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ANALYSTS' VIEW: Congress gets $700 bln financial bailout plan
September 22, 2008 / 5:42 AM / 9 years ago

ANALYSTS' VIEW: Congress gets $700 bln financial bailout plan

NEW YORK (Reuters) - The Bush administration on Saturday sent a $700 billion financial markets rescue plan to Congress aimed at stemming the financial crisis that grew out of the steepest U.S. housing slump since the Great Depression.

KEY POINTS: According to a draft of the proposed legislation obtained by Reuters: * The government could purchase as much as $700 billion in mortgage-related assets from U.S.-headquartered institutions. * Decisions by the treasury secretary related to the buyback program could not be reviewed by any court. * In a related move, the U.S. government’s debt limit would be raised to $11.315 trillion from $10.615 trillion.



On proposed federal mortgage bailout:

“It’s going to work. This is what we need to do. There is not enough liquidity in the market right now to put a price on a lot of these securities. It’s becoming increasingly difficult to find a buyer for them. Once the government takes some of the supply out of the market, these securities will trade again. This is a way to get the inventory down.”

“What this program does indirectly is that it will support home prices.”

“Taxpayers can make money off this program, albeit it would be a long time. A lot of the mortgages are still good and they are performing. Still no two mortgage pools are alike and how do you find the proper clearing prices for them?”

“There’s no such thing as an instant fix. There is so much that’s broken.”

On the catalyst for the bailout plan:

“What is too big to fail? It was Lehman.”

The Primary Reserve fund “broke the buck because of the Lehman bankruptcy. Institutions started withdrawing money from money market funds. The money market froze up. Businesses can’t finance inventories because they can’t sell their commercial paper. The FHLB (Federal Home Loan Bank), which was selling $50 billion in discount notes a month, couldn’t sell those notes.”

“On top of that, institutions pulled money from their prime brokerage accounts at Morgan Stanley and Goldman Sachs. They didn’t have any more securities to lend out. That drop in liquidity was a wake-up call.”

On the Federal Reserve and other central banks:

“I don’t think it’s necessary for foreign central banks to play this game” - on other central banks needing to set up their own mop-up funds for bad mortgages.


”It looks like it was as expected.

”As unthinkable as it is that we have to take these extraordinary measures, it was absolutely necessary to do so to stop global markets from freezing over.

”While this is only for US banks, we live in a flat world and I would expect there would be coordination between the central banks and governments.

”I don’t know if this will do the trick.. We are in unchartered waters and this is a live litmus test.

”We don’t know what stocks will do next week.. we would expect extreme volatility to continue.

“I think there will still be political jawboning but I think both democrats and republicans will realize these measures are absolutely necessary and it is the obligation of the house and senate to trust in the leadership here. This should not be politicized.”


”The plan is pretty much what I thought it would be and it is a very poorly crafted plan. When you go into negotiations the last thing you want to do is assure that you will purchase the assets -- now the bargaining power of the Treasury is left on the curb. So the banks will be able to negotiate a much better deal than they would normally have got.

”If you go into an agreement to purchase a house, and you are negotiating. The one thing you don’t want to say to the seller is “I have to buy this house.” You’ve lost your negotiating power.

”Another poorly crafted bit of this: when you plan on issuing $700 billion that amount is accrued the already skyrocketing annual deficits. Now these skyrocketing annual deficits will put pressure on the federal reserve to monetize the debt away. If the Federal Reserve refused to monetize the debt, the sharply rising annual deficits will lead to sharply rising Treasury yields which will counteract and negate all what Treasury is trying to do to reignite the housing market. When you have the national debt at $9.6 trillion and you are adding a trillion plus a year to the debt then the amount of debt outstanding outstrips the tax base.

”What is the end game? You are trying to recapitalize the banks by exchanging non viable and non performing assets putting them on the balance sheet of the tax payer and recapitalizing the banks by sending them cash. Here is where the plan has faults: you are trying to compel the banks to make more non performing loans at a time when the banks are over leveraged and consumers are overleveraged.. Trying to get these banks to lend more money to a consumer who already is overleveraged, its like throwing gasoline on the fire and it is kicking the can down the road a few feet and the problem is going to be a lot more pernicious the next time.

”These banks are getting a great deal. The price of those loans flew on Friday, these banks now have the upper hand. This bid is going to be much better than they are going to get from the free market.

”Foreign central banks are going to rethink about whether they will reinvest in the US. They already got burned with MBS and now buying the Treasury debt that is backing MBS, no thank you.

“This is a very vague plan.”

On stocks: ”Next week is not as important.. Let’s see what happens when they allow short selling again after October 2.

”In the long run this is an extremely poorly crafted plan and it will be much worse than it was. You’re just kicking the can down the road and we have to deal with the a much worse problem further down the road. This is what lies in store for this country: higher inflation, slower growth, higher taxes, just because you didn’t allow the free market to work.

“We are just rolling asset bubbles. There’s no magic here.”


On concerns/questions raised from proposal plan:

“I am concerned about them, but I‘m still a 100 percent behind it. We have to get it done.”

On the range of assets possibly being purchased:

“They need to maximum flexibility to what they can buy.”

On who will manage the fund:

Brenner thinks Blackrock, maybe Pimco, may be used as advisor(s) to buy and manage these assets. Blackrock has the expertise which the Treasury doesn’t and is already do it for the Maiden Lane (Bear Stearns) assets on Fed’s balance sheet.

