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Monday, September 22, 2008

Two IBs Apply For Bank Charter?

Goldman Sachs and Morgan Stanley:
The Wall Street that shaped the financial world for two decades ended last night, when Goldman Sachs Group Inc. and Morgan Stanley concluded there is no future in remaining investment banks now that investors have determined the model is broken.

The Federal Reserve's approval of their bid to become banks ends the ascendancy of the securities firms, 75 years after Congress separated them from deposit-taking lenders, and caps weeks of chaos that sent Lehman Brothers Holdings Inc. into bankruptcy and led to the rushed sale of Merrill Lynch & Co. to Bank of America Corp.
Well, that was approved quickly. Do they really have the required capital, or are they going to use the Paulson Bailout Fund to get it?

I don't approve of the Paulson Bailout Fund, because it imposes no haircut on those who are selling overvalued assets to the fund, and it gives control of all that money to essentially one person. Paulson has given no indication that he knows what he is doing. Less than none, really. The "Paulson Committee" repeatedly reviewed financial sector risks and hedge fund risks in the run-up to this debacle, and kept concluding that the problem was too much regulation. See, for example, this WSJ commentary on the 2006 Committee on Capital Markets Regulation report. There were international pushes to enhance hedge fund oversight, and he always kept insisting that he could put his fingers in the pie and pull out plums just as it was. Recently he came up with the idiotic covered bond mortgage plan, which will remain in my mind as one of the most clueless proposals of the last century.

Paulson is the last person who should have control over .7 T of the taxpayers' money.

Someone laughed at me over at CR's earlier this year when I said that in 2008, the auto and cc securitizations were going to bust, but:
Officials made the changes two days after unveiling plans for an unprecedented intervention in financial markets. The change to potentially allow purchases of instruments such as car loans, credit-card debt and other devalued assets may force an increase in the size of the package as the legislation proceeds through Congress.
No, this is not a good solution.

We do need some sort of intervention to support liquidity, so that new good loans to decent applicants can be made. That need not entail buying bad loans. It could, for example, come in the form of a government-backed funding pool from which banks could get low-interest loans for commercial lending and so forth, some temporary buying pool which imposed later costs on participants, and perhaps a suspension of mark-to-market for certain classes of debt assets, such as those currently paying. But just buying bad debt for no haircut is suicidal, and giving Paulson, who came out of GS, the free rein to do whatever he wants will create an opaque process with no checks and balances. Everyone - including me - will believe that Paulson is looking after the interests of a particular, small, group.

Also, any such intervention should include significant expansions of the budgets for the bank regulators, because over just the last month, the banking sector has aggregated the IBs. The bank regulators now have all those risks to oversee and not enough staff with which to do it.

The SEC really has been asleep at the switch. It allowed the massive leverage ratios which are killing the IBs off. So they don't need to have control over it.

If Congress decides to do this, it should give control over that .7 Trillion credit line to the FDIC. The FDIC is the agency that has the most experience in valuing and unwinding assets.

Update: CR thinks the same - that this plan is based on buying assets for far above rational value, thus effectively giving money directly to financial corporations. My theory is that if the government wants to recapitalize financial corporations, it needs to do so by taking convertible stock options with 5 and 10 year dates, and giving them the money, and then letting debt float on the market to find its own worth.


When you posted about the auto loan and credit card securitizations going bad, my reaction was, "I'm not alone!"

But don't forget the ludicrous LBOs. There must be at least a trillion of those on their way to oblivion, too.

What horrifies me most about this situation is that the enormous government deficits are being covered almost entirely by borrowing from foreign sources, and that there are only two ways to get away from that -- raise taxes to reduce the deficit (exactly what you don't want to do in a severe recession), or monetize the debt by running the printing presses full blast (another road we don't want to travel). So I see no way out of this without suffering excruciating pain.

I wonder whether one reason Paulson is advocating the kind of solution he has is that he is aware of how near one of our major sources of foreign funding -- China -- is to coming apart at the seams, and of how public opinion there would react to any solution that forced bondholders to takes significant losses.

