Tuesday, 24 March 2009

Anatomy of a Giveaway (or Why Stocks Soared Yesterday)

The stock market’s positive reaction—best 10-day gain since 1938—should leave no doubt about Geithner’s bank rescue plan: it’s a mammoth taxpayer giveaway to investors. Or so the market believes it’s going to be. Forthwith, a tutorial for those not quite clear about the mechanics of the giveaway.

(At the bottom, there’s an extra credit question. And there’s a prize for being first to get it right!)

Having taxpayer’s absorb the banks’ bad assets means equity holders are no longer in line to eat those losses. Take Citigroup stock for example. At $1 a share, C’s shareholders were essentially buying a call option on the possibility that the government would rescue them from their bank’s terrible mistakes. It’s a small bet with potentially huge upside.

On a stand-alone basis, the bank is insolvent. It’s equity is worthless and much of its debt would be in line for a huge haircut. But if the government is going to absorb the bank’s toxic assets, then suddenly the balance sheet looks a heck of a lot better.

A busted bank balance sheet is very similar to an upside down mortgage. Understanding the mechanics of the rescue is to understand why equity is miraculously increased…
OA’s erstwhile example uses an imaginary condo buyer, who in 2006 plunked down $1 million for a phat pad that in 2009 is only worth $500k. His original equity investment was his $50k downpayment; the other $950k was financed with a mortgage. The condo buyer’s before and after balance sheet looks like this (recall assets = liabilities + equity):

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Condo Buyer, 2006—$1m condo = $950k mortgage + $50k downpayment.

Condo Buyer, 2009—$500k condo = $950k mortgage - $450k equity

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This is what it means to have “negative equity.” The value of the asset isn’t high enough to pay off the liability, so equity is negative. Someone has to eat the loss. It should be the bank. After foreclosing on the buyer (assuming he stops paying his mortgage), the bank has to sell the house at the $500k market value and write off the $450k portion of the mortgage it’s never going to collect.

So here is the bank’s balance sheet:

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Bank, 2006—$950k mortgage loan = $400k consumer deposits + $400k debt + $150k shareholder equity.

Bank, 2009—$500k mortgage loan = $400k consumer deposits + $400k debt - $300k shareholder equity.
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The bank’s stock is just a single share of its total equity. If equity is negative, then the stock is $0. In the example, there’s still $300k of losses to absorb after equity is wiped out. This puts the bank into bankruptcy, where creditors have to fight it out to determine how they’ll share the losses.

But the bank hasn’t been forced to write down the value of the mortgage just yet. It hasn’t foreclosed on the home just yet, so its day of reckoning is delayed. The market knows the writedown is coming, so the stock trades at a paltry sum, probably $1 or less. Why does it have any positive value? Because it’s possible the government will still rescue the bank.

To do so, the government has to do something about the toxic asset on the left side of the equation. This is how the Geithner plan miraculously repairs the bank’s equity. Using government money, he creates a brand new balance sheet to buy the $950k mortgage from the bank at close to that price.

The Fed prints money to buy Treasury bonds–>the Treasury uses proceeds of the bond sales to finance its public-private partnership vehicle–>the vehicle buys the toxic asset, the mortgage, for $850k let’s say.

Here is the vehicle’s balance sheet:

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Vehicle, 2009—$850k mortgage = $720k FDIC debt + $65k Treasury equity + $65k private equity.
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Having paid $850k cash for the bank’s mortgage, suddenly the bank’s balance sheet is rescued:

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Bank, post Geithner plan—$850k cash = $400k deposits + $400k debt +$50k equity.
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Suddenly the bank again has positive equity value. Shareholders are saved! The stock market skyrockets!

Ah, but like a good economist, you note that there’s no free lunch. The condo is still only worth $500k. Who eats the additional $350k loss? Well, you do.

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Vehicle 2010—$500k mortgage = $720k FDIC debt - $220k Treasury equity + $0 private equity.
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The money loaned to the vehicle is non-recourse, so the private partner stands to lose no more than his initial investment. It’s Treasury and FDIC, i.e. you and me, that ends up eating the loss.

And that’s how you use taxpayers’ money to rescue a bank.

Source: Rolfe Winkler

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