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.

JP Morgan 'Fee Income' by Business Segment

Felix at Market Movers details those losses by JP Morgan that reduced their profit (still impressive given the environment - if you believe the #'s) to $702 million:

Interestingly, the bulk of those losses -- $2.9 billion -- came from writing down the investment bank's leveraged loans. During the boom years, it was an article of faith that investment banks needed huge balance sheets, because no one would use their M&A advisory services if they couldn't get cheap loans at the same time.But looking at the scale of these losses, it seems clear that no amount of M&A advisory fees could make up for them: JP Morgan would have been better off financially just simply axing its M&A department altogether.

Breaking out JP Morgan's 'Fee Income' by business segment, I am surprised at how well most have done.



In coming months, we'll see if these other sources of income are enough to outpace what I expect to be growing losses in trading.

Bank Valuations --> Then and Now

Details per Tom Lindmark:

A year ago, ABN (ABN) was purchased by Royal Bank of Scotland (RBS) with some help from Fortis, Santander (STD) and Bank of America (BAC). The purchase price was $100 billion approximately. The chart dismally shows what you could buy today with that money. Once again, the people that should have known what something was worth, what the assets on the balance sheet were truly worth, vastly overpaid. It’s stunning.

Source: The Big Picture

Who Will Save Citi?

With news that Citi will be slashing its workforce by 50,000 people, there is an interesting post / conspiracy theory over at John Hempstead's Bronte Capital detailing how desperate a situation Citi may be in and how Wachovia's troubles created an opportunity for it to be saved (only for that opportunity to slip away).

First lets rewind back to September 29th, when the FDIC released the statement that:

Citigroup Inc. will acquire the bulk of Wachovia's assets and liabilities, including five depository institutions and assume senior and subordinated debt of Wachovia Corp. Wachovia Corporation will continue to own Wachovia Securities, AG Edwards and Evergreen. The FDIC has entered into a loss sharing arrangement on a pre-identified pool of loans. Under the agreement, Citigroup Inc. will absorb up to $42 billion of losses on a $312 billion pool of loans. The FDIC will absorb losses beyond that. Citigroup has granted the FDIC $12 billion in preferred stock and warrants to compensate the FDIC for bearing this risk.

This is where John dives in (FYI- Sheila Bair is the Chairperson of the FDIC):

And so we need to understand the significance of that guarantee. The significance is as follows: Once Citi owns $312 billion in assets on which they can only lose $42 billion the remaining pool must be worth $270 billion. That $270 billion is guaranteed by the US Government – as the FDIC is a full faith and credit organisation. Citigroup can put that $270 billion (plus the $42 billion in non-guaranteed assets) in a pool and repo it – and as Treasuries yield very little they will wind up paying well under a percent of interest. The Sheila Bair decision was equivalent to a cash injection into Citigroup of 270 billion because the repo-market will turn government guaranteed loans into cash.

In other words, while Citi was assuming Wachovia liabilities (i.e. deposits), the guarantee enabled Citi to turn the deposits into cash at a time when cash is king. Back to John:

That cash injection is almost 40 percent of the size of the whole bailout package and it was given to Citigroup by Sheila Bair without congressional oversight. We got all stroppy at giving Paulson that sort of unilateral powers – but – hey – we are prepared to forget that Sheila Bair already has them.

Unfortunately for Citi, Wells Fargo strolled in and pushed Citi out of the picture. It is becoming clearer why it is so important to instill confidence at Citi. Felix Salmon points out over at Portfolio:

If you ask me, Citi's "unique global universal bank model" is in fact its greatest weakness. As of June 30, Citigroup had a whopping $820 billion in total deposits -- but its estimated insured deposits were only $126 billion, and fully $554 billion -- yes, well over half a trillion dollars -- was held abroad.

Felix concludes:

Citi, of course, is big and global, but it's not looking nearly as safe these days as it used to be. And so it stands to reason that a large number of Citi's foreign depositors might be moving their money elsewhere. If that happens, it's hard to see how Citi can survive without a massive cash infusion of hundreds of billions of dollars. All banks are vulnerable to bank runs, but Citi is one of the few which is vulnerable to even a large minority of its foreign customers deciding to take their money out.

I would tend to agree with him on the shakiness of Citi, but I believe the "big and global" nature of Citi makes them an entity that is too big to fail. Whether the FDIC was intending to provide a backdoor bailout or not, I expect something else (policy or entity) to save Citi when necessary.