One question, on the issue of buying bad debt vs facilitating future lending. Why not let these zombie entities go BK, then let the strong pick up the usable pieces (servicers, retail presence, etc.)? Fannie and Freddie are still around to provide liquidity for conforming loans, for anything else there shouldn't be any federal support anyways.

Anon 5:37, we don't want to let things go BK because the panic will crash the market. We're trying to avoid results that involve adding the Roman numeral "II" to the words "Great Depression".

I'm mighty curious to see what kind of Federal rescue plan actually comes out the far end of the legislative sausagemaker.

I'd like to see the FDIC in charge, because that would put responsible oversight in place. I don't trust the SEC, Fed, or Treasury to handle things cleanly.
Everyone - I have spent a lot of time over the last couple of days contacting lawmakers. I suggest you do the same. Congress' first impulse was to adjourn and flee the fray, so their collective feet should be held to the fire.

John - I'd prefer to offer a bailout in the form of capital needed to restore solvency, paid for by future equity, and let the debt be sold on an open market. That's just me, I suppose.
"It could, for example, come in the form of a government-backed funding pool from which banks could get low-interest loans for commercial lending and so forth, some temporary buying pool which imposed later costs on participants, and perhaps a suspension of mark-to-market for certain classes of debt assets, such as those currently paying."

Why not suspend the mark to market rules for illiquid securities (CMOs/CDOs)for 18 months to two years? During that time the firms holding these securities could work their way thru them finding their true value and then selling or retaining them as they saw fit. This would, of course, require government oversight and frequent reports to insure openess and prevent bogus book keeping. The debt servicers know which debts are performing as advertised and will probably be key in finding true values for the CMOs/CDOs.

This would improve the banks liquidity immediately and that, coupled with your idea of a Fed source of low interest loans to further stabilize liquidity, would allow the work out of these instruments without putting the tax payers at so much risk.

Whatta ya think, MOM?
I share the preference, MoM, but the political class does not want to face the fact that any money spent on this bailout is exactly that, spent -- they prefer telling us the fiction that these assets may someday be worth more than the government pays for them.
MOM, what do you think of John Hussman's analysis/proposal, which basically is that banks do have adequate capital without government intervention IF bondholders are require to eat losses?
David - I'll quote Brian Horey:
Secretary Paulson cites the “illiquid assets that are clogging up the financial system” as the reason to undertake this massive assignment of taxpayer wealth to the banks. But this misconstrues the fundamental problem facing the banks, for the root of the problem is truly the banks’ solvency, that is, inadequate levels of capital, not the illiquidity of impaired assets.

You can't make the bondholders take all the losses, because when you do these deals, the originators retain the worst lots, and they get the rejects back. Even when you pool this stuff, loans which default and then are fraudulent, etc, come back! There is always some residual liability, plus the wreck tranches.
John, the whole reason these assets are declining in value are the rising defaults. So yes, you're right.

Jimmmy, that's a good idea in practice, but without some sort of capital infusion just pretending the stuff is worth something isn't going to do it. Banks aren't lending to each other because they don't trust each other now. If everyone's sitting with fake values on their books, interbank trading won't resume.

I have written this before, and often, and I've written this long ago. The big losses are coming from Alt-A, HELOCs, CRE and the other debt doodads. Especially the Alt-A.

Subprime loans are easier to fix - they carry higher interest rates, which can be written down. And subprime MBS usually have about 15-20% coverage in the lower tranches before the investment grade stuff will not pay off.

A lot of Alt-A MBS has 6-8%, and it's going to incur losses way, way above that. So if you're stuck with it, you truly are going to take a loss.

Fannie MBS is a different story - most of that will pay off as scheduled. For that, I can see allowing carrying at higher than FMV value if the intent is to hold to maturity. But is it liquid capital? Not really.
jm - I think we have to take equity positions in the firms we bail out. That can be used to offset the debt later.

Anything else is suicidally stupid. Whatever we do, we can't stick it to debtholders who bought the GSE paper, not if we ever want them to buy again. And we do.
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