The Mother Of All Bailouts
September 29 – October 10, 2008
People have a right to be angry. The financial system is in a sorry state. There will be plenty of time to assign blame. Over the next couple of years, Congress will institute reforms to prevent the same thing from happening in the future. However, right now, the focus should be on getting us out of the mess – or at least limiting the downside impact on the overall economy. The Treasury’s bailout plan is not a cure-all. The economy will remain weak in the near term (at least into the first half of 2009). However, the consequences of inaction would be much more severe.
There was a lot of misunderstanding and misrepresentation of the Treasury’s draft proposal. The primary goal is not to bail out “Bush’s friends” or “Paulson’s golfing buddies.” Some individuals and companies will benefit (for example, Warren Buffet, following his investment in Goldman Sachs). Rather, the bailout plan is meant to prevent the economy from weakening a lot more. Critics of the Bush Administration have had a lot to quibble about over the years, but Treasury Secretary Paulson’s heart is in the right place on this one. He is focused on the greater good.
Burdened by illiquid assets, banks and other financial institutions have struggled to raise capital and deleverage. Banks have been increasingly reluctant to lend to each other and even to their best customers. While the Fed lowered rates earlier this year, banks have continued to tighten terms and standards on a wide range of consumer and business loans. These troubles have reached crisis levels in the last few weeks. The demand for liquidity has surged and the cost of interbank borrowing has risen. Strains are quickly working through the lending system. For example, medium-sized businesses, which often rely on short-term loans (to meet payrolls, etc.), are having a tougher time obtaining credit. Those that can get credit are paying a higher price to borrow. Simply put, loan creation is what drives economic growth. A lack of lending would coincide with a weak economy. A contraction in lending would be consistent with a severe recession.
Under the plan, Treasury will issue debt and use the proceeds to buy illiquid assets, mostly mortgage-backed securities. In buying these assets, Treasury will effectively create a market for them. As Fed Chairman Bernanke described it, one can think of there being two prices for these assets: the fire-sale price (what they could get if they had to sell immediately) and a hold-to-maturity price (the value if held to maturity). Banks have to mark assets to market. Faced with the fire-sale prices, they must raise capital. However, strains should decrease if they can use the hold-to-maturity price. Treasury purchase should help push the price toward the hold-to-maturity level. Banks may still face some difficulties, but the freeing up of liquidity should allow them to get back to the business of lending.
The draft plan, as submitted by the Treasury, was a bare bones outline. Treasury did not slap it down and say “take it or leave it.” In congressional testimony, Paulson welcomed a number of additions to the proposal. In the draft plan, Treasury wrote of the need to make decisions authorized by the plan “non-reviewable and committed to agency discretion” and stated that they “may not be reviewed by any court of law or administrative agency.” That sounds sinister, but is largely financial legalese designed to prevent interference in the mechanics of the plan. If the Treasury is buying securities, it can’t have someone second-guessing the decision to the point where these purchases are nullified. That requires some trust. However, that doesn’t preclude someone from looking over Paulson’s shoulder. Indeed, in his testimony, Paulson welcomed such oversight and the general Agreement on Principles hammered out by congressional leaders stipulates a number of measures on oversight and transparency (ensuring the proper use of funds and preventing waste, fraud, and abuse).
The Agreement on Principles includes a number of other provisions, including standards “to prevent excessive or inappropriate executive compensation” for participating companies. To reduce the risk to the American taxpayer, Treasury will receive some equity interest in the firms that are aided. Congress also requested efforts to modify mortgages of homeowners at risk of foreclosure and required loan modifications for mortgages owned or controlled by the federal government. None of these stipulations was a deal-breaker for the Treasury.
So what happens when the plan passes? The economy will still be weak in the near term. Credit conditions have been strained in recent weeks, but should begin to relax over time. Growth will still be weak in the near term (real GDP growth is increasingly likely to be negative in the third and fourth quarters). The economy will continue to shed jobs. The unemployment rate will head higher. However, things would be much worse in 2009 if the plan isn’t passed.