Source: Bronte Capital

The End of Wall Street / Investment Banking Bonus Matrix

Michael Lewis has a great article titled 'The End' in Portfolio which inspired the investment banking bonus matrix below. I wrote back in September about the Downfall of the Investment Banking Model and he goes 1000 steps further, with details that are only possible from starting out in Wall Street's epicenter in the early 1980's. While I highlight some sections of the article, I highly recommend you go and read the whole thing. He doesn't take long to dive in:

To this day, the willingness of a Wall Street investment bank to pay me hundreds of thousands of dollars to dispense investment advice to grownups remains a mystery to me. I was 24 years old, with no experience of, or particular interest in, guessing which stocks and bonds would rise and which would fall. The essential function of Wall Street is to allocate capital—to decide who should get it and who should not. Believe me when I tell you that I hadn’t the first clue.

The amazing part is that after a while, the pure and absolute ego that drives Wall Street makes those that stay feel like they deserve all this money. Even after ALL that has happened over the past year and a half, they can look you in the eye and honestly say they DESERVE another round of massive bonuses. Does the fact that they have accepted hundreds of billions of taxpayer money stop them? Of course not... every situation can be explained by the Investment Banking Bonus Matrix...

Enough of a rant... back to the article. As Lewis points out in a later passage regarding the supposed "changes" that were made on Wall Street in the 1990's:

The changes were camouflage. They helped distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture.

And he traces this misalignment all the way back to John Gutfreund, the former CEO of Salomon and antagonist of his great book Liar's Poker. John Gutfrend changed the social order of Wall Street by transforming Salomon Brothers from a private partnership into Wall Street's first publicly traded corporation. Why? By doing so:

they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today—market value: $27.) But it made fantastic sense for the investment bankers.

And in a statement that seals my opinion on Gutfrend once and for all, he delivers this doozy:

“When things go wrong, it’s their problem,” he said—and obviously not theirs alone. When a Wall Street investment bank screwed up badly enough, its risks became the problem of the U.S. government. “It’s laissez-faire until you get in deep shit,” he said, with a half chuckle.

A Picture is Worth 1000 Words... Wachovia Edition

Not that any of this is a surprise...

Banks and Brokerages: The Writing was on the Wall

If an equity investor had an eye on credit markets, they would have seen the writing on the wall before the all out financial equity collapse. The cost of borrowing for a AA rated banking and brokerage firm spiked to 50 bps above treasuries from practically nothing from July 27th - September 17th, 2007. Over that same time frame, financial equities (as defined here by the ETF XLF) actually rallied 1%.

Since then, the cost of borrowing for a AA rated banking and brokerage firm has rocketed another 300+ bps above treasuries and financial equities have dropped more than 50%.

Digging a little deeper, comparing the cost of borrowing for a AA rated bank to those rated A or BBB (all Investment Grade), AA's have escaped most of the harm... relatively speaking. Cost of borrowing for A and BBB rated banking and brokerage firms are now both more than 8% wider than the comparable treasury rate.

Before I consider a move back into financials (in the equity market), I'll need to see significant improvement here.

The U.S. Banking System is Over-Rated

In a survey by the World Economic Forum, the U.S. ranked as the 40th soundest banking system. Per Reuters:

The United States, where some of Wall Street's biggest financial names have collapsed in recent weeks, rated only 40, just behind Germany at 39, and smaller states such as Barbados, Estonia and even Namibia, in southern Africa.

and

The World Economic Forum's Global Competitiveness Report based its findings on opinions of executives, and handed banks a score between 1.0 (insolvent and possibly requiring a government bailout) and 7.0 (healthy, with sound balance sheets).

I'd put us significantly closer to a 1 these days...

Are Equities the Least of Our Worries?

Per Paul Krugman:

Stock prices are, however, the least of our worries. The money markets are frozen; the TED spread is 4.14%.

G7 meeting tomorrow, IMF-World Bank over the weekend. Now is the time for major action — an announcement of coordinated capital injections, liquidity measures, and more. If we’ve had nothing except vague assurances by Monday ….

I'd have to agree. Equity market crashes are painful. No credit market = no global economy.

Federal Reserve Bank Credit Balance Swells

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.

Concentration Risk Among U.S. Deposits

With JP Morgan acquiring WaMu's deposit base, they rocketed above Citigroup as the biggest bank in terms of deposits. This increases concentration among the largest five deposit holders to a massive 45% by market share (assuming $7 Trillion in total deposits), but I'm not so convinced that bigger is better.

