Well it looks like I jumped the gun - Paulson's master plan is no RTC. In fact, I'm not sure what it is ... what is clear after yesterday's hearing is that the main problem with this crisis is the unprecedented and excessive complexity of the securities at the heart of the problem which precludes a simple solution. Understand that as presented, this is not a "deal" as such but an abstract concept. No one knows how much it will cost in the end, no one yet knows the mechanism for valuing illiquid assets and, unsurprisingly I guess in light of that no one even knows if it will work. Wheather or not Bernanke was afraid of putting his neck out and making a prediction, in the way that doctors are highly unwilling to offer proabilities on the success of an operation, I don't know. But I could have sworn he outright refused to vouch for its chances, saying only that it was the best they could come up with ...
The plan seems to be to conduct a series of reverse auctions for the problematic illiquid securities. These auctions will be designed by egg-headed game theoriticians to establish fair prices where currently there are none. At the moment, there is no proper market for these securities so they are only sold at distressed levels. Once the sale has been done though, the seller and any other banks holding similar securities are forced to mark their capital to those distressed prices. In this way, I think the argument is, banks' capital is mismarked to give the appearance of being dangerously low when in fact it isn't. And if the scheme can establish a fair price and pay the banks slightly below that fair price but still considerably above the distressed price, then everyone is a winner. The bank wins because they get to mark up the value of their holdings and therefore their capital from the current deeply distressed level to one which is meaningfully higher. Meanwhile the taxpayer benefits too because they will pay less than than fair value for the assets.
But will it work? What if the banks are still too levered even with a liquid market for assets which can be marked at fair value? Loads of the really toxic stuff is held as level 3 anyway and so not marked to market at all. Indeed, last I read Goldman Sachs - to take an example - had $96bn in Level 3 assets, three times its capital ... and what about commercial banks who don't trade as heavily as brokers and so aren't under the same pressure to mark to market? Don't they hold that stuff at model values anyway? Paulson said the heart of the problem was the real estate market. I actually think the heart of the problem is concern that the banking system is under capitalised and in a poor position to withstand the problems in the real estate market. And I'm not sure if the remarking of capital which will result from the greater liquidity and fairer pricing in the toxic areas of concern the scheme will provide will be enough to address that issue.
Markets fell as the hearing progressed. The one month bill yield collapsed from 70 to 10bps ... according to the commentators it was because the bail out looked less likely to be approved ... I have no idea why this stress reapeared in the market, but my heart sank as I realised that any light at the end of the tunnel is distant indeed ... aside from concerns that the plan might not work, it's also clear that it's no quick fix. There will be an auction for each type of security and it will take months to work through each asset, starting with the simplest first according to Paulson. That means the money markets remain frozen for months. Which means no liquidity for the real economy for months. Which means continued deflationary pressure.
I have no doubt that this bill will be passed. The posturing by senators yesterday with the world's gaze firmly on them would have been too good an opportunity to pass up on. It was clear that each one of them understood that the costs of doing nothing would enormous. You don't need to be a student of financial history to understand that the precedent for "letting it burn" was established in 1929/30 and led to the Great Depression and all that societal stresses which followed, including the rise to power of an Austrian oddball with a funny moustache. Which ones will be brave/stupid enough to take that risk? No, the bill will be passed and I'd expect some short term relief in the markets in response. But will it work? Hmmm ... still need to think.
Where does that leave us on the markets? ... Rogers, Chanos and Paulson have all recently restrained their bearishness on the financials. Now Buffet has added even more glitz to the already dazzling list ... futures are higher this morning on Buffet buying a $5bn stake in 30x levered with chunky Level3 assets Goldman Sachs ... hope its a better judgement than his one in Salomon Brothers ... it's being done on distressed terms to be fair, as you'd expect. Munger once said Berkeshire like to insure bridges against fire risk only if they're made of concrete and covered in water. Here, they get $5bn in preferred stock with a 10% dividend abd warrants to buy common stock at $115 at any time in the next five years. GS will also sell $2.5 in a public offering.
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