Commercial Paper.... Release the Hounds

Bloomberg (hat tip Naked Capitalism):

Sales of longer-term commercial paper soared 10-fold after the Federal Reserve began buying the corporate IOUs, a sign that the central bank's efforts toward unlocking the market may be working.

Companies yesterday sold 1,511 issues totaling a record $67.1 billion of the debt due in more than 80 days, compared with a daily average of 340 issues valued at $6.7 billion last week, according to Fed data. The central bank probably absorbed about $60 billion of the total, said Adolfo Laurenti, a senior economist at Mesirow Financial Inc.

Source: Federal Reserve

Bailout Can Work and At No Cost to Taxpayers

While I do think there are better alternatives than the current plan, something is needed. HOWEVER, I absolutely think this plan can help unfreeze the credit markets and recapitalize the financial institutions at a small or no cost to taxpayers. How? Let’s first rewind to see how we got into this mess using a very simple bank I'll call Bank A.

PART I) UNFREEZE CREDIT MARKETS

Background
In mid 2007, Bank A was doing well with $100 in assets and $60 in liabilities, thus had equity of $40. Unfortunately all the assets bank A owned were subprime mortgages, which now have a market value of $50. Which means Bank A currently has negative equity of $10 and is insolvent. As such, no other bank will provide lending to Bank A as they will fold with no government intervention. This would be fine (and a natural part of capitalism), except Bank A is intertwined with Banks B, C, D, and E and if Bank A goes bankrupt, all these banks go bankrupt. Thus, credit markets are frozen (i.e. NOBODY can get a loan).



Bailout
Under the bailout the Treasury buys the assets currently priced at $50 for $90 (I will explain later why this won’t cost taxpayers money), Bank A uses the proceeds to make $90 of loans to small businesses / individuals that need credit (for things such as payroll), Bank A’s equity rebounds to $30, Bank A is now solvent (and other Banks are once again willing to lend them money), and the credit markets are now functional (i.e. if you have decent credit, now you can get a loan - forgot the "old" days of easy money).

PART II) LIMITED OR NO COST TO TAXPAYER

Won’t this cost taxpayers money you ask? After all, they did buy assets worth $50 from the bank for $90? Nope... fortunately for the U.S., the Treasury can borrow money on the cheap.

Value of Assets to Bank A
Assuming Bank A's subprime assets pay $4 coupons per year over 8 years and returns the $100 principal in year 8 (I understand this is not how subprime deals work, but lets keep this simple) and requires a return on capital of 15% (bank capital ain’t cheap these days), the assets are worth the $50 shown above (the NPV calculation is shown in the chart below).

Value of Assets to Treasury
However, the Treasury currently has the ability to borrow at less than 4% / year for 10 years (the current yield on the ten year bond is ~3.7%). Assuming the same cash flows as above, but discounting them at 4% per year instead of 15%, the assets are worth $100 (again the NPV is shown below). Lets assume the Treasury pays Bank A $90 for these subprime assets "worth" $100. In this case, it doesn't only not cost taxpayers a cent, but they “receive” $10.



Conclusion
The bailout will not solve all the economic problems we are currently facing. In fact, not even close. We still have a massive amount of leverage in the system that needs to be unwound. However, if this bailout is done right, it should help unfreeze credit markets (which are currently non-functioning) at little or no cost to taxpayers.

Derivative Exposure at U.S. Commercial Banks

As Barry stated:

$90 Trillion dollars derivative exposure for JPMorgan ? No wonder the Fed "rescue" of Bear Stearns was via JPM -- it was their own derivative exposure that was at risk.

Source: Treasury (Page 22)

United States Balance Sheet / Dependence on Foreign Capital

Ben Bittrolff points us to an interesting take on the fragility of the current International Financial system via Bloomberg:

"A failure of U.S. mortgage finance companies Fannie Mae and Freddie Mac could be a catastrophe for the global financial system, said Yu Yongding, a former adviser to China's central bank.

"If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic,'' Yu said in e-mailed answers to questions yesterday. "If it is not the end of the world, it is the end of the current international financial system."

"The Chinese are getting a little feisty as their losses continue to mount.

"China's $376 billion of long-term U.S. agency debt is mostly in Fannie and Freddie assets, according to James McCormack, head of Asian sovereign ratings at Fitch Ratings Ltd. in Hong Kong. The Chinese government probably holds the bulk of that amount, according to McCormack."

Lets take a look at just how large the U.S. dependence on foreign investors is:

Source: Federal Reserve

Hard to Sell Assets

WSJ: More Broker Writedowns? You Don't Say!:

The subjects are Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., and Morgan Stanley, and the shooter is Citigroup’s Prashant Bhatia, who lowered earnings estimates on all three due to the “difficult operating environment, characterized by lower client-related trading volumes and losses on hard-to-sell assets.”