And further concentration is likely... per CNNMoney.com:

Wachovia is reportedly mulling a deal with another large bank, including Citigroup and Spain's Banco Santander, according to reports published Friday afternoon.

Should Citi and Wachovia merge, the big 3 (Citi, JP Morgan, and Bank of America) would combine for almost $3 Trillion in total U.S. deposits.

Just another data point as to why additional regulation and oversight is so important...

Source: Infectious Greed

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.

Pay for Performance?

Per Barry over at the Big Picture:

With Congress recognizing the public's dismay over this massive taxpayer giveaway, we are starting to see some serious questions about the folks who drove the financial ship of state aground.

Hence, its time to take a closer look at pay and severance packages for CEOs at investment houses, banks and mortgage lenders, who perversely stand to benefit from the public's largesse.

Here's a quick overview:

Goldman Initiates the $7.5B "Buffett Bounce"

Per Bloomberg:

Goldman Chief Executive Officer Lloyd Blankfein is turning to Buffett, the billionaire investor and second-wealthiest American, to boost market confidence even though Goldman hasn't reported a quarterly loss since it went public in 1999. The bankruptcy of Lehman Brothers Holdings Inc. and emergency sale of Merrill Lynch & Co. to Bank of America Corp. on Sept. 15 have fueled fears about firms that rely on bond markets for funding.

Expect the "Buffett Bounce" to fall flat. As reader Scott Frew astutely points out in a post by Yves over at Naked Capitalism regarding the $5 billion preferred portion of the capital raise:

$5 billion of 10% preferred--Goldie's been of late on a $7-8 billion annual net income run rate, so this dividend, which is paid in after-tax dollars, is a significant hit. The warrants are $10 in the money at the moment of the deal, $25 a share in the money not much later as the market reacted. This is not cheap capital for Goldman, to put it mildly.

Is it Time to "Exchange" Your GS / MS Investment for CME?

Per Smart Money:

Goldman Sachs and Morgan Stanley may intensify their use of exchange-traded derivatives to recapture leverage lost by their transformation into federally regulated banks, according to a sector analyst.

This has certainly been a benefit to CME Group shareholders, as the stock has returned a stellar 20% since the Fannie / Freddie Bailout, while Goldman and Morgan Stanley are down 30%+ each.

How Things Have Changed....

WSJ:

In the span of about a week, Raymond James leapt from being the fourth-largest investment banking operation to the largest in terms of market capitalization, even though at $4.58 billion, it is dwarfed by the former bulge-bracket firms that have now completed the 75-year-plus journey from commercial bank, to investment bank, to commercial bank again.

New to EconomPic Data? Check out our Greatest Pics

One of these Investment Banks is not like the Others...

Source: Yahoo! Finance

U.S. vs. U.K.: Relative Use of "Liquidity" Facilities

The Telegraph points out that use of the U.K.'s liquidity facility may be significantly larger than first thought:

When Bank Governor Mervyn King first unveiled the Special Liquidity Scheme in April he indicated that it might be used for £50bn, while debt specialists forecast a total take-up of £90bn-£100bn by the time the scheme closed on October 20.

Alastair Ryan, UBS banks analyst, has calculated that "the take-up could be £200bn or more".

Just how large is that?

Yves over at Naked Capitalism puts it into context:

The UK's GDP is roughly $2.8 trillion. The US economy is a bit under $14 trillion, or nearly 5 times bigger (note that on a purchasing power parity basis, the size difference is even greater, over six times). If you use an exchange rate of $1.8 = £1, that £200 billion is equal to $360 billion. The support to the banking system is roughly 75% of the size of the usage made of the Fed's facilities (remember, some like the PCDF, vary a lot over time, while the TAF seems to be fully subscribed) for an economy 20% as large.

Well, that would certainly explain a portion of the recent Pound sell-off.

Merrill Lynch: 1/4 of All Historical Profits Gone

Per the FT:

Merrill Lynch’s losses in the past 18 months amount to about a quarter of the profits it has made in its 36 years as a listed company, according to FT research. Merrill had the highest ratio of credit crunch losses to historical profits among 10 western financial groups analysed by the FT, which included Citigroup, JPMorgan, Bank of America, Morgan Stanley, Goldman Sachs, Lehman Brothers, Credit Suisse and UBS.

It's almost frightening how much this looks like a previously posted GM Chart...