Continued Volatility in AIG

With AIG down another 6% pre-market, I thought I'd share an update regarding the volatility of AIG after the 100%+ jump we saw in August (hint... it's not letting up). First, as I detailed last month regarding the the volatility in AIG share price:

This type of volaility for AIG shouldn't be all that unexpected. After all, AIG is no ordinary stock. It is just a binary option on the continued bailing out of an entity currently too big too fail. At the end of the day, AIG should be worth $0.00 (i.e. nothing) or a high multiple of its current valuation.

The reason being it is a non-zero probability that the government will hand over billions more to equity investors via subsidized financing of their operations for years to come. How do you model that?

I'm curious if any readers are currently "betting" on the final (or temporary) direction?

Source: Yahoo Finance

$4 Trillion Down... Up to $9 Trillion to Go

Click for Ginormous Chart of Taxpayer Outlays

Source: Bianco Research via Ritholtz' The Big Picture

Update: The above chart is a direct reproduction of the Bianco table. Jake (i.e. me) spent no effort verifying the data, which long time reader dblwyo believes may be off:

My own inspection indicates that there are many different instruments here - that flows are very badly confused with stocks - and that authorities with actual outlays.

That set of mistakes is being made all over, e.g. with the arguments that all the bailouts exceed WW2. Excuse me authorizations for credit authorities are what percent of the real economy and represent what level of disruption in the situation ?

I find it fascinating that the stimulus isn't working at all (not true btw) yet it's more massive than WW2 :) ! Amazing.

When $3 Trillion Seems Like Small Potatoes

The blogosphere is buzzing with the news that the U.S. rescue "could" reach $23.7 Billion after Neil "I Need PR Lessons" Barofsky (the special inspector general for the Treasury’s Troubled Asset Relief Program) said (bold mine):

U.S. taxpayers may be on the hook for as much as $23.7 trillion to bolster the economy and bail out financial companies.

The Treasury’s $700 billion bank-investment program represents a fraction of all federal support to resuscitate the U.S. financial system, including $6.8 trillion in aid offered by the Federal Reserve.

May be is the key. While the Fed and Treasury have spent an unbelievable amount of money to date in an attempt to save the system (which in itself may cause as many problems as it fixes), $23.7 trillion reflects such a worst case scenario that if that were to happen our government's debts are the least of our concerns (I'll let you doomsayers think out of the box with that one).

Further details as provided by the WSJ:

The $23.7 trillion figure also includes total forecast exposure of the Fed, the FDIC, the Treasury — outside the TARP program — as well as the cost of swallowing up Fannie Mae and Freddie Mac, not too mention the potential cost of the enlarged guarantees tied to agencies such as Ginnie Mae. (For the full rundown on everything thrown into the number check out this section of the watchdog agency’s quarterly report.)

Thus, the current balance is more like $3 trillion, which almost seems small after considering $23.7 trillion. Hmmm. maybe Neil Barofsky is better at PR than I first thought.

Source: WSJ

TARP Review: Taxpayers Paid too Much

The Congressional Oversight Panel (hat tip Felix) reports the Treasury "overpaid" for assets from troubled banks in the first round of TARP; especially when compared to investments made from private investors:

The Panel’s review of the ten largest TARP investments the Treasury made during 2008 raises substantial doubts about whether the government received assets comparable to its expenditures.

It doesn't surprise me that TARP paid above market value for assets (intentionally overpaying made it a form of equity injection - I thought this wasn't a bad thing at the time, though what banks have done with that equity has made me rethink that view). As Yves at Naked Capitalism stated back in September:

The intent is to overpay relative to current market prices, and with real estate and the economy headed south, these assets are certain to trade at even lower prices for a very long time. Plus banks will sell the stuff where they think Treasury is overpaying the most, and hang on to those assets that they think have the most upside.

That being said, I completely agree with Felix on his comment that:

If Treasury wants to overpay for bad assets, in order to recapitalize the banking system, then it should do so transparently. What's unforgivable is lying, and saying that you're paying a fair price when you're not.

How Much of the Bailout Money Will Make it into the System?

