Obama preserving the monopoly that Wall St. has over leverage

Its still astonishing that people would rather spend a ton of money to hire people to pour cement than utilizing that money to invest in human capital in an important industry like health care. 2 trillion dollars folks. You can buy out all the best doctors and medical professors with 2 trillion dollars. For all the talk about public/private vehicles to invest in financial ‘toxic assets”, there is no talk at all about a public/private investment in medical schools, practices or anything else. Instead of fronting a few hundred billion dollars to private equity so that they can leverage up their financial returns, why not provide the same cheap financing to anyone or any group that aspires to start a medical school or practice? In exchange for this cheap and non-recourse leverage and a fraction of the equity, the potential practitioner or the medical school den can equally leverage up the returns from the expanded scale of operations and would naturally demand less in return for tuition or other expensive to meet the desired returns. Sadly, our current financial genius in the administration and elsewhere are not capable of conjuring up a plan as simple as this.

Pax Americana…enjoy while it lasts….

With the appearance of new classes of nuclear submarines and advanced warships in Hainan, many observers have concluded that China is building up its forces to thwart any attempts by powers to blockade its shipping lanes from the Middle East. The power in question is the United States, whose navy operates freely and with impunity in that part of the world. So it must comes as a shock that it wasn’t an Aegis destroyer but a fleet of low tech Somali pirates that has been constantly harassing Chinese cargo ships near these shipping lanes. If anything, the Chinese have been a beneficiary from the presence of US naval ships in those regions.

One of the biggest beneficiaries of the strength of the US military is China. The focus on potential arenas of conflict between the armed forces of US and China misses the point, because it assigns the probability of conflict too high. While a conflict in the Taiwan could certainly break out in the future and the US navy could stop oil shipments to China, it’s undeniable that China has benefited from the presence of stable regimes in the Gulf states aided by the USG, from which her growing appetite for oil are satiated. Along the same line, it’s possible that growing American presence in South and Central Asia could jeopardize the long term interests of China and Russia, but who can deny that both have benefited tremendously from the relative stability in the nuclear South Asia and the diminished operational capabilities of Islamic fundamentalists in the region? And not to mention that the US has kept the lid closed on the Japanese, Taiwanese, and SK nuke programs.

The importance of these contributions are magnified by the fact that China lacks the power projection capabilities and influence to fully contain any of these situations. Except for direct conflict, China benefits from the world policing mentality of the US. After all, there are a lot of thieves and robbers around the world.

Geithner tries again

Geithner’s plan is the biggest condemnation of Mark to market accounting yet, and by association, also a condemnation of government officials and academics who favor M2M accounting. The whole purpose of providing a trillion dollars of financing to private parties steams from the realization that there is not enough capital in the private system, that assets are depressed not due to belief in their true economic value, but due to the lack of capital. Why is that Treasury officials and other academics who are rolling out this financing plan are also the ones who believe in MTM accounting? Truly baffling.

Is O(bat)ma a bird or a mammal?

It was announced yesterday that the Term Asset-backed Security Loan Facility will be launched in March. That means the Obama administration will begin providing up to $200 billion of initial financing to financial institutions that would like to hold asset backed securities related mostly to the consumer market on their balance sheets. The plan sounds benign enough, since on paper, it would simply be a reversal of the flow of funding from the private markets to the Treasuries that sparked off tremendous stress in the credit markets ever since Lehman’s collapse. What is terribly misleading is the claim that the entire notional value of the assets will be rated AAA, which is only assigned to the most creditworthy debt instruments. It would only be delusional to assume that the distressed households, where the cash to repay these loans would come from, should be slapped with a trip A rating. There has to be an equity cushion in the loan structure that protects the Triple A tranche of the loan. So who or what is this cushion?

I believe that this equity cushion, or a bad loan provision, whatever you want to call it, is the $20 billion of TARP money assigned to provide credit protection against the asset portfolio. In other words, taxpayer funds from the TARP will take the bullets so that the private equity guys can still get their principal payments for participating in the asset program. If we assume that the $20 billion is only a provision for the first $200 billion of this asset program, then taxpayers could be looking at $100 billion in credit losses if this program expands to $1 trillion like Geithner stated that it might. Triple As indeed.

In the first couple of months in office, Obama has already pledged to forcibly alter mortgage contracts for those who can’t afford the homes that they had speculated on. Everything he has done so far has contributed to a stellar resume as a leftist. So why is this robin hood proposing to use taxpayer money to subsidize   the evil and greedy fund managers’ portfolios? At some point, the bat has to choose sides between the birds and the mammals, or risk abandonment from both camps. Likewise, Obama would be well advised to start picking a mask that he could wear for all next four years.