The Treasury plan isn’t a miracle cure for the economy. As Fed Chairman Bernanke noted last week, “the economy must still confront substantial challenges.” However, the removal of impaired assets from the balance sheets of financial institutions “will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth.”
Happy, Happy, Joy, Joy!
September 22 – September 26, 2008
Financial market difficulties appeared to crest last week amid a crushing demand for liquidity. The Federal Reserve and Treasury have taken on financial problems on a case-by-case basis, helping to prevent a broader collapse. However, financial strains have continued over the last year, and have grown substantially worse in the last few weeks. A broader solution is needed. Treasury Secretary Paulson called for the federal government to create a program, similar to the Resolution Trust Corporation of the early 1990s, to remove illiquid mortgage securities from the market. This is a good news / bad news situation. It’s good that policymakers are actively involved and are taking action to restore the financial system. The bad news is that this isn’t going to happen overnight. A further tightening of credit threatens to prolong the current economic slowdown; yet the alternative of no action would be a lot worse.
First, let’s take a step back and think about what got us to this point. The root cause was excessive lending in the mortgage market. With a political bent, some have placed the start of the problems with the Community Reinvestment Act of 1977, which was meant to provide credit to underserved populations, improving home ownership in inner cities and providing loans to small businesses. However, the CRA impact, while typically seen as a drag on business earnings, is tiny compared to the recent expansion of mortgage debt. Subprime mortgage lending had a small, but justified niche in the credit markets. For example, a recent MBA grad with a limited credit history and starting a family might not qualify for a prime mortgage loan, but would after a few years of working. The subprime mortgage market provided such people an opportunity for home ownership sooner rather than later. The excesses came as subprime lending expanded well beyond its scope. Mortgage originators, interested only in a fee, had little incentive to make sure that the borrower would be able to pay if, for example, adjustable-rate mortgages were to reset at higher levels. Easy credit, fueled partly by a global savings glut, and lax supervision in the industry helped create the bubble. Speculators played a part too, especially toward the end of the housing boom.
Mortgage securitization has been an important success over the years, expanding homeownership and providing opportunities for investors worldwide. The problem was leverage. Fannie and Freddie got greedy. Investment banks levered up, borrowing to buy higher-yielding securities backed by subprime debt. As anyone familiar with the real estate market knows, leverage is great on the way up, but deadly on the way down. If you put 10% down and the asset price increases by 10%, you’ve doubled your money. If the price falls 10%, you’re out of luck. And if the price falls 20%, then you’re in serious trouble. In the U.S., distressed homeowners can simply walk away, leaving the lender with the asset.
A little over a year ago, banks began to distrust each other. Typically, banks might lend to each other on a short-term basis, pledging securities as collateral. However, amid growing distrust, banks were no longer willing to accept subprime mortgage debt and even prime mortgage debt. Treasury securities effectively became the coin of the realm. Inflation has been a major concern over the last year and the federal budget deficit has risen – which would have normally pushed Treasury note yields significantly higher. However, the increased demand for liquidity and continued strong global demand has kept Treasury yields remarkably low. The Federal Reserve began rewriting the playbook last December, creating a number of special liquidity facilities, each designed to substitute Treasury securities for riskier, less liquid assets. Financial problems have continued, but that does not mean that the Fed’s efforts have been ineffective. Rather, conditions would have been much worse if the Fed hadn’t taken action.
The Fed facilitated JPMorgan’s takeover of Bear Stearns in March. The Treasury took control of Fannie Mae and Freddie Mac two weeks ago. Last week, the Fed agreed to lend up to $85 billion to AIG for two years in exchange for an 80% equity stake in the company. These institutions were deemed “too big to fail,” meaning that their collapse would have generated much wider problems within the financial system, yet Lehman Brothers was allowed to fail. Clearly, the piecemeal approach to the financial crisis was not working.
After the collapse of the savings and loan industry in the late 1980s (another example of a lack of oversight and regulation), the government created the Resolution Trust Corporation, which was designed to liquidate troubled S&L assets. The vast majority of assets were real estate. From 1989 to 1995, the RTC closed or resolved 747 thrifts with total assets of $394 billion.