We've already detailed how Goldman is expected to pay bonuses in excess of the $10 billion equity injection provided by the Treasury. Now, according to Alternet, of the $125B paid to the largest 9 recipients of the bailout to date, only $17B is projected to remain at the institutions:

It turns out that the nine banks about to be getting a total equity capital injection of $125 billion, courtesy of Phase I of The Bailout Plan, had reserved $108 billion during the first nine months of 2008 in order to pay for compensation and bonuses.

Paying Wall Street bonuses was not supposed to be part of the plan. At least that's how Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson explained it to Congress and the American people.

National Debt Jumps $880B Since September

Per Calculated Risk:

The National Debt has increased $880 billion since the beginning of September - that isn't a typo - almost $1 trillion in less than two months as the Treasury raises cash for the TARP and for the Fed's liquidity initiatives.

The National Debt is now $10.53 trillion. Remember when the debt passed $10 trillion? That was on September 30th ... less than one month ago.

Source: Treasury Direct

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.

Senate Passes Bailout....

Congress vs. Registered Voters

And I thought they were only looking out for their own interests (or maybe they misintepreted what those interests were):

Per ABC News:

With the administration and Congressional leaders saying they'll take up the issue again, 51 percent are confident the government's efforts ultimately will prevent the country's financial situation from getting worse. But nearly as many, 47 percent, lack that confidence. And a mere 6 percent are "very" confident of success.

Nonetheless, as noted, voters divide on the plan itself ¬– using up to $700 billion to shore up failing financial institutions – with 45 percent in favor, 47 percent opposed. (Contrary to the vote pattern in Congress, support is higher among Republicans, 55 percent, than Democrats, 42 percent.) Registered voters narrowly, by a 6-point margin, think the plan would have done too much to help financial institutions that got into trouble, and by much broader margins think it would have done too little to help the economy, and especially, to assist ordinary Americans.

What's important is that:

Eighty-eight percent in this ABC News/Washington Post poll, conducted Monday night, say they're concerned the action in Congress could worsen an economic downturn; 51 percent are "very" concerned about it.

Source: NY Times

Calm Before the Storm...

Updated: With the Dow down an incredible 777 points, the title may seem a little odd (in fact it was the title prior to the market open). However, as we'll detail later in this post, 777 points may just be the tip of an iceberg.

While the failed bailout package did remove some of the stigma associated with selling securities to the taxpayer (bailed out companies would still have a tough time hiring new talent after they use the bailout, but it encouraged current management to do so) AND I was wrong that prices paid by the taxpayer would be remotely near intrinsic valuations - click here for more details, it did mention helping homeowners and perhaps the most important change, it included a clause that allowed the Fed to pay interest on reserves (which should open up the floodgates for further Fed liquidity - for the why, go here).

However, it did have many additional holes (per Professor Roubini via Naked Capitalism):

1. The plan is inefficient (i.e., it doesn't discriminate between who ought to be saved or not, and in fact rewards those who created dud assets)
2. It runs counter to the best models of how to deal with this sort of problem
3. It does not punish current shareholders or management

In other words, we have not learned from policy mistakes made in the past as this bailout seems to help out those that are in the worst shape, the most. Per the NY Times:

The Asian crisis teaches us that it is imperative that U.S. policy makers tell us which financial institutions will survive; and which not. This could possibly involve blanket government guarantees to unfreeze money markets. Until this uncertainty is resolved, financial institutions will be reluctant to deal with each other.

In other words, it probably wouldn't have worked... (per Financial Ninja):

Out of 42 systematic banking crises across 37 countries, despite the implementation of a wide range of policies, all resulted in the re-allocation of wealth AWAY from taxpayers and towards debtors (banks). None avoided recessions and all recessions were SEVERE.

Source: Table 3 IMF Report (Table 3)

No Response to a 25% Increase in Fed Liquidity

Ahead of an official bailout, from September 10th through September 24th, the Fed pumped ~$250 Billion of liquidity into the banking system through the Federal Reserve Bank "FRB" credit (the "FRB" credit is how much money the Fed has loaned to the banking system). The FRB credit spiked from $888 Billion to $1,135 Billion. This was an unprecented increase of more than 25% from levels in August and a month over month increase 5x larger than seen after 9/11.

