Affordable Housing Institute : US

[Continued from yesterday's Part 1.]

What do you do if you own assets that you think are worth much more than Treasury is willing to pay for them, but Treasury is the only buyer and you’re a bank under enormous capital pressure?

What do you do?

You jump.

I didn’t make millions at Goldman Sachs by being a dummy

 

Though the price is below the current carrying balance, in selling your questionable asset, you get $4,250,000 cash money, and you get a release of $650,000 of additional cash.  Your bank now has $4,900,000 of good capital.

 

On balance, I’m better off selling

 

Either way, the financial system – and with it, our economy and the global economy – gain a huge lift.  All of a sudden, you have cash to spend, and no more headaches about this painting you just sold.  As the New York Times quotes President Bush:

 

 “There is now widespread agreement on the major principles.  We must free up the flow of credit to consumers and businesses by reducing the risk posed by troubled assets.”

 

Reduce risk, free up cash; reinvest the proceeds in the economy; grow the country.

 

That’s the plan, and it requires clearing out all these dodgy goods.

 

Back to you the owner of that dubious Vermeer.  In your heart of hearts, you’re convinced it’s the genuine article, and it should be worth $7,000,000 – but you’ve taken the $4,250,000 cash, and you’re happy.  Somewhere, Hank Paulson is smiling.

 

I don’t know much about art, but I sure know a bargain.

 

That Hank Paulson – and through him, we taxpayers – will be smiling is the postulate of a provocative Wall Street Journal op-ed that I referenced yesterday, by reformed born-again retired hedge-fund manager (and author of “How We Got Here,” Collins, 2005), Andy Kessler:

 

The Paulson Plan
Will Make Money
For Taxpayers

 

My analysis suggests that Treasury Secretary Henry Paulson (a former investment banker, no less, not a trader) may pull off the mother of all trades, which could net a trillion dollars and maybe as much as $2.2 trillion — yes, with a “t” — for the United States Treasury.

 

With a capital T and that rhymes with P and that stands for profit!

 

He starts by asserting that Secretary Paulson’s two biggest bets are already in the black:

 

Taxpayers will get their money back on AIG. My models suggest that Fannie and Freddie, on the other hand, are a gold mine. For $2 billion in cash up front and some $200 billion in loan guarantees so far, the U.S. government now controls $5.4 trillion in mortgages and mortgage guarantees.

 

Fannie and Freddie each own around $800 million in mortgage loans, some of them already at discounted values. They also guarantee the credit-worthiness of another $2.2 trillion and $1.6 trillion in mortgage-backed securities. Held to maturity, they may be worth a lot more than Mr. Paulson paid for them. They’re called distressed securities for a reason.

 

Good stuff cheap, reads the tag line at Building 19, a Massachusetts discount reseller of just about anything.  No frills, no salesmanship, not at lot of explanation, but a cheesy pulp-printed flyer with tacky cartoons listing all the large consignments of stuff for sale. 

 

They’re sprawling warehouses with stuff piled higgeldy-piggeldy, salvaged from bankruptcies, fires, overstock – you name it, if it was legal and somebody wanted to offload it, you can find it here.  For over thirty years, Building 19 and its offspring have flourished selling marked-down goods as-is, where-is.  Buyer beware; buyer be alert; and there are bargains to be found: quality products once you get past the water-damaged boxes or cover nicks. 

 

Many is the hour the Careful Shopper has browsed their aisles, looking for – well, for bargains.  Whatever’s a bargain.

 

Is this a bargain?

 

That’s the store – Building 700,000,000,000 – Treasury is preparing to open now. 

 

Now Mr. Paulson is pitching Congress for $700 billion or more to buy distressed loans and CDOs from the rest of Wall Street, injecting needed cash onto balance sheets so that normal loans for economic activity can be restored. The trick is what price he will pay.

 

Exactly right.

 

Better mortgages and CDOs are selling for 70 cents on the dollar. But many are seriously distressed (15-25 cents on the dollar) because they are the last to be paid in foreclosures. These are what Wall Street wants to unload the quickest.

 

Mr. Kessler echoes our poker-bluff judgment above:

 

Firms will haggle, but eventually cave — they need the cash. I am figuring Mr. Paulson could wind up buying more than $2 trillion in notional value loans and home equity and CDOs for his $700 billion.

 

In other words, Mr. Kessler thinks that for every $1 he spends, the Treasury secretary will own $3 worth of paper.

 

You think I’ve got something up my sleeve?

 

So the U.S. will be stuck with a portfolio in the trillions of dollars in bad loans and last-to-be-paid derivatives. Where is the trade in that?

