly, the whole of the banking system would not be healthy and this would prolong the uncertainty in the system as a whole.

To conclude, use of this capital by banks to make acquisitions is not against the interests and the intent with which this program was undertaken.  Rationalization of the banking system will create healthier surviving banks and a healthier banking system as a whole.  As the banks get healthier they will make all of the good loans they can find.

We did not get ourselves into this gigantic mess in a few months or even a few years.  To expect us to get out of it in a few weeks or months by assuming that banks will pump hundreds of billions of capital into an economic future that no one understands is silly.

Let the banks rebuild their foundation.  Growth will follow.

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The $58 Trillion elephant in the room has just taken a dump

October 21, 2008 · Posted in Big Business Ripoffs, Financial Crisis, Thoughts on the economy · 1 Comment 
Image provided by Conde Nast - Portfolio

Image provided by Conde Nast - Portfolio

Truly that line was just too humors for me to pass up (at least to me), but in all honesty it is a fairly accurate representation of our current financial situation. Which is why in this post I will cover with a very very wide brush a lot of complex detailed data that in the interest of time I will not be able to explain, so I encourage you to view this post http://www.hearditinabar.com/2008/10/14/it-would-not-be-a-big-dealif-it-did-not-effect-your-paycheck-mortgage-college-loan/ for more information on the subject, and for everyone in eye sight of this article I encourage you with all my heart to read this incredible article in Conde Nast Portfolio – http://www.portfolio.com/views/columns/wall-street/2008/10/15/Credit-Derivatives-Role-in-Crash.

So here we go. “Market fundamentalism” is a crock. How is that for an opening statement? Well in my humble opinion it is true, in today’s world at least. Market fundamentalists believe that the market is the most effective mechanism for allocating the flow of money into or out of a particular area, which if analyzed in a vacuum chamber may be accurate, but in today’s market place to few have the power to keep accurate checks and balances on the process (please visit – http://www.portfolio.com/interactive-features/2008/10/Timeline-of-Derivatives-Market for an interactive representation of the timeline for derivatives).

Take for instance J.P. Morgan and the Broad Indexed Secured Trust Offering or “Bistro” for short. This was the catalyst for what in large part was the major reason for the economic crisis we are currently in. To make a long story short J.P. Morgan (”JPM”) had a significant portion of its extendable debt obligated to 300 or so key clients, however these clients essentially had letters of credit for the money as opposed to a traditional loan on the books, therefore having the obligation outstanding kept JPM from being able to utilize this money in more profitable areas which became a real problem for the bank. Enter Blythe Masters from stage left please. Blythe Masters understood the delicate situation JPM was in, and he conceived a strategy with his fellow JPM bankers to utilize a little known instrument called a credit-default swap, which was originally brought to the market place by another institution call Banker’s Trust. In short what Blythe and the gang came up with was a way for JPM to sell its debt in the open market through a Credit-default swap instrument called Bistro. Well long story short it was successful, JPM offloaded $9.7 Billion dollars worth of risk and started a revolution in the industry. As a side note, by successful I do not mean that the investors in Bistro made money, in fact most lost their shirts when one of the companies inside the package defaulted, but rather success in this case means JPM freed up capital and the market was willing to help them do it.

Virtually overnight banks around the world were taking debt and putting it on the open market. At first it was primarily made up of corporate debt, but where the real prize lay was with the mortgage backed default swaps, welcome the seeds of a future financial crisis…

Ok, I gave you that information so I could take a big jump forward and discuss my original topic of market fundamentalism is a crock. As you have probably discerned from the previous few paragraphs the foundation blocks for our current financial crisis are not as exciting as say Dancing With the Stars or whatever it is that people watch on t.v. these days, it is in fact quite dull. This total and complete dullness combined with complex financial structures makes for a market that only an elite few can understand, control and participate in, and this is where the break down not only begins, but ends.

If something as obscure as a C.D.S. can bend if not break the largest economy in the world, then how does one stand up with a straight face and tell the 95% of Americans that will never buy, sell or hold a C.D.S. product directly that the market will correct, manage and perfect itself. The answer is it can not. If the playground is so small that only a small fraction of the market can participate in and benefit from it, then it is by all accounts not a fair playing field, because even though most people are not going to investigate C.D.S. instruments they are smart enough in other areas to know that a small group of people with much to gain are easily corrupted, and in this case corruption ran unabated. Credit rating agencies were adjusting numbers to give the original C.D.S. instruments a moderate rating instead of the horrible rating it deserved. Financial institutions were swapping out good debt for bad debt as long as the rating agencies had not lowered the rating yet. This was a game of who can be one step ahead of the other, and eventually ladies and gentlemen their feet landed right up our backsides.

The long and the short of it is simple. The Reagan era economic policies work, as long as you can keep greed out of the market, or at least keep the greed spread out amongst the general participants, so everyone has an equal shot at winning. But what we experienced over the last 10 years was a system of corruption and greed that concentrated 95% of this nations wealth into on 5% of the population, and by my standards at least, that is the biggest travesty of the whole greedy decade. It clearly demonstrates that those who have the money are the best at making the money, and the family without money is the best at paying for the greed when it is all said and done.

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