Not feeling so dilutive today…

The preferred/common share swap proposed by Citi to USG should be rightfully labeled as anti-dilutive, rather than dilutive. For one, you can’t really dilute a share that’s posting one penny of dividends per share. Secondly, USG is practically already calling the shots on management and certain loan policies, as outlined by Mr. Pandit’s promise to add $36.5 billion on its books to ease political pressures. More importantly, the measure takes away the government’s priority to Citi’s cash, softening the terms of the government’s loan/investment. Now, I do not expect the government to be holding on to its common shares after Citi restores its financial health, a sentiment expressed by the Fed’s statement today. More likely, I see an offering of government shares to private hands or a buyback at a premium price commensurate with the political demand to make a profit on the taxpayer investment.

This sounds all too benign, but if true, this might be the first step to restoring market confidence, provided that the government communicates its intentions clearly.

And I thought it was illegal to buy votes in the US….

Apparently, the Obama administration is going to subsidize $75 billion in mortgage payments to nine million American households in the name of debt relief. So now we now have a government put-option aimed to help speculators in the event that they paid for too much on the speculation and can’t dump it off at a profit. Aside from the fact that the government is encouraging speculative behavior with this outrageous subsidy,  how important are nine million votes (mortgaged for 30 years) in national elections? For the first time in history, we might have a situation where the term on someone’s mortgage isn’t related to a household economic decision but a ploy to keep the allegiance of a group of voters.

Today’s random thought:

-The transmission mechanism from the forex market to the real goods market is all messed up. When countries have faced massive capital outflows in the past, they were able to export their way out of the problem thanks in part to weaker currencies. But the countries facing massive outflows today, particularly those in Eastern Europe, carry liabilities denominated in foreign currencies (USD, Euro). To stay solvent and retire their foreign debt means that they won’t have the luxury to lower the price of their exports.

Insurance would work much better

As I explained in my previous post, sucking all the capital out of the world in order to meet the demand for treasury issuance would allow the Fed and US politicians to play the role of central planners in the allocation of capital. There are very few powers which carry more significance than the power to arbitrarily allocate capital. This of course invites abuse from officials seeking to take advantage of populist constituents and promote the kind of spending that is not necessarily good for the economy but that which is favorable to his re-election chances. To avoid this scenario, I propose an alternative to direct purchases of debt and other assets: utilizing Federal guarantees and insurance.

Back on Sept. 24 of last year, I proposed this insurance plan to recapitalize banks:

Just spent some time thinking about my proposal and I want to clarify some points.

One, instead of being a party that borderline resembles an investor/creditor for these distressed financial institutions, the government should instead act in the capacity of an investment banker on both the buy-side and the sell-side. The government should establish the value of these assets (Mr. Bernanke being the valuation analyst here), and sell these assets to private and institutional investors at a premium in exchange for government insurance on the credit of these assets. So basically, act as the investment banker for the transaction and the insurer as well for the buy-side, which will be responsible for taking some of the investment risks of owning these securities from the taxpayers.

I think this approach is good because it leaves the government as a last option, and secondly, government guarantees plus bargain values should be able to generate a pretty sizable market. This approach retains all the positives of the current bailout plan, but also transfers a portion of the risk of ownership from taxpayers to private investors and institutions. Sounds fair?

Additional specifics to the plan: the insurance would be issued in the form of a put option. An example of a transaction would be:

Bernanke determines that the ytm of a security would give it a value of 30 cents to the dollar. The government then markets the security to a wide variety of potential buyers by offering a 7 cents premium, which would result in a selling price of 37 cents with an attached put option that would allow the investor to sell the security back to the government at 30 cents under a specified timetable. So basically, the taxpayer’s money would only suffer a write-off if the value of the underlying security drops off to less than 30 cents to the dollar, which suffers less exposure than purchasing the asset at 37 cents .

The key thing here to note is that between prices of 37 and 30, the loss is taken by private investors, rather than by the taxpayer. So this is an allocation of risk from the taxpayers to market participants.

In addition, the put options would have different expiration periods, which would suit a wider variety of potential investors, thus attracting more potential buyers.

The advantages of my plan over the current government plan:
1). encourages participation of private money and diminishing the role of the government in financial dealings.
2). better protects taxpayer money by spreading the credit risk of the underlying securities to private investors and institutions.
3). allows private investors to recapitalize the books of distressed institutions in the form of the insurance premium rather than taxpayer money.
4). having the government as an ultimate guarantor of the security would provide the needed liquidity for the market of these instruments.

