Last week the US legislators approved the Emergency Economic Stabilization Act of 2008 (EESA). The bill is the successor to the Troubled Asset Relief Program (TARP), a simpler version of the same bill which was rejected by the House of Representative days earlier.
What is It?
The measure arms the United States Treasury with $700 billion in capacity to purchase and guarantee illiquid and distressed assets (primarily toxic commercial and residential mortgage backed paper) from financial institutions. The bill also:
· Encourages federal agencies to modify residential mortgages to help stave-off foreclosures. (1)
· Demands that the US government receive an equity stake in firms that benefit from the bail-out funds, in order that taxpayer may participate in potential profits. (1)
· Caps compensation and termination packages for executives of rescued firms. (1)
· Extends a variety of tax relief provisions to tax payers and special interest groups.
· Temporarily increases the FDIC deposit insurance limit from $100,000 to $250,000 and provides the FDIC with unlimited borrowing authority from the Treasury. (2)
Funding is promised in three stages: $250 billion released immediately; an additional $100 billion released with unilateral Presidential approval; and a final $350 billion subject to Congressional disapproval.
Pricing and procedures are left to the discretion of the Treasury, but three primary acquisition mechanisms are anticipated, including:
· Reverse auction: The primary mechanism for purchase is through reverse auction, whereby institutions bid on RFPs and the Treasury fills the order with the most attractively priced collateral. (2)
· Direct purchase: As a secondary mechanism, the legislation authorizes direct purchase of assets in situations where a market mechanism is not feasible or appropriate. This may be used for distressed banks or certain esoteric assets where an auction is not feasible. (2)
· Insurance: The Treasury is also provided the option to guarantee principal and interest payments of assets held by institution, in return for a risk-based premium. (2)
Eligible institutions include banks, broker dealers, and insurance companies, reports Goldman Sachs in its October 3rd US Economics Analyst Issue Number 08/40. These institutions hold of the majority of non-agency mortgage debt. Hedge funds and mutual funds are excluded. The Goldman Sachs’ reports continues, “US subsidiaries of foreign institutions are eligible, but foreign holding companies are not. Non-qualifying firms may sell assets to qualifying firms, but sales to the Treasury may not be for a higher price than the price paid for the asset.” (2)
Will it Work?
Illiquid debt assets on the balance sheets of our financial institutions are the heart of the problem; there is no meaningful market for afflicted institutions to sell these troubled assets. Consequently, value is in a vortex. Jonathan Laing of Barron’s comments “A negative feed-back loop has developed for the banks in their pell-mell rush to deleverage, raise capital and remain liquid. The more mortgage securities they sell, the weaker the prices get, which, in turn, forces even more security sales at ever lower prices in a futile attempt to outrun the credit tsunami.” (1)
The EESA intends to establish a value for these assets, accelerate recognition of appropriate losses, re-balance the capital ratios of participating institutions, increase confidence in short term inter-bank lending, and (it is hoped) clear the log jam in our capital markets. Essentially, the Treasury will attempt to leverage the largest balance sheet in the word (the US Government’s) to break the negative feedback loop that is destroying liquidity.
Some are concerned that $700 billion in asset purchases may not be sufficient to absorb all of the troubled assets. According to the Goldman Sachs October 3rd US Economics Analyst Issue, approximately $11.3 trillion in face-value residential mortgage debt is currently outstanding. Of this, roughly $1 trillion is delinquent or in foreclosure as of the second quarter 2008. Another $150 billion in commercial loans are delinquent or in foreclosure. Given that the Treasury will buy assets at a substantial discount to face-value (Bill Gross of PIMCO estimates 65 cents on the dollar), it is likely that the $700 billion capitalization yields buying power approximately equivalent to the face-value of bad real estate debt. (2)
It is not yet clear how the assets to be purchased will be valued. The Treasury is required to provide guidance within 45 days of enactment (i.e. mid-November) or two days after the first auction is held. Goldman Sachs expects the first purchases in the first week of November. A major purpose of the EESA is to establish a value for troubled mortgage assets that is greater than the current “fire-sale” pricing. According to Goldman Sachs however, congressional testimony and legislative discussions imply that the program should not attempt to artificially infuse capital into troubled institutions by paying inflated prices to buy bad assets. Instead, the Treasury is likely to estimate the intrinsic “hold-to-maturity” value of the securities, and use this price as a benchmark in auctions. (2)
The program will initially focus on helping major money center banks on Wall Street, which hold the majority of the illiquid securities being targeted. However the balance sheets of main street institutions, such as regional banks, are equally troubled by bad residential loans (primarily land and construction debt). It is yet unclear how EESA may benefit or ignore thousands of small banks.
Jonathan Laing in Barron’s dismisses the notion that US tax payers will get stuck with the bill. (3) His analysis (and that of Warren Buffet among others) suggests that the whole endeavor could turn a tidy profit. Indeed, the notion makes sense. The Treasury is taking advantage of an extraordinarily low costs of funds (3% to 4% T-Bills) to “invest” in assets at a historic benchmark low; even with draconian default and recovery assumptions, the Treasury stands to make a positive 7% to 8% yield spread on the purchase.1 What’s more, the Treasury is unhampered by balance sheet ratio requirements or shareholder return expectations that could force untimely liquidation. The sheer volume of the investment may reverse pricing. "Essentially this secondary effect would do much to lift housing out of its funk and actually improve the performance of the securities that Treasury ends up buying," says Jeffrey Gundlach, Chief Investment Officer at major mortgage fund manager TCW Group. "Thus, I think that there's a good chance that the bailout plan will be a win-win for both the taxpayer and the financial system." (3) If the Treasury buys right and holds these assets long enough, prospects for the US tax payer are good.
Notes:
(1) Richard Simon and Nicole Gaouette, Los Angeles Times, October 4 2008
(2) Goldman Sachs, US Economics Analyst Issue No: 08/40, October 3, 2008
(3) “Making a Mint” by Jonathan Laing, Barron’s Cover, September 29, 2008
