I'm Headed Back to DC, With Blogger's Opinions in Hand!
March 30, 2009
I will be headed to DC in a few hours to attend the Congressional Black Caucus Economic Security Taskforce TARP/TALF Access Summit. Yeah, I know, its a pretty long title. Bernanke, et. al. will be speaking to the CBC and I must admit that I am quite curious to hear what he has to say. Better yet, if I can corner him for just a few minutes to ask a few choice questions of my own. Remember, I have a track record of making money from the errors borne of erroneous monetary and fiscal policy. See"The Great Global Macro Experiment, Revisited". The most recent annual performance numbers are available here: Updated 2008 performance.
Below, I have outlined and detailed strengths and a glaring weakness in the PPIP plan proposed by Geithner. I also included a relatively simple and easy to implement solution to the problem, a problem which if left unchecked puts the US taxpayer at guaranteed and highly unnecessary risk. I will be passing this information around in DC like candy on Halloween! If I am allowed to, and if my cell phone and notebook batteries hold up, I will do some live videoblogging directly from the event. If not, then, well,,, not.
Reggie Middleton overview of the strengths and weaknesses of the TALF from an objective perspective
The program, as Geithner has represented it, is relatively well thought out, contrary to what many are saying in the media and the blogosphere. I believe too many are focusing on the PPIP (without reading the actual documents behind it) and not on the entire plan which also encompasses TARP funds and stress testing.
There is one potential flaw and one major whole, though. The potential flaw is the worst case scenario in the stress testing is not pessimistic enough, therefore may make the banks seem stronger than they actually are. This is the concern of Nouriel Roubini, who (along with myself) has been very accurate in calling the machinations of this collapse from the very beginning. I have been in contact with Mr. Roubini (an NYU professor and currently a rock star economist and entrepreneur consultant) and our views are quite corollary, at least along the lines of the outlook of the economy and the corporations within it over the next year or so. We both have been, and continue to be significantly more pessimistic than the consensus. To date we have been right. Reference the Forbes article that details my calling of the fall of the banks and real estate firms well in advance of other analysts, economists and investors, not to mention management, themselves - http://www.forbes.com/2009/03/01/short-stocks-middleton-personal-finance-investing-ideas_reggie.html.
The distortion of natural market pricing and its inevitable results
The second issue, which is truly a most significant issue, is that the nature of the non-recourse loans offered by the government acts as an implicit put option (a sort of derivative insurance policy, similar to CDS) for the investors who purchase the products (and by default, potentially the banks/insurers, etc. as sellers). The significance of this is that it can, and most likely will, distort the risk taking behavior of the buyers of these assets (the investors). It is apparent that the government is counting on this distortion to a certain extent (hence the reason for the inclusion of non-recourse loans) to achieve the maximum pricing of the loans and the legacy assets. This distortion, unfortunately, fails to lead to true "price discovery" in the market, for the entire market cannot borrow at the Treasury's cost of funds, and at up to an implicit 14x leverage that the chosen participants of the PPIP plan can. Most importantly, the entire market will not be able to borrow with the implicit put option that is a non-recourse loan. Most of us will have to act with considerably more prudence when levering up, if able to lever up in this environment, simply because we will be on the hook not only for our equity investment, but for the monies borrowed as well.
This concern, or prudence, is the lever that assures not only accurate market pricing (or at least the valid attempt to achieve such) but the lack thereof is exactly what got this country into the predicament that it is in now. Very high loan to value (LTV) and effectively non-recourse loans (as in the construction loans used to build the overcapacity in residential, retail and commercial real estate, or the so-called "liar loans" that were used to buy these properties) allowed participant and players who didn't have enough "skin in the game" to bid up assets to an unsustainable level, that was perpetuated by the access, and excess, of free flowing leverage at high levels. When "reality" finally hit the fan, that credit dried up nearly instantaneously, and the dearth of extremely leveraged, "effectively non-recourse" loans caused asset prices to literally drop through the floor - and they are still dropping at a very rapid clip. As the pre-eminent economic power in the world (at least thus far), the very least we can do is to learn from this most recent and egregious of mistakes and avoid dooming ourselves to repeating it, particularly since the mistake is just two years or so old.
What this analogy was designed to bring to fore is that the prices achieved via this "PPIP" mechanism will be significantly higher than the natural market will bear. Even if the investors were to purchase these "toxic" assets with the intent to hold them to maturity, the "true" market price will be significantly lower than what they paid for them, although the banks will be much happier with the purchase price than they would be with the "true" market price.