On the Federal reserve:

“What we need is liquidity. If the Fed can achieve it without lowering rates, it’s okay by me.”

On the government’s efforts in the past week:

“I would give the government a solid B-plus. However, I will give the Fed an A; Treasury B-minus and the SEC up until the last few days a F.”

On expected market reaction:

“I could see this could have legs and we could have a powerful year-end rally.”


”It’s giving them a lot of breathing room to do a lot of stuff and it is extremely vague. It’s scary. This administration has been doing this kind of thing for quite some time, like the Bush doctrine, that give them a lot of power.

”My problem with it is that its not thought out. They are flying by the seat of their pants.

”This could be the medicine that kills the patient, who knows, or it could be the right thing to do. I just don’t know that just throwing money at something is the right thing to do.

”This is probably doing to help a bit, but let’s say they do this, then what is next?

”The stock market is not going to just come right back up it is going to go down again there is going to be more fallout. And what are they going to do next?

”This news was absolutely baked into the stock market because you saw this stupendous rally on Friday. The sad part about this is that the taxpayer will have to pay this money and this will lead to inflation. If you look at the charts it looks like the stock market will sell off on money when the euphoria dissipates.

On political risk:

”There is going to be resistance from some people but I have a feeling it will be rubber stamped through and that it will happen so quickly. I expect it to be washed through in a couple of days.

”You’d think the republicans want it pushed through as fast as possible because they want to look like they saved the world. It’s a political hot potato.

”Obviously we are not going to be bailing out other countries. But if our government pulls this off you will see

stabilization in the market and overseas banks may not have to take write-downs.

“But we’ll see if they pull it off. It also depends on what each of the other countries governments do.”


”Basically, I see three main conditions for resolving the crisis (a slicker marketer would call them “The Three R‘s”):

a) Recognition. We need to find out what the assets on the balance sheets of banks and other financial institutions are really worth, and what the balance sheets of the most troubled institutions look like under a regime of realistic marks.

b) Recapitalization. The US banking system needs a lot more capital. Credit losses are depleting equity capital, and deleveraging increases the required equity capital per unit of balance sheet capacity. So capital infusions are needed to avert a sharp contraction in lending.

c) Relief. In many cases, we need to restructure the loan terms of homeowners who lack the ability (or economic incentive) to service their mortgage. This isn’t just in the interest of the homebuyers, but it’s often also in the interest of the lender (given the cost of foreclosure) and certainly in the interest of the macroeconomy (given the feedback effects between foreclosures, home prices, and economic performance).

”We don’t yet know exactly how the program addresses these issues, especially as far as recapitalization and relief are concerned. At a minimum, however, it should promote recognition by generating ‘market’ prices for illiquid assets. Here’s how this could work. Let’s say $100 billion of the total $700 billion are devoted to the purchase of 2006 subprime RMBS (residential mortgage-backed securities). First, Treasury staff (or an outside money manager) determines a maximum price using a model of expected cumulative loss rates. Then, banks are invited to submit offers. Finally, the lowest $100 billion of offers are accepted at the stop-out price. The stop-out price is then the ‘market’ price for 2006 subprime RMBS.

”Such an auction scheme can lead to greater clarity on both the quality of balance sheets and the fair price of illiquid assets. A bank that sells an illiquid asset marked at 80 (cents on the dollar) at an auction price of 50 has to write down its equity capital accordingly. Moreover, a bank that continues to mark a similar asset at 80 will come under greater pressure to take a write-down (for an ‘available for sale’ asset) or ultimately a larger credit provisions (for a ‘held for investment’ asset).

”However, this particular auction method -- if that’s what they adopt -- also raises some important questions:

a) Credit quality can vary substantially even within relatively narrowly defined asset classes, depending on the originator, the regional concentration, and other factors. This means that if the classes are defined broadly, the Treasury will end up with the lowest-quality assets, driving up its fiscal cost and reducing its usefulness in promoting recognition. However, if the classes are defined narrowly, only a few institutions will own the asset in question and there may not be enough bidders for an auction. So it might make sense to think about alternative, more sophisticated auction mechanisms.

b) There is a conflict between using an auction to price standardized assets and getting the most illiquid assets off books. For example, CDO-squared (collateralized debt obligation) vary a lot more than simple RMBS and are therefore much harder to price in a uniform manner. So an auction scheme may have to be supplemented by bilateral negotiation in certain cases. The latter, however, involves significant asymmetric information problems because the seller knows much more about the quality of the asset than the Treasury.

”In any case, recognition is only a start. In fact, recognition actually increases the need for recapitalization because it brings capital shortfalls out into the open. So it will be important to see how the Treasury proposal addresses this. Do they force banks to seek equity infusions from private investors in a specified time period? Do they simply ‘pay over the odds’ for the assets (this would promote recapitalization but jeopardize recognition)? Is part of the program earmarked for the purchase of preferred stock in banks?

Or is there a public/private partnership scheme such as an issuance of publicly financed puts in exchange for warrants for would-be private investors?

“Regarding the third condition -- relief -- they needs to decide what to do with the newly purchased troubled loans. Large-scale loan modifications are likely, but the devil is in the detail. Do they just reduce the interest rate to enable homeowners to meet their monthly payments? Or do they also write down the principal to give homeowners an economic incentive to keep servicing their loans? The former is more cost effective and limits ‘moral hazard’, but the latter may be more effective in maximizing recoveries given the cost of foreclosure and resale.”

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