Meet the bankers and brokers responsible for the financial crisis - and the officials who let them get away with it!
Dirty Dozen
Source: Rolling Stone
Showing posts with label U.S. Treasury. Show all posts
Showing posts with label U.S. Treasury. Show all posts
Monday, 30 March 2009
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):
**********************************************************************************
Condo Buyer, 2006—$1m condo = $950k mortgage + $50k downpayment.
Condo Buyer, 2009—$500k condo = $950k mortgage - $450k equity
**********************************************************************************
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:
***********************************************************************************
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.
***********************************************************************************
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:
***********************************************************************************
Vehicle, 2009—$850k mortgage = $720k FDIC debt + $65k Treasury equity + $65k private equity.
***********************************************************************************
Having paid $850k cash for the bank’s mortgage, suddenly the bank’s balance sheet is rescued:
***********************************************************************************
Bank, post Geithner plan—$850k cash = $400k deposits + $400k debt +$50k equity.
***********************************************************************************
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.
***********************************************************************************
Vehicle 2010—$500k mortgage = $720k FDIC debt - $220k Treasury equity + $0 private equity.
***********************************************************************************
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
(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):
**********************************************************************************
Condo Buyer, 2006—$1m condo = $950k mortgage + $50k downpayment.
Condo Buyer, 2009—$500k condo = $950k mortgage - $450k equity
**********************************************************************************
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:
***********************************************************************************
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.
***********************************************************************************
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:
***********************************************************************************
Vehicle, 2009—$850k mortgage = $720k FDIC debt + $65k Treasury equity + $65k private equity.
***********************************************************************************
Having paid $850k cash for the bank’s mortgage, suddenly the bank’s balance sheet is rescued:
***********************************************************************************
Bank, post Geithner plan—$850k cash = $400k deposits + $400k debt +$50k equity.
***********************************************************************************
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.
***********************************************************************************
Vehicle 2010—$500k mortgage = $720k FDIC debt - $220k Treasury equity + $0 private equity.
***********************************************************************************
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
Monday, 23 March 2009
Geithner's Five Big Misconceptions
Tim Geithner has finally revealed his plan to fix the banking system and economy. Paul Krugman, James Galbraith, and others have already trashed it.
Why?
In short, because the plan is yet another massive, ineffective gift to banks and Wall Street. Taxpayers, of course, will take the hit.
Why does Tim Geithner keep repackaging the same trash-asset-removal plan that he has been trying to get approved since last fall?
In our opinion, because Tim Geithner formed his view of this crisis last fall, while sitting across the table from his constituents at the New York Fed: The CEOs of the big Wall Street firms. He views the crisis the same way Wall Street does--as a temporary liquidity problem--and his plans to fix it are designed with the best interests of Wall Street in mind.
If Geithner's plan to fix the banks would also fix the economy, this would be tolerable. But no smart economist we know of thinks that it will.
We think Geithner is suffering from five fundamental misconceptions about what is wrong with the economy. Here they are:
The trouble with the economy is that the banks aren't lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it. As consumers retrench, companies that sell to them are retrenching, thus exacerbating the problem. The banks, meanwhile, are lending. They just aren't lending as much as they used to. Also the shadow banking system (securitization markets), which actually provided more funding to the economy than the banks, has collapsed.
The banks aren't lending because their balance sheets are loaded with "bad assets" that the market has temporarily mispriced. The reality: The banks aren't lending (much) because they have decided to stop making loans to people and companies who can't pay them back. And because the banks are scared that future writedowns on their old loans will lead to future losses that will wipe out their equity.
Bad assets are "bad" because the market doesn't understand how much they are really worth. The reality: The bad assets are bad because they are worth less than the banks say they are. House prices have dropped by nearly 30% nationwide. That has created something in the neighborhood of $5+ trillion of losses in residential real estate alone (off a peak market value of housing about $20+ trillion). The banks don't want to take their share of those losses because doing so will wipe them out. So they, and Geithner, are doing everything they can to pawn the losses off on the taxpayer.
Once we get the "bad assets" off bank balance sheets, the banks will start lending again. The reality: The banks will remain cautious about lending, because the housing market and economy are still deteriorating. So they'll sit there and say they are lending while waiting for the economy to bottom.
Once the banks start lending, the economy will recover. The reality: American consumers still have debt coming out of their ears, and they'll be working it off for years. House prices are still falling. Retirement savings have been crushed. Americans need to increase their savings rate from today's 5% (a vast improvement from the 0% rate of two years ago) to the 10% long-term average. Consumers don't have room to take on more debt, even if the banks are willing to give it to them.
In Geithner's plan, this debt won't disappear. It will just be passed from banks to taxpayers, where it will sit until the government finally admits that a major portion of it will never be paid back.
Source: BusinessInsider
Why?
