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Friday Notes

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Hang on, help is on its way!

Fri, Sep 26 2008, 12:21 GMT
by HVB Group Global Markets Research

HVB Group

• Bail out. Despite some resistance, there has been convergence on the basic principles of a rescue plan for the US financial system, although a final agreement will not be reached until the weekend. But the result will be a substantially modified program, as the original Paulson plan faced resistance from both lawmakers and financial experts (pages 2-6).

•  Reworking. Major concessions can be expected in terms of help for beleaguered homeowners, of strict oversight, strong compensation standards for executives at participating firms, and an equity position for taxpayers in the companies that accept public funds, providing upside potential once bank stock market valuations increase.

• Patience. Nevertheless, it will be some time before a plan is fully implemented. Furthermore, history teaches us that even then months can still go by before markets and the economy gain ground again. The crisis is not over yet, and the specter of recession remains with us.

• Credit crunch. The latest economic numbers were disappointing. The tightening of US lending standards was followed by a slump in lending (pages 7-9). The fear is that this picture will be repeated in the eurozone, where purchasing manager indices already sounded the alarm.

• Hope. Support is, however, coming from the lower oil price. We revised down our forecast for 2009 to USD 105 (2008: USD 110; pages 12-15). That is not only bolstering purchasing power but also triggering a decline in inflation and inflation expectations (page 16 & chart below). This creates scope for monetary policy. The fear of second-round effects, however, continues to tie the ECB’s hands for the time being (p. 10-11).

• Further topics:
  

  – Data outlook: Sentiment indicators to remain depressed (page 17).

  – Market outlook: Uncertainty remains high (page 26).

The debate

Markets are watching anxiously as the political debate on Paulson’s Troubled Assets Relief Program (TARP) unfolds. US lawmakers are torn between the sense of urgency that market and economic developments continue to convey – with money market tensions running high and growth weakening – and the desire to devote enough time and attention to the discussion to make sure that the final design of the plan is as effective and fair and possible.

It is a real emotional roller-coaster. Yesterday in the early evening of European time, the announcement that Democrats and Republicans had reached agreement on a set of principles that would underlie the plan boosted market optimism that the TARP could be approved today. A few hours later, however, presidential candidates McCain and Obama said that congressional leaders and administration officials had not yet reached an agreement. And in the early morning hours of today, it transpired that House Republicans had tabled an alternative proposal, a move that threatened a significant delay to the process.

It seems most likely that negotiations will stretch into the weekend, but that a deal will be struck before the opening of Asian markets on Monday morning. The issues at the center of the debate are serious, and have been discussed openly during Bernanke’s testimony to Congress on Wednesday. Lawmakers expressed strong reservations on some key aspects of the proposal: its overall size, whether it should be implemented through asset purchases or capital injections, and the proposed lack of oversight are among the most controversial. In his testimony, Bernanke defended the idea of asset purchases, stressing that the essence of the proposed plan is to restore transparency and confidence in the balance sheets of financial institutions, thereby making it easier for them to attract new private capital, and hence enabling them to resume lending and support growth. He appeared openminded on other proposals, notably on closer congressional oversight, and he dismissed concerns that the program might be inflationary.

One of the toughest and most controversial issues is determining the price at which illiquid assets would be purchased by the Treasury. The choice implies an uncomfortable tradeoff: the lower the price, the smaller the risk to taxpayers, but the harder the impact on the balance sheet of financial institution – —and not only those involved directly in the transaction, as other institutions may be forced into further writedowns once a low price has been established. In fact, if the price is too low it might discourage firms from participating in the program – at least until it becomes clear that the alternative is bankruptcy… It is with this concern in mind that Bernanke suggested assets might be bought at a “hold-tomaturity price” rather than at the “fire-sale prices” that would prevail if firms are forced to sell the assets into illiquid markets. This would help the financial institutions, but would clearly imply a subsidy element, as the root of the problem is exactly that financial institutions cannot hold the assets to maturity and value them at the corresponding price. Arguably that would make sense because (a) the goal is to foster a recovery in the financial sector; and (2) to the Treasury the assets should be worth the “hold to maturity price” since the Treasury can hold them indefinitely. But the question of course is how to estimate the hold to maturity price.

Some lawmakers have strongly argued that the taxpayer should acquire a right in any upside in the financial sector’s rescue through equity or warrants. The basic idea is that if the public sector shoulders the cost and risk of the bailout, it should also share in the gains that might ensue; under Paulson’s proposal, the upside would lie in the possibility that some time down the line the Treasury would be able to sell the assets at a higher price than it paid to the banks. An equity stake would allow the public to share in the targeted improved performance of the financial institutions.

