Day: January 16, 2009

Time for a Weekend

We don’t try to be a news site – it’s too much work to keep up with everything that happens on an hour-to-hour basis – and generally we try to provide analysis and commentary instead. But right now I just want to note the major turn events have taken in the last few days.

After a few weeks of relative calm – the economy was doing badly, but we knew that already, and there were no major controversies or scandals since the auto bailout and Bernie Madoff – the pace has picked up again. To summarize, in case you were on vacation this week:

  • Bank of America started falling into the abyss, but got a lifeline, just like Citigroup 2.
  • Speaking of which, Citigroup announced that its strategy for the last ten years has been a failure and that it is splitting itself into two banks, a “good bank” and a “bad bank” – but unfortunately it still owns both of them. It also announced $6.0 billion in increased loan loss reserves, $7.8 billion in writedowns on securities, and a $5.3 billion writedown on derivatives (I wonder how much of that affects the $300 billion in assets guaranteed by the government), but nevertheless made an Orwellian assertion of “Continued Capital and Structural Liquidity Strength.”
  • The Bank of America bailout undoubtedly made Congressmen even more mad about TARP, but at the same time all these shaky banks (and personal lobbying by Barack Obama) convinced the Senate to release the second $350 billion (both houses would have had to block it). The vote was 52-42, with 46 Democrats and 6 Republicans voting in favor. From one perspective this is not surprising: the Democrats are supposedly the party of activist government, and it was mainly Democrats who passed the bill in the first place. But seen from a long-term perspective . . . the Democrats are the party in favor of saving big banks? and the Republicans are willing to let them fail? How things have changed.
  • In a story that hasn’t gotten the attention it deserves (no doubt due to general bailout fatigue), Treasury is lending $5 billion in TARP money to Chrysler Financial. Now, is Chrysler Financial a healthy financial institution that just needs a little more capital to resume lending, or is it a systemically significant financial institution whose failure must be prevented? Right, I don’t know the answer either. But I guess after the GMAC bailout it was a foregone conclusion. Chrysler, of course, announced that it was relaxing credit standards and offering zero-percent financing on pickup trucks and minivans. (Full disclosure: I own a minivan.)
  • The CPI declined 0.7% in December (excluding food and energy, unchanged), meaning that in Q4 the CPI fell by about 3.4% (excluding food and energy, it fell 0.1%)., further stoking deflation fears. But again, most of the fall in prices is just the reversal of the run-up in energy prices in 2007-08. Now that oil prices seem to have flattened out (gasoline and heating oil are up slightly), we should be able to see what is going on. I am still in the camp that the Fed will be able to prevent deflation. It’s basically a question of how hard they want to try, and they are afraid if they try to hard they will overshoot and create too much inflation.
  • And Ben Bernanke gave a speech in which he floated the idea of creating a government-sponsored “bad bank” that would buy troubled assets from troubled banks: “Yet another approach would be to set up and capitalize so-called bad banks, which would purchase assets from financial institutions in exchange for cash and equity in the bad bank.” This idea got further support from Henry Paulson and Sheila Bair, and could be the big story of the next week (except for something else happening in Washington on Tuesday). Isn’t this original TARP all over again? Yes, it’s similar, but there are good ways and bad ways to do it. The biggest problem I had with original TARP was that it necessarily involved overpaying for assets; Simon and Peter have outlined one way of avoiding that problem.

Overall, this pace of news, primarily from the financial sector, has not been a good sign over the past several months. It’s usually a sign that things are going to get worse, although there is always some chance that this time we will solve these problems once and for all. And there is a new crew moving into town on Tuesday.

Bank of America Gets Quite a Deal

We have a deal.  You, the US taxpayer, have generously provided to Bank of America the following: one Treasury-FDIC guarantee “against the possibility of unusually large losses” on a pool of assets taken over from Merrill Lynch to the tune of $118bn, and a further Fed back stop if the Treasury-FDIC piece is not enough.  In return we receive $4bn of preferred shares and a small amount of warrants “as a fee”.  There is a $10bn “deductible,” i.e., BoA pays the first $10bn in losses, then remaining losses are paid 90% by the government and 10% by BoA.

We are also investing $20bn in preferred equity, with a 8 percent dividend.  There will be constraints on executive compensation and BoA will implement a mortgage loan modification program.  Essentially, this is the same deal that Citigroup received just before Thanksgiving, known as Citigroup II, which was generous to bank shareholders but not good value for the taxpayer.

This is more of the same incoherent Policy By Deal that has failed to stabilize the financial system, while also greatly annoying pretty much everyone on Capitol Hill.  Hopefully, it is the last gasp of the Paulson strategy and the Obama team will shortly unveil a more systematic approach to bank recapitalization; it would be a major mistake to continue in the Citi II/BoA II vein.

In addition, you might ponder the following issues raised by the term sheet. 

1. The $118bn contains assets with a current book value of up to $37bn plus derivatives with a maximum future loss of up to $81bn.  This is more detail than we got in the Citi deal, so there is evidently greater sensitivity to calls for transparency.  But the maximum future loss is based on “valuations agreed between institution and USG.”  What is the exact basis for these valuations?  From the term sheet, it sounds like we are talking mostly about derivatives that reference underlying residential mortgages.  Absent any other information, my guess is that they can easily lose more than $81bn – depending on how the macroeconomy and housing market turn out.

2. What is the strike price of the warrants?  This was controversial in the Citigroup II deal (because it was unreasonably high), but at least it was quite explicit up front.  The announcement is suspiciously quiet on this point, perhaps due to the recent spotlight on warrant pricing terms.

3. What kind of reporting will there be by BoA to Treasury, and what will be disclosed to Congress, in terms of the exact securities covered by this guarantee and how they perform?  The lack of information is a big reason why TARP became discredited and Capitol Hill is so concerned to see more transparency going forward.  There is nothing in the term sheet that reveals the true governance mechanisms that will be put in place, or how information will be shared with the people whose money is at stake (you and me, or our elected representatives).  I understand there is market-sensitive information present, but there are obviously well-established ways to share confidential information with members of Congress.

Overall, it feels like the latest (and hopefully the last) in a long line of ad hoc deals, which have done very little to help the economy turn the corner.  The new fiscal stimulus needs to be supported by a proper bank recapitalization program, as well as by a large scale initiative on housing.