In short, because the plan is yet another massive, ineffective gift to banks and Wall Street. Taxpayers, of course, will take the hit.
Why does Tim Geithner keep repackaging the same trash-asset-removal plan that he has been trying to get approved since last fall?
In our opinion, because Tim Geithner formed his view of this crisis last fall, while sitting across the table from his constituents at the New York Fed: The CEOs of the big Wall Street firms. He views the crisis the same way Wall Street does--as a temporary liquidity problem--and his plans to fix it are designed with the best interests of Wall Street in mind.
If Geithner's plan to fix the banks would also fix the economy, this would be tolerable. But no smart economist we know of thinks that it will.
We think Geithner is suffering from five fundamental misconceptions about what is wrong with the economy. Here they are:
The trouble with the economy is that the banks aren't lending. The reality: The economy is in trouble because American consumers and businesses took on way too much debt and are now collapsing under the weight of it. As consumers retrench, companies that sell to them are retrenching, thus exacerbating the problem. The banks, meanwhile, are lending. They just aren't lending as much as they used to. Also the shadow banking system (securitization markets), which actually provided more funding to the economy than the banks, has collapsed.
The banks aren't lending because their balance sheets are loaded with "bad assets" that the market has temporarily mispriced. The reality: The banks aren't lending (much) because they have decided to stop making loans to people and companies who can't pay them back. And because the banks are scared that future writedowns on their old loans will lead to future losses that will wipe out their equity.
Bad assets are "bad" because the market doesn't understand how much they are really worth. The reality: The bad assets are bad because they are worth less than the banks say they are. House prices have dropped by nearly 30% nationwide. That has created something in the neighborhood of $5+ trillion of losses in residential real estate alone (off a peak market value of housing about $20+ trillion). The banks don't want to take their share of those losses because doing so will wipe them out. So they, and Geithner, are doing everything they can to pawn the losses off on the taxpayer.
Once we get the "bad assets" off bank balance sheets, the banks will start lending again. The reality: The banks will remain cautious about lending, because the housing market and economy are still deteriorating. So they'll sit there and say they are lending while waiting for the economy to bottom.
Once the banks start lending, the economy will recover. The reality: American consumers still have debt coming out of their ears, and they'll be working it off for years. House prices are still falling. Retirement savings have been crushed. Americans need to increase their savings rate from today's 5% (a vast improvement from the 0% rate of two years ago) to the 10% long-term average. Consumers don't have room to take on more debt, even if the banks are willing to give it to them.
In Geithner's plan, this debt won't disappear. It will just be passed from banks to taxpayers, where it will sit until the government finally admits that a major portion of it will never be paid back.
Source: BusinessInsider
The Geithner Plan FAQ
Q: What is the Geithner Plan?A: The Geithner Plan is a trillion-dollar operation by which the U.S. acts as the world's largest hedge fund investor, committing its money to funds to buy up risky and distressed but probably fundamentally undervalued assets and, as patient capital, holding them either until maturity or until markets recover so that risk discounts are normal and it can sell them off--in either case at an immense profit.
Q: What if markets never recover, the assets are not fundamentally undervalued, and even when held to maturity the government doesn't make back its money?
A: Then we have worse things to worry about than government losses on TARP-program money--for we are then in a world in which the only things that have value are bottled water, sewing needles, and ammunition.
Q: Where does the trillion dollars come from?
A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.
A: $150 billion comes from the TARP in the form of equity, $820 billion from the FDIC in the form of debt, and $30 billion from the hedge fund and pension fund managers who will be hired to make the investments and run the program's operations.
Q: Why is the government making hedge and pension fund managers kick in $30 billion?
A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.
A: So that they have skin in the game, and so do not take excessive risks with the taxpayers' money because their own money is on the line as well.
Q: Why then should hedge and pension fund managers agree to run this?
A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.
A: Because they stand to make a fortune when markets recover or when the acquired toxic assets are held to maturity: they make the full equity returns on their $30 billion invested--which is leveraged up to $1 trillion with government money.
Q: Why isn't this just a massive giveaway to yet another set of financiers?
A: The private managers put in $30 billion and the government puts in $970 billion. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year. In this case, the private managers' returns can be thought of as (a) a share of the portfolio's total return proportional to their 3% contribution, plus (b) a "management incentive fee" of (i) 0% of the capital value and (ii) between 0% (if the portfolio returns 3% per year) and 9% (if the portfolio returns 10% per year)--much less than hedge-fund managers typically charge. the Treasury is only paying 0% of the capital value and 17% of the profits every year.