There is a broader public debate on this second issue. Luigi Zingales and Raghuram Rajan at the Univesity of Chicago and Charles Calomiris at Columbia Business School have argued that a much better line of action would be directly targeted at bolstering the capitalization of financial institutions – as replacing illiquid assets with USTs would still leave firms in need of raising new capital. Rajan has argued that large leveraged financial institutions should be forced to suspend dividend payments and to make rights offerings. Zingales favors the enforcement of debt/equity swaps. Calomiris proposes “Matched Preferred Stock” assistance, which would involve combined capital injections by both the public and private sector.

The main argument made in favor of capital injections solutions is that they would directly address the capitalization issue, and that they would bypass the asset valuation problem. Once financial institutions have been adequately recapitalized, markets should unfreeze and the fair price of currently illiquid assets would be gradually discovered through the market mechanism.

In his testimony Wednesday, Bernanke argued that while direct capital injections were indeed the weapon of choice in previous crises, the circumstances now differ: capital injections were used to recapitalize institutions already failed or on the brink, in which case it was logical to wipe out existing shareholders and provide new equity. But in this case we are dealing with ongoing concerns, and there is a risk that if the government were to inject capital it might be seen as taking over the firms at the expense of private shareholders, making it more difficult to raise new capital from private sector sources. Bernanke conceded that capital injections could be used for firms which are on the brink of failure.

It is also not clear, however, that determining the adequate level of recapitalization would be that much easier than determining the adequate purchase price for the illiquid assets. In the end, the needed level of capitalization also depends on the valuation of the assets. In fact, Bernanke’s statements also indicate that unless the asset side of the balance sheet is cleaned up, there is little guarantee that market confidence in the institutions would be restored.

The essence of the proposed plan, Bernanke stressed, is to restore transparency and confidence in the balance sheets of financial institutions, thereby making it easier for them to attract new private capital, and hence enabling them to resume lending and support growth.

Another highly controversial aspect is the degree of discretion and lack of accountability claimed by the Treasury. Paulson and Bernanke have argued that discretion and flexibility are needed to deal with an extremely complicated problem, where learning by doing will help refine the strategy. Lawmakers broadly agree with this, but they want to participate in the learning by doing. Senator Schumer suggested releasing the USD 700bn in stages rather than all at once, arguing that the whole amount might not be needed anyway. Bernanke replied that this might undermine the psychological, confidence-boosting impact of the plan, whereas continued monitoring by Congress might be a preferable solution.

Bernanke addressed and easily dismissed concerns that the TARP might be inflationary. He noted that the program would not amount to a fiscal stimulus – indeed the Congressional Budget Office clarified that the federal budget would record only the difference between the purchase cost and the expected future earnings from the assets. Any impact on inflation would come indirectly through the macro-economy: if the plan is successful, banks will lend more, leading to stronger growth, and Bernanke noted that in this case the Fed might need to hike rates sooner than otherwise. The bottomline here is very simple: the TARP is aimed at partially offsetting a forced deleveraging and credit crunch that would otherwise have a powerful recessionary and deflationary effect; it cannot cause inflation unless it can actually more than offset the deleveraging and quickly boost above-potential growth, quite an unlikely scenario.

There is a strong push for a companion effort to support homeowners, as the idea of pledging taxpayers’ money to rescue the financial sector while regular citizens are left in dire straits is politically highly unpopular. Bernanke recognized the importance of supporting a stabilization and recovery in the housing sector, and highlighted the role that will be played by the Treasury’s control over Fannie and Freddie.

Lawmakers put on the table again the idea of imposing limits on the compensation of the executives of firms participating in the TARP. Bernanke acknowledged that the issue of executives walking away with large payouts after running their companies into the ground and requiring government assistance should be addressed. He cautioned however that linking it to the TARP might discourage participation in the program, whereas ensuring the maximum participation is crucial both to guarantee that the assets are purchased at low prices – through competition in the auctions from participating firms – and to maximize the chances of a successful stabilization of the system.

It seems most likely that stronger oversight and some form of executive pay curbs will be part of the final plan – Paulson’s and Bernanke’s arguments on these two points have been unconvincing. It also seems likely that the plan might include some form of equity participation by the public sector to allow it to share in the potential gains. However, it appears that the basic idea of taking impaired assets off the balance sheets of financial institutions will be retained. We will hopefully get the answers soon. The immediate impact of the final announcement should be positive for equities and could be marginally negative for the USD, but the dollar should recover thereafter. Money market tensions are unlikely to dissipate completely upon the announcement, as it will take time to start cleaning the banks’ balance sheets and thereby reduce perceived counterparty risk. A moderate beneficial impact on money market spreads, however, should be immediate.

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Published on  Fri, Sep 26 2008, 12:34 GMT