Breaking this down further, we can see the majority of this increase has fallen into "Other Loans".

What are these other loans? According to the Federal Reserve, credit extension to AIG (September 18th), non-recourse loans to U.S. depository institutions and bank holding companies to finance their purchases of high-quality asset-backed commercial paper from money market mutual funds (September 19th), and credit extension to the U.S. and London based broker-dealer subsidiaries of Goldman Sachs, Morgan Stanley, and Merrill Lynch against all types of collateral that may be pledged at the Federal Reserve's primary credit facility for depository institutions or at the existing Primary Dealer Credit Facility (September 21st).

Unfortunately, credit markets didn't respond, thus the need for additional Treasury balance sheet the bailout will provide. Per the WSJ:

“We have a complete disconnect between monetary policy, low interest rates, and low federal-funds rates and credit and banking conditions,” says Adolfo Laurenti, senior economist at Mesirow Financial in Chicago. “Even if fed rates are at 2% and they’re doing whatever possible to inject liquidity into the system, the transmission mechanism is clogged and you don’t see growth.”

That’s why the Fed has responded lately by going nuts. Helped by money it is borrowing from the U.S. Treasury, in the seven-day period ending Sept. 24, the Fed increased its own credit at its reserve banks by 18% to $1.134 trillion.

The Fed is using its funds to buy asset-backed commercial paper and others types of assets from the nation’s banks, who have remained frozen while money-market funds lose their value and investors retreat to the safety of Treasury notes.

We Have a Bailout.... No More Fear

The Good (a deal was needed):

Top U.S. policy makers emerged from hours of tense negotiations with a clear message just after midnight Sunday morning: A deal to bailout U.S. financial markets has been agreed on and all that remains to be done is to commit the legislation to paper.

The Bad (playing on fear):

No matter how you feel about George Bush's credibility, it is unnerving to watch the president of the United States stare his country in the eye and declare that "we are in the middle of a serious financial crisis" and "our economy is in serious danger."

Hmmm.... we've seen that before (via The Daily Show):




I'll provide my thoughts on the final plan later...

Game Theory: Why the Bailout Won’t Work

Lets assume for the time being that there are only two banks; Bank A and Bank B.

The media / political pundits would have you believe the likely outcome of the bailout is the top-left box in which both Bank A and B sell risk assets to the Treasury. In this case, the result is a more regulated banking industry, with imposed limits to salary, but importantly markets clear.

Click for larger table:

HOWEVER, it is in BOTH banks interest to deviate from that.

Why? Simple. If Bank A (or B) believe the other is selling their risk assets to the Treasury; they will each be better off holding on to theirs.

Why? If the other bank sells and they hold, markets will still clear (in theory) and the bank that holds onto their risk assets can sell at the new market prices. This results in increased market share as they:

*Can pay more for talent
*Are less regulated
*Don’t have the stigma of selling to the Treasury (think of what selling portrays to the market)

This is even worse in the “real world” as all banks have the incentive to wait for other banks to sell risk assets to the Treasury to clear markets.

The likely result? The bottom right box in which no bank sells voluntarily and markets remain frozen. While there were many problems with the initial plan, at least there was a 100% incentive to sell the assets.

Update: Thanks for the link Yves from Naked Capitalsim. Her take on my post:

Brilliant, except it assumes that assets sold to the Treasury will be lower than the prices they will later fetch. We think that's completely wrong; the intent is to overpay relative to current market prices, and with real estate and the economy headed south, these assets are certain to trade at even lower prices for a very long time. Plus banks will sell the stuff where they think Treasury is overpaying the most, and hang on to those assets that they think have the most upside. But more of this sort of reasoning is badly needed.

I get where she's coming from. My assumption above was that markets clear if the "other" bank were to sell to the Treasury eliminating the need for all banks to sell to the Treasury. For more on Yves opinion that this is in fact a capital injection (i.e. the Treasury plans to intentionally overpay, click here).