A: The private managers put in $30 billion and the government puts in $970 billion. If we were investing in a normal hedge fund, we would have to pay the managers 2% of the capital and 20% of the profits every year. In this case, the private managers' returns can be thought of as (a) a share of the portfolio's total return proportional to their 3% contribution, plus (b) a "management incentive fee" of (i) 0% of the capital value and (ii) between 0% (if the portfolio returns 3% per year) and 9% (if the portfolio returns 10% per year)--much less than hedge-fund managers typically charge. the Treasury is only paying 0% of the capital value and 17% of the profits every year.
Q: Why do we think that the government will get value from its hiring these hedge and pension fund managers to operate this program?
A: They do get 17% of the equity return. 17% of the return on equity on a $1 trillion portfolio that is leveraged 5-1 is incentive.
A: They do get 17% of the equity return. 17% of the return on equity on a $1 trillion portfolio that is leveraged 5-1 is incentive.
Q: So the Treasury is doing this to make money?
A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.
A: No: making money is a sidelight. The Treasury is doing this to reduce unemployment.
Q: How does having the U.S. government invest $1 trillion in the world's largest hedge fund operations reduce unemployment?
A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lazy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.
A: At the moment, those businesses that ought to be expanding and hiring cannot profitably expand and hire because the terms on which they can finance expansion are so lousy. The terms on which they can finance expansion are so lazy because existing financial asset prices are so low. Existing financial asset prices are so low because risk and information discounts have soared. Risk and information discounts have collapsed because the supply of assets is high and the tolerance of financial intermediaries for holding assets that are risky or that might have information-revelation problems are low.
Q: So?
A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.
A: So if we are going to boost asset prices to levels at which those firms that ought to be expanding can get finance, we are going to have to shrink the supply of risky assets that our private-sector financial intermediaries have to hold. The government buys up $1 trillion of financial assets, and lo and behold the private sector has to hold $1 trillion less of risky and information-impacted assets. Their price goes up. Supply and demand.
Q: And firms that ought to be expanding can then get financing on good terms again, and so they hire, and unemployment drops?
A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.
A: No. Our guess is that we would need to take $4 trillion out of the market and off the supply that private financial intermediaries must hold in order to move financial asset prices to where they need to be in order to unfreeze credit markets, and make it profitable for those businesses that should be hiring and expanding to actually hire and expand.
Q: Oh.
A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.
Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.
A: But all is not lost. This is not all the administration is doing. This plan consumes $150 billion of second-tranche TARP money and leverages it to take $1 trillion in risky assets off the private sector's books. And the Federal Reserve is taking an additional $1 trillion of risky debt off the private sector's books and replacing it with cash through its program of quantitative easing. And there is the fiscal boost program. And there is a potential second-round stimulus in September. And there is still $200 billion more left in the TARP to be used in other ways.
Think of it this way: the Fed's and the Treasury's announcements in the past week are what we think will be half of what we need to do the job. And if it turns out that we are right, more programs and plans will be on the way.
Q: This sounds very different from the headline of the Andrews, Dash, and Bowley article in the New York Times this morning: "Toxic Asset Plan Foresees Big Subsidies for Investors."
A: You are surprised, after the past decade, to see a New York Times story with a misleading headline?
A: You are surprised, after the past decade, to see a New York Times story with a misleading headline?
Q: No.
A: The plan I have just described to you is the plan that was described to Andrews, Dash, and Bowley. They write of "coax[ing] investors to form partnerships with the government" and "taxpayers... would pay for the bulk of the purchases..."--that's the $30 billion from the private managers and the $150 billion from the TARP that makes up the equity tranche of the program. They write of "the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money..."--that's the debt slice of the program. They write that "the government will provide the overwhelming bulk of the money — possibly more than 95 percent..."--that is true, but they don't say that the government gets 80% of the equity profits and what it is owed the FDIC on the debt tranche. That what Andrews, Dash, and Bowley say sounds different is a big problem: they did not explain the plan very well. Deborah Solomon in the Wall Street Journal does, I think, much better. David Cho in tomorrow morning's Washington Post is in the middle.
A: The plan I have just described to you is the plan that was described to Andrews, Dash, and Bowley. They write of "coax[ing] investors to form partnerships with the government" and "taxpayers... would pay for the bulk of the purchases..."--that's the $30 billion from the private managers and the $150 billion from the TARP that makes up the equity tranche of the program. They write of "the Federal Deposit Insurance Corporation will set up special-purpose investment partnerships and lend about 85 percent of the money..."--that's the debt slice of the program. They write that "the government will provide the overwhelming bulk of the money — possibly more than 95 percent..."--that is true, but they don't say that the government gets 80% of the equity profits and what it is owed the FDIC on the debt tranche. That what Andrews, Dash, and Bowley say sounds different is a big problem: they did not explain the plan very well. Deborah Solomon in the Wall Street Journal does, I think, much better. David Cho in tomorrow morning's Washington Post is in the middle.
Subscribe to:
Posts (Atom)