 

There are risks: the paper might be really bad:

 

“What, me worry about redemption?”

 

The thing is, most of those questionable Vermeers will be the real thing.  With proper care and asset management, they will recover their value. 

 

Further, I’ve previously observed that securitization created blockages to loan resolution because it sliced up the obligation into many different pieces.

 

Tranches?  I don’t like tranches

 

When Treasury buys back such large loan books, it ought to be able to reassemble many of the pieces into something that looks a heckuva lot more like a whole loan.

 

Worth more when the pieces are put back together

 

Once reassembled, Treasury (or its asset resolution agents) should be able to offer loan restructurings, discounted payoffs, and other quick-settlement methods that don’t make sense for an investor who holds only a narrow slice, but make enormous sense for a buyer who has bought at a discount.

 

Even without such added values, Mr. Kessler’s calculator is optimistic:

 

You can slice the numbers a lot of different ways. My calculations, which assume 50% impairment on subprime loans [meaning the lender group recovers 50% of face value – Ed.], suggest it is possible, all in, for this portfolio to generate between $1 trillion and $2.2 trillion — the greatest trade ever.  Every hedge-fund manager will be jealous.

 

He also observes that when the sovereign makes a bet, the sovereign has ways of helping make the bet a good one:

 

The Treasury and the Federal Reserve get to cheat. It’s not without risk, but the Feds, with lots of levers, can and will pump capital into the U.S. economy to get it moving again. Future heads of Treasury and the Federal Reserve will be growth advocates — in effect, “talking their book.” While normally this creates a threat of inflation and a run on the dollar, and we may see dollar exchange rates turn south near term, don’t expect it to last.

 

We don’t like runaway inflation

 

Mr. Kessler’s more sanguine about the prospects of medium-term inflation than I am, but let him have his head.

 

With Goldman Sachs and Morgan Stanley now operating as low-leverage bank holding companies, a dollar injected into the economy will most likely turn into $10 in capital (instead of $30 when they were investment banks). This is a huge change. Plus, a stronger U.S. economy, with its financial players having clean balance sheets, will become a safe haven for capital.

 

The US has long been seen as generally the world’s best place to invest long-term.  

 

Europe is threatened by an angry Russian bear. The Far East, especially China, has its own post-Olympic banking house of cards of non-performing loans to deal with. Interest rates will tick up as the economy expands — a plus for the dollar. Finally, a stronger economy driven by industry instead of financials means more jobs, less foreclosures and higher held-to-maturity payouts on this Fed loan portfolio.

 

At least Mr. Paulson is following the first maxim of the bargain-hunter:

 

Buy low.

 

Time to buy?

 

 

UPDATE: Linked by Mickey Kaus of Slate:

 

Tuesday, September 30, 2008

TARP, Baby! Veteran Fannie Mae critic David Smith builds on Andy Kessler to explain why Paulson’s “troubled-asset” purchase plan may make sense. The taxpayers could even make so much money that the government could fund … national health care! (Take that, Jim Lehrer.) …

 

Kaus tries to ward off being reverse-linked by AHI

 

As usual, Smith’s post is exceptionally easy to follow for those (like me) who don’t understand fancy financials. It’s a particularly useful antidote to Krugman’s critique–which seems to assume, in at least one of its forms, that the government will only pay the current, going, distressed market price for the assets it buys. Smith argues it could pay more than this going, “immediate” “market” value and still a) be driving a reasonably hard bargain, b) boost the economy by freeing up capital, and c) make money down the road. ..

 

In part that’s because the market in “troubled assets” isn’t completely rational right now, something that shouldn’t surprise leftish economists. In part it’s because, as Smith and Kessler note, the government (unlike an ordinary purchaser) can goose the economy to make sure its “troubled assets” regain some of their value….

 

Two obvious problems: 1) Goosing the economy usually means inflation. Kessler is not wildly convincing on why this isn’t a threat; 2) Smith seems to assume that of course real estate will bounce back if the economy does. But why? A bubble is a bubble. A growing economy didn’t bring back the tech stocks that were overpriced in the 90s–unless someone got rich off their old Pseudo.com stake without telling me. …

 

Smith responds (via e-mail):

Two points. (1) Smith’s Law of Inter-generational Revenge: Inflation is the revenge the young take on the old for the previous generation’s overspending. Yes, I expect inflation to rise, and the question is whether its rise stalls the economy. (2) Unlike tech stocks, which rode on anticipated future earnings, real estate has earnings (homeowners’ cost of occupancy); and real estate is a necessity, not a luxury. You can consume less or more real estate, but you’ve got to occupy something.” …

 

 

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