Reason for Optimism . . . Market Moving Development!!
Posted by Larry Doyle on January 28, 2009 6:37 AM |
In the midst of the discussion on nationalizing parts of our banking industry, I am hearing increasing banter of the likelihood that the Obama administration will launch an “Aggregated Bad Bank.” Perhaps I am too literal, but if this initiative is launched and works as hoped, I would recommend a name change. Let’s use “Bank Transition.” Ultimately, the name is less important than the implementation and effectiveness of this entity, but being a positive person and optimist by nature, the term “bad” does nothing for me. How might this entity work? Why is it a good and necessary development? What might it cost? Why wasn’t this move made by Paulson and team? Does this mean we can finally go back to the good old days of the last 5 years? So many questions. Let me try to clarify and offer my opinions.
1. How might this entity work?
As I have referenced previously, I always focus on an entity’s mission and funding. “Bank Transition” would most likely be managed by Sheila Bair of the FDIC. It would be mandated to purchase “toxic assets” (primarily distressed CDO (collateralized debt obligations) assets backed by an array of loans…mortgages, credit cards, auto, manufactured housing, commercial mortgages, corporate loans, and credit default swaps). It would be funded via the issuance of FDIC or FDIC-like bonds. Don’t be surprised to see a separate name used, such as “Transition Bonds,” which would have an explicit government guarantee. These bonds would probably have a few different maturities (1yr, 3yr, 5yr) to provide a degree of financial flexibility for this entity.
Bank Transition as THE buyer, and currently the ONLY buyer of SIZE of these assets, will be able to establish the market price for these assets. How will it do that? Let’s take a virtual walk into the offices at Citi Holdings (the newly established “bad” bank for assets and divisions that Citi looks to sell). Make no mistake that this entity, Citi Holdings, and Citibank as an entire entity are working in total sync with the government right now. The assets from the SIVs (structured investment vehicles) that held these “toxic assets” at Citi are moved into Citi Holdings at some price. Let’s say for argument purposes that price is 20 cents on the dollar. The price is being set by people at the bank and the government as the precursor for buying more like assets from other institutions.
Don’t think for a second that the transferral of assets and price has not already been communicated to the powers that be at Bank of America, Morgan Stanley, Goldman Sachs, and JP Morgan. While all of these toxic assets are not homogenous, there are plenty of sharp minds on “the street” (colloquial term used to describe the banks) and within the government to make “relative value” assessments between different bonds.
As a sidelight, it is ridiculous to think that senior management at Bank of America was not fully aware of Merrill Lynch’s toxic positions, valuations of those positions, and expected further writedowns as they proceeded with their purchase of that firm. They certainly knew all that information, as did the government which pushed for and encouraged that marriage. While John Thain made plenty of bad PR moves, he only joined Merrill in late 2007. IMO, he is being unjustly tarred and feathered. His aggressive moves at Merrill in 2008 actually saved a fair amount of value within that organization. What is being reported in the press does not strike me as an accurate representation of what likely truly occurred. Pardon my digressing from the topic at hand.
2. Why is the establishment of Bank Transition good and necessary?
Very simply, unless and until banks are able to clear their books of these assets, they can not and will not lend in a proactive and vibrant fashion because they need to continually set aside more and more capital as reserves against losses on these assets, as well as losses on individual loans that are not held in securitized form. Even with Bank Transition, they will need to set aside more capital as chargeoffs on loans increase. However, without the further burden of these toxic assets, they will be able to start to lend somewhat more freely. As lending increases, then and – in my opinion, only then – will we begin to develop some degree of real stabilization in the housing market and the economy.
3. What might it cost?
The $64,000 question. I would “guesstimate” the government will announce that Bank Transition will be initially capitalized with perhaps $300 billion dollars. If that funding is put in place over a 6 month time frame, we should expect regularly scheduled auctions of 1yr, 3yr, and 5yr maturity bonds of 15-20 billion in size. Is that all the funding that will be needed? Likely not, but the game plan for Bank Transition is not to hold these assets forever, but to attract private capital into the process. While Bank Transition would ultimately run competitive auctions to sell these assets, the hope would be that by establishing a price that Bank Transition is willing to purchase and hold to maturity IF NEED BE that private capital will come into the market.
4. Why wasn’t this move undertaken by the Bush-Paulson team?
You can rest assured that with Bush and Paulson now out of the picture, they will be the poster boys for not being more aggressive in fixing this mess. While Bush and team could have done plenty of things better, in my opinion they could not have implemented this Bank Transition on their watch. Why? Remember that it was only a mere 4 months ago that Lehman Brothers failed. The government’s allowing that failure can and will be debated for years. I am not going to debate that here. Given that it occurred, it precipitated a significant decline in asset valuations which led to the erosion in value across the economy and the banks. That erosion in value brought Citi to its knees and the government into the position of calling the shots there. That presence and the leverage it gives the government to wrest control of the toxic assets at other institutions is where we are currently. While the last 4 months have been torturous, and for many seem like 4 years if not 4 decades, in economic and market terms 4 months is a VERY short time frame. The government would not have the current leverage over Citi and other banks if the market itself had not brought Citi to its knees.
5. Does this mean we can go back to the good old days of the last 5-10 years?
Don’t bet on it. On a going forward basis, credit will be priced on a more judicious and prudent basis. Down payments, income checks, rigorous credit reviews, thorough analysis of assets and liabilities. All the procedures which never should have been neglected.
While this Bank Transition is still “behind the scenes” and can be faulty in design and execution, the markets this morning are looking forward, believe some form of it will occur, and are pricing it in.
Last but not least, while the Obama stimulus plan is getting a lot of attention, that plan pales in comparison to the impact that a successful implementation and execution of Bank Transition means for our future. I view the spending programs in the stimulus plan as more a means of Obama promoting his agenda. Our economy does need capital, liquidity, and stability. Bank Transition, if properly implemented and executed, will mean more than the stimulus.
Please understand that all of the thoughts and opinions in this piece are purely my instincts based upon my experience. Please also understand that if Bank Transition is enacted, the implementation and execution will take considerable time and we will likely continue to see significant layoffs and economic pain. More banks will fail and businesses close if they do not possess real staying power and liquidity to service their debt. I could be totally wrong, but for the first time in a while I think there is “Reason for Optimism.”