Wednesday, March 25, 2009

Financial Recovery

So Treasury Secretary Timothy Geithner pitched his vision of ridding banks of their troubled assets on Monday (3-23-09).

In essence the Treasury will front some money, the FDIC will guarantee a whole lot more and the private sector partner will also provide a few percent of the total cost. This money will be used to bid for assets being shed by banks. If the trinity make successful bets, they will make a profit off their investments. Alternatively they will make a loss if their bets prove wrong. And since the federal government has fronted most of the cost, it will bear significant risk as well.

The problem assets are truly mind boggling especially for this feeble mind. You start off with homes Joe Schmoe's like us own which are packaged and re-packaged with a bunch of other homes and real estate investments into instuments that are sold and resold across the world. If this isn't a direct participation by Joe Schmoe in the global economy, nothing else is. So when a homeowner pays his mortgage, it trickles up into  the return on investment for a derivative.  It is no longer a bank holding a humble mortgage and using simple spreadsheets to track returns on a real asset.

But that apart, the whole notion of auctioning a banks bad assets leads to a few challenges. 

Firstly many banks are living in a state of denial not unlike us small shareholders who grimly hang on to some of our stocks that have declined precipitiously, hoping for an upswing. For banks, it is more than hope. By continuing to value assets at a higher price than they may fetch in the current market, they can show - on paper atleast - that they meet capital requirements.  So if they sell these assets via auction at reduced prices, they may need to shore up their capital using funds they may or may not have. This is another reason banks are fighting the mark to market rule because this rule forces institutions to value assets at current prices and not at the price of the transaction (buy or sell). By keeping inflated assets in their balance sheets banks can appear healthier than they are.

Secondly of course there has to be a market for the auction. The packaged derivatives may have prevented the Feds from attacking the problem from the bottom that is the individual homes. So they have approached the problem from the top in an all encompassing sweep including all asset classes including derivatives. But an opaque derivative means, the people bidding on the auctions are bidding blind using mathematical models. Remember these models were also used infamously to hike up the prices of the derivatives.

Thirdly, I am betting that the financial community will be happy about participating in the auctions. The financial institutions holding these assets may be more circumspect becauce it may lead to deterioration to their balance sheets, but the companies bidding on the assets are essentially betting on huge returns for an investment of only 6 cents to a dollar. Obviously the higher the bidding goes, the happier the banks will be. And we all know how Wall Street loves speculation.

Examined all together, we are talking of
  1. Still a fundamental lack of knowledge of the assets being purchased
  2. A potential for cleaning out balance sheets but conversely a hit to these.
  3. Mathematical modeling
  4. Large bets being placed  with little of one's own money.
Aren't at least three of these four factors what got us into this mess in the first place? Also, the government is hoping that once the assets are auctioned off, the successful bidder will keep these long term to enable stabilization of the assets, gradually expiring the derivatives and mortgages as people buy the assets and pay them off. However if the successful bidder resells the assets, they may further decline in value. Also, if the underlying asset fails to get new owners, they may deteriorate - e.g. a vacant home getting mold or getting vandalized. This would then further lower their value.

The feeble mind hopes that this strategy pays off. It wishes the government and participants all the luck. Otherwise the coming years will be very interesting and will make 2008 seem like a walk in the park.

1 comment:

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