Equal Time for Roubini

Yesterday I gave space to the ECRI in the post, ECRI Pounds the Table So Hard It May Break. Giving equal time to a more bearish expert, I am linking to a recent Roubini Global Economics Monitor piece, Easing Job Losses Don’t Change Weak Prospects for U.S. Recovery.

In it, the following comment appears:

In a severe consumer-led recession like this one, labor market is a leading (rather than lagging) indicator of economic recovery and the consumer still drives the U.S. economy (private consumption still makes up over 70% of U.S. GDP). A slowdown of the pace of job losses from 650,000 to 250,000 is welcome but in no way offers comfort about a prompt comeback of the U.S. consumer. This raises concerns about the strength and sustainability of any economic recovery that most people are expecting in H2 2009 and beyond.

ECRI is looking at its predictors. It states that these predictors have worked based on a century or so of data. However, ECRI was only formed about 60 years ago. It would thus appear that these predictive algorithms have been formed to fit the prior data. Hmmm . . .

One potential difference between the Roubini approach and that of ECRI may be found in the above paragraph. If consumer wage (and interest) income is now a leading indicator, that might dramatically change the ECRI prediction.

The Roubini approach actually fits the 2000-2002-3 bear market in stocks better than the presence or absence of recession. The recession ended in the fall of 2001; the optimal time to buy the average stock was in late Q1 of 2003, 3 years after the stock market peak. The ECRI asserts that by next year, anyone will be able to look at the data and see a strong, broad economic recovery underway. Yet that was the general case in 2002.

Market action is mixed. The move out of a base by Wal-Mart after mediocre sales and earnings is technically encouraging, and goes along with the rotation one would want to see in a true bull market. On the other hand, McDonald's keeps eroding despite fine operating results; same for FPL. Other quality companies such as Northern Trust trade at unattractive valuations and have so-so charts. I only want to own companies that I expect I would want to own if the stock market closed for a year. MCD and FPL fit that bill. Probably GD and TEVA do as well. At cheaper valuations, ROST and NPK also qualify. All the above companies have strong long-term charts, rising dividends, reasonable to low P/E's, and strike me as generally shareholder-friendly. (No comments herein represent investment advice.)

Except perhaps for periods in the 1930s, there is probably no precedent in Angl0-American financial history in which the net deficit of the central government roughly equaled business profits, as I suspect is the case today. Talk about borrowing from Peter to pay Paul!

As Dr. Roubini punned some months ago, this all may be a "made-0ff" economy.

Caveat investor.

Copyright (C) Long Lake LLC 2009

More on Treasury's Plan for Toxic Assets

Given its importance, perhaps there are some people who would like a summary of comments across the Web on the Obama-Geithner plan to deal with bad assets on the books of large complex financial companies.

Now that I have read numerous comments, I remain appalled.  Please see, e.g., Krugman's analysis in the first section below.  The taxpayer is taking almost all the risk for only half the upside.  Better the taxpayer take all the risk for all the upside.  Even better, the bond holders need to pay.  That's simply how it is in business.  

Two of the leading sites for commentary are Nouriel Roubini's RGE Monitor (subscription required) and the real estate-oriented blog, Calculated Risk (www.calculatedriskblog.com).

Here are excerpts from each website presenting opinions.  In addition,   First, from RGE Monitor:

• Reactions:

• FT Alphaville: At the heart of this complex plan is liquidity, which Geithner has identified as both the problem and the answer. Increase liquidity and assets price will rise towards fair value, banks’ capital ratios will improve and they will start lending again. What if value of assets is low because of reduced cash flow expectations--> see also 'Fire-Sale' Vs. 'Hold-to-Maturity' Prices: Is The FASB Yielding To Pressure From The Industry? 
  
• Alea: The plan is good in theory as private investors have no incentive to overpay because they are in a first-loss position. However, there is likely to be a gap between the mtm value of the toxic assets and what a rational investor would pay, reducing or eliminating the incentive for banks to participate. Only the truly cash-starved banks will jump.
• Blog comments: private investors will take long positions in the selling banks’ stocks (or other long positions in derivatives) and will then have an incentive to grossly overpay for the securities in this program. They’ll gladly take some losses in this program to boost their other positions outside the program.  
  
• Krugman: Huge taxpayer subsidies to the private sector are involved: Suppose that there’s an asset with an uncertain value: there’s an equal chance that it will be worth either 150 or 50. So the expected value is 100. But suppose that I can buy this asset with a non-recourse loan equal to 85 percent of the purchase price. How much would I be willing to pay for the asset? The answer is, slightly over 130 [in a competitive auction.] Why? All I have to put up is 15 percent of the price — 19.5, if the asset costs 130. That’s the most I can lose. On the other hand, if the asset turns out to be worth 150, I gain 20. So it’s a good deal for me.
• cont.: Another way to say this is that by financing a large part of the purchase with a non-recourse loan , the government is in effect giving investors a put option to sweeten the deal.
• John Mauldin (via TechTicker): I'm in the hedge fund business myself but as a taxpayer I don't believe Treasury should subsidize hedge funds.

Next, from CR's post, first showing commentary from Wells Fargo (surprise, they like having money thrown at them) and then CR's personal comments:

“My gut reaction is that this is an excellent plan. This plan will go a long way toward getting banks in better position to lend more aggressively and break the deleveraging feedback loop that is now in place."
Scott Anderson, senior economist, Wells Fargo

I think this is a myth that banks will lend "more aggressively" once the toxic assets are off their balance sheets. To whom? Perhaps Anderson is making the moral hazard argument here - maybe he is saying since the banks (and their investors) are being bailed out with above market prices for toxic assets that they will once again engage in risky lending. I hope that isn't his argument. 