While I agree that the Treasury will pay above market prices, it is my opinion that market prices are artificially low due to many technical factors and a lack of global balance sheet for risk assets (i.e. everyone is selling, not buying). I feel expectations of 10-15% returns based on today's marks, even with very conservative assumptions, are reasonable.

In thinking more about it, they would NEED to pay more for them than currently marked. Unless a bank was insolvent, why would they clear assets yielding 10-15% to make room for new loans yielding 8%? (it also doesn't hurt that the Treasury just needs to beat their unbelievably cheap financing rate - currently under 4% for 10 year bonds).

That being said, I think there is still a huge incentive for each bank to wait for others to clear the market at these higher prices (and people tend to do what's best for themselves vs. shareholders). In addition, while this in theory could clear the frozen credit markets, I think any package of this size should also impact the housing problem, which this does not.

When $25 Billion is Chump Change... Auto's Bailed Out

This slipped through late yesterday; per U.S. News:

With Congress preoccupied with the massive, $700 billion bailout plan for the financial industry, General Motors, Ford, and Chrysler have finally secured Part One of their own federal rescue plan. A bill set to be passed by Congress and signed by President Bush as early as this weekend--separate from the controversial Wall Street bailout plan--includes $25 billion in loans for the beleaguered Detroit automakers and several of their suppliers.

This next comment makes me want to throw up in my mouth:

"It seemed like a lot when we first started pushing this," says Democratic Sen. Debbie Stabenow of Michigan, one of the bill's sponsors. "Suddenly, it seems so small."

Note this is just "Part One" of a likely $50 Billion package (see my previous "Auto Bailout... What's Another $25 Billion" post for more).

Is it Possible the Bailout Might be Profitable?

CRS Report via Zubin Jelveh's Odd Numbers:

Depending on the proceeds from the debt and equity considerations, the federal government may very well end up seeing a positive fiscal contribution from the recent interventions, as was the case in some of the past interventions summarized in the tables at the end of this report. The government may also suffer significant losses, as has also occurred in the past.

One thing is certain... uncertainty.

Bailouts + Packages: Twice the Size of the War on Terror

And this DOES NOT include the potential / likely costs of all the new lending facilities / conversion of Morgan Stanley or Goldman...

War on Delever
Feb. 13: Initial Stimulus Package (i.e. rebate checks)

Mar. 17: Bear Stearns Guarantee

Sept. 7: Freddie / Frannie Bailout

Sept. 17: AIG

Sept. 20: Bail-out Proposal

TBD: Potential Auto Bailout

Just how big is this? It's roughly 2x the size of spending to date on BOTH the Afghanistan and Iraq wars to date... Ladies and gentlemen. We have a new financial war in progress....


Cost of the Iraq / Afghanistan Wars to Date

Cheaper Fannie Financing...

Source: Accrued Interest

Is the Plunge Protection Team Losing Power?

Per The Big Picture:

Another weekend, another bailout, another market reaction:

How many Sunday press releases is it going to take to save the financial system from ruin? If you’re are keeping score at home, this is now the sixth Sunday night/Monday morning press release in 14 months aimed at saving the financial system. Consider the recent history of these weekend rescues:

• Recent Events:
• August 2007, when the credit crunch was officially recognized by the Fed, when they cut the discount rate.
• December 2007, with the announcement of the TAF and other credit facilities
• January 2008 Soc Gen panic, and a 75 bps emergency cut
• March 2008 with the Bear Stearns bailout.
• July 2008 the first Fannie/Freddie rescue attempt
• September 2008 the actual Bailout of Fannie/Freddie

IN A PERFECT WORLD: BAILOUT = END OF CREDIT CRISIS

Over the past few weeks there has been much criticism over the potential (now actual) Government Sponsored Agency “GSE” bailout due to the potential cost to taxpayers, the moral hazard it would encourage, etc... I do not disagree with most of these criticisms, but the cost of NOT doing anything would be much greater. To show the potential benefits of the bailout on both housing and credit markets, which in turn will benefit the economy, below is how the bailout will unfold in a “best case” scenario. While I do not believe it will solve all of the problems detailed below (or even a fraction of them) in this manner, I do believe it is important to look at the bail-out in terms of a "glass half full" and how it can help alleviate the liquidity problems associated with today’s credit markets.