Freddie Balance Sheet: Godfather Edition

Fredo, like Freddie, is the "little brother" that tried to do well. All either of them wanted was a little love. The result?

Michael Corleone:

Fredo, you're nothing to me now. You're not a brother, you're not a friend. I don't want to know you or what you do. I don't want to see you at the hotels, I don't want you near my house. When you see our mother, I want to know a day in advance, so I won't be there. You understand?

Barron's: The Endgame Nears for Fannie and Freddie:

It is growing increasingly likely that the Treasury will recapitalize Fannie and Freddie in the months ahead on the taxpayer's dime, availing itself of powers granted it under the new housing bill signed into law last month. Such a move almost certainly would wipe out existing holders of the agencies' common stock, with preferred shareholders and even holders of the two entities' $19 billion of subordinated debt also suffering losses.

We all know what happened to Fredo. Isn't it time we put Freddie out of his misery?

Total Borrowings of Depository Institutions

The Update:

• Extension of the Primary Dealer Credit Facility (PDCF) and the Term Securities Lending Facility (TSLF) through January 30, 2009.

• The introduction of auctions of options on $50 billion of draws on the TSLF.

• The introduction of 84-day Term Auction Facility (TAF) loans as a complement to 28-day TAF loans.

• An increase in the Federal Reserve's swap line with the European Central Bank to $55 billion from $50 billion.

The Good:

Michael Feroli, U.S. economist with JPMorgan in New York added: “more and more banks are trying to take advantage of the pure economic advantage of borrowing at a cheap rate and you are seeing a gradual fading away of the stigma of using the discount window.”

The Bad:

U.S. banks' direct primary credit borrowing from the Federal Reserve rose to a record high in the latest week. Banks primary credit borrowings averaged $17.45 billion per day in the latest week, up from the previous record set last week of $16.38 billion, the Fed said on Thursday.

On the day of July 30, banks' primary credit borrowings inched lower to $17.38 billion, down from $17.68 billion on July 23. Banks' overall discount window borrowings averaged $17.64 billion per day in the week ended July 23, up from an average of $16.51 billion per day the week before. Dealers borrowed $3 billion average per day from the Primary Dealer Credit Facility in the latest week after not borrowing at all the week before.

Round II: Citi Write Downs to Date

Yesterday, we took a look at where Merrill stood to date with write-downs, and with a recent forecast of another $8 Billion more to come from Citi, I thought it was only appropriate to look in their direction (for the record the huge interest in yesterday's entry makes the contrarian investor in me think I have to put some money to use on the long side...)

I again searched all over the web, but was unable to find a cumulative total of write-downs to date for Citi (except here as of 1/18/08, BUT the numbers are flat out wrong - Citi had already hit $28B at this point).

So... below is my attempt to piece together what I calculated at ~$54B (thanks for the tip Nicholas!) based upon statements directly from Citi (linked to below). Again, please let me know where I may have gone awry.
Click to see larger chart:

October 1st, 2007: $5.9B (Pre-release): "Our fixed income trading business has a long history of earnings power and success, as shown in this year's record first half results. In September, this business performed at more normalized levels and we see this quarter's overall poor trading performance as an aberration. While we cannot predict market conditions or other unforeseeable events that may affect our businesses, we expect to return to a normal earnings environment in the fourth quarter," said Prince.

October 15th, 2007 (Earnings date): "As we move into the fourth quarter, we are focusing closely on improving those areas where we performed below expectation, while at the same time continuing to execute on our strategic priorities," said Prince.

November 5th 2007: $8-11B (in chart as $9.5): Citigroup Inc. (NYSE: C) announced today significant declines since September 30, 2007 in the fair value of the approximately $55 billion in U.S. sub-prime related direct exposures in its Securities and Banking (S&B) business. Citi estimates that, at the present time, the reduction in revenues attributable to these declines ranges from approximately $8 billion to $11 billion

January 15th, 2008: $12.9B: "Citi's fourth-quarter results are unacceptable," said Vikram Pandit, recently named chief executive of the company, which is the largest U.S. bank by assets. "We need to do better, and we will do better," he said in a conference call with investors and analysts.

April 18th, 2008: $12.1B: The bank sees "strong momentum throughout the organization. To start with, we're not happy with our financial results this quarter, although they're not completely unexpected given the assets we hold," Pandit later said on the conference call.

July 18th: $7.2B: "We continue to demonstrate strength in our core franchise. We cut our second quarter losses in half compared to the first quarter. The cost of credit increased by 20% from the first quarter, but write-downs in our Securities and Banking business dropped by 42%. " said Vikram Pandit, Chief Executive Officer of Citi.

Aggregate Reserves of Depository Institution...

Does this show what I think it shows? YIKES!

A little further back.

Source: Federal Reserve

Wachovia Non-Performing Assets

For additional data, go here