Treasury Secretary Paulson has proposed that Congress create a program similar in style to the RTC. However, while the marching orders for the RTC were clear (here are some real estate holdings, liquidate them), the solution to the current crisis is less certain. The goal, as stated by Paulson, is to remove distressed mortgage assets from the financial system. What happens to the current holders of these assets and how this is all supposed to work is unclear, yet details should be hammered out relatively quickly – and this being an election year, Congressional action could be relatively swift. The tax payer will be left with the check, but the alternative (of not acting) would be much worse.
Is Anybody Worried About The Deficit?
September 15 – September 19, 2008
Last week, the Congressional Budget Office released its latest projections of the federal budget deficit. The CBO is now looking for a 2.3 trillion deficit over the next 10 years. The CBO’s outlook assumes current law (the Bush tax cuts sunset as scheduled at the end of 2010), but does not include additional costs from Fannie Mae and Freddie Mac. CBO Director Peter Orszag said that “the nation is on an unsustainable long-term fiscal course.” Neither of the two presidential candidates is proposing that we get the federal budget deficit back on track.
We’ve come a long way in seven and a half years. Projections of growing budget surpluses were not worth the paper they were printed on, but they were used to justify tax cuts. Those tax cuts may have helped the economy grow faster than it would have otherwise, but it also left the U.S. with a lot more debt.
The federal debt is now approaching $9.7 trillion, $4 trillion higher than in early 2001, and is now back near its peak as a percentage of GDP.
Mandatory spending (mostly Social Security and Medicare) account for more than half of federal outlays (about 11% of GDP, expected to rise to 12.5% in 2018). Nondefense discretionary spending makes up less than 15% of government spending (about 3.1% of GDP). Note that we are currently running surpluses in Social Security and Medicare, but that won’t last forever. The government has been building up trust funds to be applied against future liabilities, but has borrowed against them. Hence, to make good on its promises, the government will have to cut spending in other areas, raise taxes, or (most likely) borrow more.
Given the increased borrowing outlook, why aren’t Treasury yields a lot higher? Strong global demand and increased liquidity needs have help push yields lower, but deficits may crowd out private investment and will limit the scope for policymakers to counter a slowdown.
Tax decisions are more about politics (who pays taxes and when) than economics. Evaluating the proposals of the two presidential candidates presents some challenges. Once in office, McCain or Obama would not be able to get everything they want. Furthermore, what is said on the stump often disagrees with what is described by the campaign staff. The nonpartisan Tax Policy Center puts the 10-year change in tax revenue under Barack Obama’s campaign proposals at $2.9 trillion ($2.6 trillion based on stump speeches) and John McCain’s at $4.2 trillion ($6.9 trillion based on stump speeches). Obama is proposing spending increases and McCain is counting on “unspecified” cuts, which will be hard to achieve.
No one could get elected campaigning on a balanced budget platform since that would entail tax increases or large cuts in entitlements. But is it too much to ask that our candidates realistically address the budget issue? Does it have to be about personality? The sad truth is that we get the government that we deserve.
The opinions offered by Dr. Brown should be considered a part of your overall decision-making process. For more information about this report – to discuss how this outlook may affect your personal situation and/or to learn how this insight may be incorporated into your investment strategy – please contact your financial advisor or use the convenient Office Locator to find our office(s) nearest you today.
All expressions of opinion reflect the judgment of the Research Department of Raymond James & Associates (RJA) at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the foregoing report is accurate or complete. Other departments of RJA may have information which is not available to the Research Department about companies mentioned in this report. RJA or its affiliates may execute transactions in the securities mentioned in this report which may not be consistent with the report's conclusions. RJA may perform investment banking or other services for, or solicit investment banking business from, any company mentioned in this report. For institutional clients of the European Economic Area (EEA): This document (and any attachments or exhibits hereto) is intended only for EEA Institutional Clients or others to whom it may lawfully be submitted. There is no assurance that any of the trends mentioned will continue in the future. Past performance is not indicative of future results.