I) BAILOUT DETAILS
Specific features of the bailout that impact the outcome to the credit market include the Feds new liquidity facility, the goal to increase Fannie and Freddie's mortgage-backed security portfolios through the end of 2009, the right for the Treasury to actively purchase MBS in the open market to reduce spread (and cost to future homeowners), and the future goal to reduce the GSE balance sheet by 10% annually starting in 2010. In the first part of my "perfect world" analysis, I predict that these features (and others – go here for 10 key features) will help put a floor on housing prices.

II) RATES MATTER

Homeowners that already qualify for high quality prime loans will not be as impacted directly by the new moves by the Fed. Why? Agency spreads are near historic wides, but absolute levels are already near historic lows.

HOWEVER, borrowers that do not currently qualify for these low rates should see their rates drop dramatically. Why is this important? If a homeowner that qualified for a 9.5% rate can access a 7% government “subsidized” loan, their buying power increases by almost 25% (all else equal).

These “subsidized” loans will prop up the housing market as the size of the payment made is what truly matters for a homeowner (specifically one that intends to live in that home for the foreseeable future). Importantly, these rates are not “teaser” rates that reset, but more manageable fixed rates for the life of the mortgage.

III) THE IMPORTANCE OF ATTRACTING THE MARGINAL BUYER TO THE MARKET
The goal is to entice the marginal buyer to come to the market / have “bad loans” refinance at more manageable rates. In the past 6-12 months potential homeowners have been sitting on the sideline as prices continue to make new lows (nobody wants to catch a falling knife). With the new “bailout” limited time horizon (increasing balance sheet through 2009), this SHOULD bring a sense of urgency for new homeowners (expect emphasis on the "limited time offer" aspect).

If these low rates do put a floor on home prices sooner than later, this should benefit the owners of subprime / Alt-A securities that have priced down as delinquencies have risen at historic levels. If the market bottoms and these owners are able to refinance at the new lower rates, get who gets off the hook? THE EXISTING MORTGAGE OWNERS who get paid back at PAR for all loans refinanced.

IV) BANKS FINALLY ABLE TO DELEVER AND MAKE NEW LOANS
Banks own a lot of these mortgage securities that have priced down and in response, over the past 6-9 months banks have attempted to delever as their equity has been written down / capital has been so difficult to come by. This system wide delevering only caused these entities to be more levered. How is this possible?

Well, if one bank attempted to delever, they’d be successful. When every bank attempts to do so at the same time, it only makes the problem worse! Let’s take a look…

As these banks all sold off assets at the same time, these assets sold priced down in value as the entire market was selling into a distressed AND illiquid market. This in turn reduced the price of assets remaining at the banks. When that happened, they were forced to write down even more assets / equity, resulting in leverage HIGHER THAN WHEN THEY INITIALLY BEGAN.

If these assets snap back even partially in value, the reverse happens. In fact, I expect a portion (maybe a tiny portion) of the underlying mortgages in securities marked as low as 60 cents on the dollar to repay at PAR when homeowners sell to new owners at the “subsidized” rate or are able to refinance themselves. In addition, liquidity injected into the market through the Treasury’s outright purchase of mortgages should bump up the price. The result will be improved leverage ratios at banks, which will slow the asset selling process we've seen from banks. In fact, expect well funded banks to actively buy securities in the market in the coming weeks / months.

It's also important that the bailout makes banks much more attractive for outside investment (think Sovereign Wealth Funds). Once new capital is injected and their balance sheets are improved, new loans can be made. This should result in improved (lower) rates for non-government mortgages.

V) THE CREDIT CRISIS ENDS?
If this all works out as I detailed in the above best case scenario, a functioning credit market at no cost to taxpayers results. What likely will happen? After everything that has transpired over the past 12+ months, I have no idea though I do expect credit markets to more accurately reflect the actual economy and not the lack of liquidity in markets. The result of which might scare investors just the same...