The key problem with the Geithner plan is that it incentivizes investors to pay more than market value for toxic assets by providing a non-recourse loan and with below market interest rates. (See Krugman on the price impact of a non-recourse loan). The investors do not receive this incentive, the banks do. And the taxpayers pay it, so this is a transfer of wealth from taxpayers to the shareholders of the banks.

Finally, I take the liberty of posting all of a somewhat lengthy commentary from the blog Information Arbitrage (www.informationarbitrage.com), because this blogger, Roger Ehrenberg, also presents his own plan and how it is superior, in his view, to Treasury's plan:

March 23, 2009

The PPIP: It's NOT the Liquidity, Stupid. It's the Marks.

You can say something about the current Administration: they are really trying. The recently released Public-Private Investment Program ("Program") details show both a lot of thought and some really good ideas. Unfortunately, the essence of the Program and its messaging are still missing the boat on a few important fronts. The main issue: the Government perceives the problem to be one of investor liquidity and the ability to finance broken asset portfolios. The problem is that they are wrong. It is all about banks not wanting to own up to inflated balance sheet values. But here are some other problems with the Program and its positioning:

• Still enamored with short-term stock market movements. Larry Summers stated that the Administration is "gratified" by the stock market's reaction to the Program. Why, oh, why, do Senior Government officials, especially those with ostensibly high IQs, say such stupid things? Guys, the focus should be on doing the right thing for the long-term, not on what will goose the market for a day or two. And while Summers et al claim to be all about the long term, then why do they keep on talking about stock market reactions to policy decisions? If there is one thing we know for sure, it's that the market is very, very jittery and volatile, and is apt to make sharp moves in response to almost any news. While the Dow could rally 500 points today, it could just as easily fall 500 points if liquidity fears rear their ugly head, another bank runs into trouble, populist rantings by Congress spook the markets, Pandit is given a long-term employment contract, etc. Bottom line: the Administration needs to stop talking about and caring about short-term stock prices. Stock prices are not unlike the Treasury yield curve: easy to manipulate on the short-end, difficult if not impossible to impact for a sustained period on the long end.     

• Forgetting the appetite of the supply side. The Program, with all the benefits provided to approved buyers - equity matching funds, cheap leverage, etc. - lists only a single line when addressing a key weakness: Participant Banks don't actually have to participate. Participant Banks can submit portfolios for auction, Approved buyers can line up, valuation firms can estimate the worth of portfolios submitted for auction, buyers can submit their bids and Participant Banks can say: no. I fail to see how the Program is a material departure from the current landscape, except for the fact that the Government is providing cheap financing. The buyers are still running equity risk regardless of the 1-1 Government match (as they should), and will only submit bids that reflect their assessment of risk and return. This may result in prices that are still far out-of-line with current bank carrying values, causing banks to reject the highest bids in a move to avoid further asset write-downs. So even a protracted auction process could result in a whole lot of nothing. What does Larry Summers think a failed auction will do to stock prices? I shudder to think.

• Perpetuating entrenched and failed managements. The Program is a vehicle for helping broken firms liquify broken asset portfolios. What it doesn't do is help broken firms get rid of broken managements that got us into these problems in the first place. In the rush to protect major lenders from going out of business (and protecting stockholders and debtholders in the process), the US taxpayer is given scant protection from the cadre of poor leadership teams that led firms into troubled waters. Why is AIG the sole whipping boy for the Government when plenty of other firms were complicit in damaging the financial system? While legacy AIG management deserves much of the scorn they've received, most broken bank executives have gotten off with nary a scratch. This I do not understand.

• Not reflecting the true magnitude of the Government's involvement in the numbers. If I read the materials properly, it seems as if the only money being counted against TARP are the equity matching funds being provided. What about the leverage being guaranteed by the FDIC? Depending upon the values realized for the purchased portfolios, those guarantees might come into play, increasing costs well beyond the equity commitments. This is more an issue of truth-in-advertising. While yes, having the private sector side-by-side is a good thing, the Government via the FDIC is providing the debt guarantee. If this isn't incremental exposure to the US taxpayer, then I don't know what it is. This needs to be clearly factored in as an explicit cost of the Program. 

My program, as discussed many, many times on this blog, is different than PPIP in one major respect: it does not rely upon the banking sector's willingness to participate; it forces the issue. Maybe banks will finally be willing to separate themselves from loan and securities portfolios at prices less than their marks. But I don't think so. The Government's plan is predicated upon the assumption that a lack of investor liquidity is the issue. But they are wrong. The issue has almost nothing to do with investor appetite and everything to do with banks avoidance of facing into the market values of their portfolios. And when push comes to shove, they will beg off and avoid selling into auctions that will validate the inadequacy of their capital positions and invalidate the quality of their marks. The only way they will do do is by force. This means Good Bank/Bad Bank, Crisis Style. 

Why is the Government wasting so much time and taxpayer money dancing around the issue? If my read of the situation is wrong and the Program is a smashing success, I'll be the first one to say so on this blog. But if my perception is right - the same perception I've had for, oh, nine months - then I'd like Treasury, the Fed, the FDIC and the President to move quickly to address the toxic asset issue once and for all. The PPIP contains many of the mechanics necessary to pull of Good Bank/Bad Bank: the main difference is compelling the supply side - the big, broken banks - to participate. Guarantee depositors funds without limit. But say goodbye, stockholders. Goodbye, unsecured debtholders. Goodbye, loser managements. Hello private investment in Good Banks. Hello, private investment in Bad Bank assets with profit sharing along with the US taxpayer at current market levels. Can't we just skip the PPIP and go straight to this? Because we know who will participate in my program: Everybody.

Copyright (C) Long Lake LLC 2009