What does this mean for us as taxpayers? Well, it means that if, for any reason any of these assets get resold in the open, natural market (which is bound to happen, which is why they call it a market), the prices will simply drop like a rock. The reason? Well, the government is not, probably will not, and definitely cannot offer such favorable terms to all buyers of these assets, at all times. The stickler, is if and when these assets get resold (and this is the natural function of the markets, buying and selling), the collapse of these asset prices will occur AFTER the expenditure of $500 billion to a $1 trillion of US taxpayer monies. This event, if it were to occur (and it is not only likely, but probably inevitable) is a travesty in the making and does serve to fuel the speculation that the end result of this plan is a tax payer funded bailout of the actors and players who were largely responsible for this mess. I posit the logical, if not the inevitable: if these assets natural market pricing will be achieved inevitably, why not have this natural pricing achieved BEFORE the US taxpayer is separated from his and her $500 billion to a $1 trillion rather than after? After all, the difference is a capital loss if the monies are put in before the asset price discovery leads to lower prices, as compared to likelihood of capital gain if the monies were invested after the natural market price discovery process. Herein lies the key word, "natural" market price discovery.
The potential and incentive for TALF participant collusion and the "gaming of the system" is high, and incentivized by the implicit put options that are the high leverage and the non-recourse nature of the loans
The plan specifically provides for the exclusion of SIVs (off balance sheet Structured Investment Vehicles of banks) from investing in the bank's legacy assets through PPIP by excluding affiliates of banks participating in distressed assets. So technically a bank cannot set up an SIV with a more than 10% stake and overbid for those assets.
However there is no such mechanism as such to prevent private investors to engage in collusion and overbid for securities, risking tax payers' money since both the parties stand to gain in such an event (out of this three party affair). The participants of such collusions can stand to gain simply by mutually overbidding (as in two banks bidding against each other) to boost the asset values of what they are bidding on, or a bank can sell a under-priced swap (ex. customized CDS) to a private bidder (say a hedge fund or private pool of capital) to indemnify that investor against the losses of its 3 to 6% equity investment of the entire levered purchase. This benefits the bank by allowing it to sell assets at higher than prudent levels, and can benefit the buyer by allowing it profit from the gain of the CDS above and beyond the relatively miniscule equity investment that was made. Since the loans are non-recourse, the equity investment partner need not worry about losses taking on the entire purchase, and just needs to be made whole on their relatively very small equity slice. The leverage inherent in an underpriced CDS would serve that purpose and allow the equity partner to actually profit handsomely as the US tax payer takes a bath, in very cold water to boot! In order for such to be the case, the bank and the investor would have to collude, for the pricing and structure of the CDS (or other contingent insurance/false hedge) mechanisms is paramount. It would not be possible to get such a deal through an exchange traded product, thus it will have to negotiated over the counter.
Below, you can find an example of the effects of two banks colluding to increase asset prices, and the effects it would have on the taxpayer:
|Seller Bank A||Seller Bank B|
|Face value||100.0||Face value||100.0|
|Price determined by auction||80.0||Price determined by auction||90.0|
|Current fair value in books, cents to dollar %||60.0%||Current fair value in books, cents to dollar %||80.0%|
|Debt-Equity ratio||6.0||Debt-Equity ratio||6.0|
|Debt FDIC Guaranty||68.6||Debt FDIC Guaranty||77.1|
|Equity by private investor, Bank B||5.7||Equity by private investor, Bank A||6.4|
|Equity by treasury||5.7||Equity by treasury||6.4|
|Interest on FDIC Debt||4.0%||Interest on FDIC Debt||4.0%|
|Fair value, cents to dollar %, actual at EOP||25.0%||Fair value, cents to dollar %, actual at EOP||30.0%|
|As seller of Legacy Assets to PPIP|
|Bank A||Bank B|
|Gain on sale to PPIP||20.0||10.0|
|Bank B (assuming it has purchased Legacy asset of Bank A|
|Value at EOP||Gian (loss)||Interest on FDIC debt||Gain to equity investor||Gain / loss to Private investor*||% return||Gain / loss to Tax Payer|
|75% discount on FV||$25.0||($55.0)||$2.7||($57.7)||($5.7)||(100.0)%||($52.3)|
|Bank A (assuming it has purchased Legacy asset of Bank B|
|Value at EOP||Gian (loss)||Interest on FDIC debt||Gain to equity investor||Gain / loss to Private investor*||% return||Gain / loss to Tax Payer|
|70% discount on FV||$30.0||($60.0)||$3.1||($63.1)||($6.4)||(100.0)%||($56.9)|
|Net Gain (Loss) Bank|
|Bank A||Bank B||Taxpayer|
|As seller of Legacy Asset||$20.0||$10.0||<--As long as bid value is greater than economic value banks stand to gain as seller|
|As Investor||($6.4)||($5.7)||<--Maximum loss as pvt investor is only to the extent of equity|
|Net Gain (Loss) Bank A||$13.6||$4.3||($109.2)||<--Maximum loss to tax payer virtually unlimited. Banks stand to gain both from sale of legacy asset and as investor.|
In the model above (which you can download for free for your own use: PPIP full model, with collusion and implied leverage 2009-03-26 01:00:41 202.00 Kb) we have assumed that Bank A and Bank B both participate in the PPIP program. Current fair value of Bank A's asset are at 60 cents on the dollar while Bank B's assets are at 80 cents on the dollar. However during the auction Bank A's and Bank B's assets are sold at 80 and 90 cents on the dollar, respectively. Bank A purchases Bank A's asset with equity investment of $6.4 while Bank B purchases Bank A's asset with equity investment of $5.4. At the end of period the actual value for these assets of Bank A and Bank B (originator) were 40 cents and 60 cents on the dollar, respectively.
