Kiss Your $700,000,000,000.00 Goodbye

This week the U. S. Congress passed and the President signed legislation that authorizes the Secretary of the Treasury to buy up to $700 billion of securities from certain companies. This is a bailout of Wall Street firms or a rescue of the U. S. banking system depending upon your viewpoint or degree of skepticism or cynicism of government.

Many politicians of both flavors are predicting that the taxpayers--meaning the citizens of the United States whether they pay taxes or not--will receive part of these funds back, all of these funds back, or may even make money on the deal.

It is my opinion this money will not come back to the treasury in any noteworthy amount. Here’s why.

Certain banks and other financial institutions are holding assets in the form of CDO’s (Collateralized Debt Obligations) and derivatives of CDO’s know as Credit Default Swaps that are not liquid…meaning no one now wants to buy them at a price at which the owner is willing to sell.

Under an accounting rule known as “Mark-to-Market” the firms holding these assets are required to value them at the market price. This has resulted in the value of many of these obligations being valued as low as 22% of their “value”. Since these firms hold great quantities of these instruments (bad management decisions) this greatly reduces the asset side of their balance sheet and thus they have to hold onto more of their cash to meet reserve requirements. This greatly reduces availability of funds to loan. Also since they may not trust the financial condition of their brothers they may not want to loan to them since they fear they may not get their money back (freezing-up inter-bank borrowing). You can quantify this reluctance by checking the daily LIBOR rate.

The bailout/rescue legislation is designed to provide a buyer for these “toxic assets” and restore liquidity and trust to the financial system.

Easy enough, but why won’t these obligations be salable by the government at some later date when the system is again healthy?

The collective value of our homes (and mortgages on them) is a very large number— trillions of dollars. Wall Street makes its money, in part, by taking a small percentage of the money that passes through its hands. In theory this “bite” allows the firm to provide liquidity and trust to the economy. The home mortgage number was just too large for Wall Street to ignore.

In an effort to compete with Fannie Mae and Freddie Mac (implied government guarantee at the time) and Ginnie Mae (implicit government guarantee) Wall Street, led, I believe, by Goldman Sachs, bought these mortgages in competition with the above entities through companies such as Countrywide. They collected the mortgages and then repackaged into Mortgage Backed Securities to spread the risk. But many of their clients could not buy securities that did not have a high rating from the likes of Moody’s or Standard and Poor’s. So the clever Wall Street folks took packages of mortgages, often sub prime since they carried higher interest rates) and repackaged them into what are known as Tranches (French for slices). They divided them into 10 or 11 slices. The top (senior debt) CDO’s were to be redeemed with principal and interest from the first funds received from the mortgages. The bottom was to be redeemed with principal and interest from the last funds received from the mortgages.

The top level tranches received high ratings from the rating agencies. This allowed them to be sold to certain entities such as state government retirement funds that were prohibited from owning low or unrated securities. These carried the lowest interest rates. The bottom levels carried high interest rates (and book value) and were generally unrated by the agencies. Generally the banks/institutions were not able to sell these CDO’s based on the lowest level tranches.

These bottom-level tranche-based CDO’s comprise what has become known as Toxic Assets.

Since home values will have to retrench, i.e. drop, to bring the housing market back into balance and have a reasonably active housing market the underlying value of the low-level tranches must also decline as the first-to-default/short-sell will result in a truncated income stream that will NEVER reach these lower level CDO’s whose value is based on these bottom-tier tranches.

Guess which securities the Secretary of the Treasury will buy?

Why was the only solution to bank/institution liquidity offered by the Secretary of the Treasury the purchase of these unwanted securities?

Guess where the Secretary of the Treasury was previously employed…yep…Paulson was a former CEO of none other than Goldman Sachs (GS). He must own hundreds of millions of dollars of GS stock.

I would like to short these securities that the government will buy…any takers?

This is somewhat simplified for ease of understanding--mine. For example, the fact that CDO’s are based on an income stream coming from certain tranches and not tranches themselves does not change the underlying risk to you the holder of the national debt. I have not discussed derivatives used, in theory, to reduce risk. The real damage to the institutions was to over leverage. They did this since it allowed them to make a bite of a much larger stream of funds. Leverage of 25 times was not uncommon. That is why such a small number of foreclosures-- to date 4% of sub prime mortgages-- has created such a large ripple.