Curiously, House Republicans led by Eric Cantor of Virginia came out with an identical plan the next day, which called on Federal insurance and insurance fees. My plan only differed in that I proposed a sizable insurance fee from the purchaser to recapitalize the banks.

Paulson opposed the insurance plan vehemently, but ended up utilizing its features in two of its most prominent bailouts: Citi and BoA. Systematic insurance isn’t without risks, but I would much rather take the contingent obligations than to allow centralized allocation of capital.

Crowding out in full swing

By all estimates, the Federal government will seek to raise well over one trillion dollars via Treasury instruments to fund a variety a bank rescues and spending programs. Where will the money come from? Indications are that central banks spent most of 2008 readjusting their portfolios, mostly by selling their existing holdings of corporate and agency bonds to purchase treasuries, and increasingly on the short end. Some central banks were less lucky and were battered with capital flight, which depleted their dollar holdings, but the money ended up in the treasuries anyway. With the rapid slowdown in global trade, it is unlikely that oil states and exporters will be adding significant treasury holdings, especially against the backdrop of capital flight.

The Fed was able to finance a large portion of its Treasury issuance in ’08, but at the expense of other financial markets. The collapse in the equity markets wiped off trillions in household wealth, inducing a sudden drop in consumption and bill payment from American households. The credit market certain suffered a heart-attack. And large states like NY and Cali are facing budget short falls in the tens of billions in the current fiscal year. Unless the Fed uses the money that it raised to refinance sovereign debt, countries in South America and deficit countries are looking at defaults as well.

Which brings us to this point: If the Fed is successful in raising the full amount of Treasuries without having to monetize the debt, the world’s financial markets will again stare in the face of bankruptcy. Private enterprises and nations will be shut out of the capital market, causing massive defaults in the private sector. Consequence would be dire if the US government choose to use this money for long term infrastructural projects, which does little to provide goods and services that people need today. A political consequence could be that nations friendly to the US may get special treatment in the form of currency swaps so that they can effectively finance their external obligations with their own currency indefinitely. And the corporations that operate the largest workforces may get friendlier responses to requests for access to working capital from the Treasury than smaller ones. The potential for political abuse is unlimited. Lenin could not have dreamed this one up any better.

As I have been saying from day one, the Fed needs to systematically insure all classes of debt in order to avoid the scenario where it becomes the central allocator of capital of the world.

Paulson’s ‘Mandarin’ plan to deal with toxic debt

Henry Paulson’s connections with the Chinese elite, nortured by more than 70 visits to the mainland as a private banker, have been widely acknowledge by the media. Perhaps that explains why Paulson latest plan to dump financial system’s toxic assets into a single ‘aggregator bank’ looks eerily similar to the Chinese effort in the late 90s to dump nonperforming loans into state-financed ‘asset management companies’ (AMCs). In a paper titled “The Chinese Conundrum: External Financial Strength, Domestic Financial Weakness”, Brad Setser, now a fellow at Council on Foreign Relations, elaborates on the Chinese model:

In 1999, RMB 1400 billion ($169 billion at 1999 exchange rates) in bad loans—roughly 20 percent of total loans at the time—were taken off the banking system’s books and given to four asset management companies.

Furthermore,

In addition to taking the banks’ bad assets, AMCs also assumed some of the banks’ liabilities to the People’s Bank of China. As a result, both the central bank and the SCBs ended up with large claims on the AMCs. Early recovery rates on the bad loans transferred to the AMCs were around 30 percent of book value, but recovery rates subsequently fell to 15 to 20 percent of the book value. Formally, the finance ministry has not guaranteed AMC bonds (Ma, 2006)—but there is little doubt that taxpayers ultimately will need to bailout the AMCs.

The gov’t will probably take the ‘carve-out’ approach, which means that they will purchase toxic assets at book value (or higher, possibly at par) and thus avoid write-downs on equity (or  to recapitalize by cash inject if they are to buy at par).

Presumably, the government does not have to mark its assets to market if the public does not demand strict supervision. But if the recovery rate is low and if the Dem. congress uses this as a tool to further impair the assets  in order to bail out the segment of the constituents facing default, the ultimate cost will be levied on all taxpayers.

footnote:

Setser, Brad. (2006),  The Chinese Conundrum: External Financial Strength, Domestic Financial Weakness (May),  CESifo Economic Studies. <http://cesifo.oxfordjournals.org/cgi/rapidpdf/ifl005v1.pdf&gt;