Although both the banks lost 100% of their respective equity under the PPIP they were considerably better off (and I do mean considerably) selling each other their legacy assets, (effectively, selling them to the Treasury) with tax payers taking the ultimate hit. This should be safeguarded against.
A comprehensive solution is not only difficult to achieve, but not without its own drawbacks. Understanding this, I can appreciate the effort that Geithner, et. al. must have put behind the formulation of this plan. With that being said, there is one relatively minor modification that I believe can effect major change in the behavior of the plan participants. Even with the assumption that all plan participants and all who had inputs in the authoring of this plan were, are, and will continue to operate with the most beneficial (to the taxpayer) of intents (a potentially very naïve assumption, but one that I positing of the sake of argument), it would be nigh impossible to enforce the continued behavior as such for the duration and life of the program. As a matter of fact (and opinion), even if such monitoring were possible it would be imprudent due to the amount of government resources needed to adequately do so - particularly at a time when those monitoring and regulatory resources can be better put to use elsewhere (ex. Madoff, Stanford, etc). I believe the solution is to alter the risk/reward proposition of the implicit put option that is the non-recourse loan.
I propose that any entity or natural person that uses the government PPIP loans (margin, leverage) to purchase assets and simultaneously, consequently, or in relation with the purchase of said assets, enters into derivative, swap, OTC (over the counter), option related agreements, or has ANY equity (ownership), or ANY controlling interests by or with ANY sellers of the "toxic", legacy or whole loan, assets or products being auctioned through the PPIP will, as a consequence, immediately cause the loans used in the purchase to go full recourse. This puts significant skin in the game for the investors who may engage in other (potentially suspect) transactions with the sellers of the assets or who may directly or indirectly have any controlling or equity interests with the sellers. This instantly, and without additional costs or the need for legislation, eliminates the need for a watchdog to police and ascertain who the "actual" investors are, what their "true" motivations are for buying, and "if" they are purposely overbidding to manipulate asset prices. It brings to bear the natural forces of the market to police the transactions. If you overpay, you stand to lose your money, and all of your investment which you would be forced to stand behind (in other words, all of your money) and not just a single digit percentage equity investment that was leveraged significantly at the tax payers risk and expense.
With the loans going full recourse, the equity investor private partner will be strongly incentivized to pay the lowest prudent price, and if for any reason that investor were to overpay, that investor would end up bearing full responsibility for those actions (and not the taxpayer). In this fashion, even if a bank (PPIP asset seller) were to implicitly back an investor, be it another bank, a shell company, or an existing private pool of capital though the use of a swap, OTC option, or even the direct overbidding for the assets, the risk of those assets falling significantly below the PPIP purchase price will still be borne by the asset buyer. This eliminates the benefit of collusion for although the assets were removed from the bank's balance sheet at an elevated price, the "insurance" that would be provided by the collusion partner would be immediately called upon and the ill gotten capital would be drained back from the balance sheet to pay for the drop in the asset prices to "natural market levels". In essence, the colluding partner would be "robbing Peter to pay Paul". This solution also leaves available the non-recourse loans for those participants who can show that they have no pre-existing relationships or interests with the asset sellers, thus providing that market price distorting, but (apparently from Treasury Secretary Geithner's perspective) necessary boost to asset prices - without overdoing it.
Additional analysis and Microsoft Excel models to use as visual aids
Illustrative models are available at my site that detail the risk vs. reward of PPIP investors, the potential and effects of collusion amongst the PPIP participants, as well as the implicit maximum leverage of 14x vs the stated maximum leverage of 6x. Please download them using this link: http://boombustblog.com/index.php?option=com_docman&task=doc_download&gid=142. I have also published additional analysis on the PPIP in two parts, here: http://boombustblog.com/Reggie-Middleton/884-Reggie-Middletons-Overview-of-the-Public-Private-Investment-Program.html and here http://boombustblog.com/Reggie-Middleton/886-Reggie-Middleotn-on-PPIP-part-2.html.