Friday, September 26, 2008

The Splurge

I've been asked by one or two what my thoughts are on the current state of banking, and the pending attempt at a bail out of the financial system. Frankly, my views are still developing, so as an attempt to work through some of this, here is how my opinion is forming and how I've come to understand the situation:

Cash for Trash in the NYT does a good job of laying out how we ended up here:

1. The bursting of the housing bubble has led to a surge in defaults and foreclosures, which in turn has led to a plunge in the prices of mortgage-backed securities — assets whose value ultimately comes from mortgage payments.

2. These financial losses have left many financial institutions with too little capital — too few assets compared with their debt. This problem is especially severe because everyone took on so much debt during the bubble years.

3. Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

4. Financial institutions have been trying to pay down their debt by selling assets, including those mortgage-backed securities, but this drives asset prices down and makes their financial position even worse. This vicious circle is what some call the “paradox of deleveraging.” 
The Times correctly points out that the current plan intervenes at phase 4. This is, in a sense, trying to put a band-aid on a gushing wound. It is the wrong place in the chain to effect a change. So, lets step back to phase 1: how do you stave off the surge of housing foreclosures? One route would be to help individuals with their mortgages - this would result in lower defaults, trickling through to less distressed investments held by banks, resulting in healthier balance sheets. $700bn in available funding divided by ~300 million people in the US equates to roughly $2,325 per person. Unfortunately, I don't think that this would do much to dent most individual mortgages, and you quickly encounter a problem of distribution. So there does not seem to be a way to stop the problem at phase 1, easily.

Before diving into details, it's important to consider history: in this case there is Sweden from about 10 years ago. While the similarities are certainly there, there is the small problem that there are more than 5 banks in the US, meaning that a government take over of all of them is not possible. But, there are important lessons to learn - the taxpayer should get part of the upside and decisive action can have meaningful results.

Fast forward to last week. As the banking industry is in the midst of change, Goldman is out raising capital. For the premium brand in banking, only a splashy deal will do, enter Warren Buffett and a $5bn investment. The interesting thing here is that the cost of this capital to Goldman is as high as 17%, meaning that this is a very expensive infusion.

This then lays out what return could be possible if the intervention is executed in a manner acknowledging the history of taxpayer upside in government lead banking bailouts and the potential financial upside in a market in crisis. Which leads me to my first conclusion, the plan needs to provide for taxpayer upside.

Taking another look at the phase 1 question is also worth a moment of thought. By buying these securities, individuals' mortgages are actually owned by the government. The government is then in the position to decide whether to foreclose on those homeowners who fail to make their payments, or to aggressively work with these borrowers to find a way for them to keep their homes. By the way, did I mention the government could make 17% on $700bn ($120bn), which could be used to help these homeowners? Some will say "why do the negligent homeowners get the upside?" To which I can only respond that by keeping them in their homes, the slide in property values is likely to stop, and thereby help all homeowners, (and make mortgages refinancable, meaning that the toxicity of assets is further reduced).

This leads to the second conclusion; a bailout could actually be "good for main street." I wont get in to the politicking that is now in full swing in Washington, or go into the merits of alternative proposals, with one exception: what happens if we do nothing?

Overnight, WaMu was seized and partially sold to JP Morgan, making it the largest US banking failure, ever. In this case, the seizure was, apparently, done to prevent the FDIC from taking a sizable hit from stepping in to support the bank. If the FDIC runs out of money, it turns around and borrows from tax payers. Accepting that WaMu wont be the last bank to fail, and acknowledging that the FDIC might run out of money, this takes us back to square one. Additionally, considering that JP Morgan will be raising additional capital to finance the partial acquisition, there aren't too many healthy banks left willing and able to step in, making it all the more likely the FDIC will have to borrow from the taxpayers.

Bringing me to my final conclusion: By splurging now, and doing so in an organized way, which can be structured to provide the tax payer with potential upsides, we are retaking control. Waiting will only cause us to end up in a similar position, but without the benefits of being on the front foot.

Other reading
  • I haven't touched on the consequences caused by the short selling ban, as I have not formed a final opinion
  • Here are a few other source for background reading

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