Monday, March 23, 2009

TARP II redux

What is the government doing?

The government announced more details on their plan to relieve banks of troubled assets. The plan is divided into two parts depending on the type of asset involved. The assets are bank loans and securitized products. The treasury will partner with private sector actors to buy up the assets. With regard to loans the government partnership will work in the following way: the Treasury will put up a dollar of equity for every dollar of equity that the private fund puts up. Then the FDIC will lend $5 to the fund to further gear it up to buy loans. The securitization purchases will be done through an expansion of the TALF and this will be a more complicated process. Most importantly the leverage allowed for securities will be ½ to one or at best 2 to one.

Will it work?

This depends on your definition of the word “work.” The leading danger right now of any government program is the potential it has to backfire politically. These programs seek to defuse that potential issue by making the government and equal equity partner in the funds. So it’s not possible for the the funds to make more money than the government. Of course in the event of losses the government bears the lions’ share of the loss, nonetheless except for large management fees the government is not likely to come under too much fire for the program. My guess is that people will be happy to participate in the program. The issue will be whether the banks wish to liquidate their troubled assets. Very likely this liberal application of risk free leverage will encourage these funds to bid aggressively for the assets which banks may wish to sell and therefore make them more likely to do so. It remains to be seen whether this will actually arrive at asset values that make sense for the taxpayers, investors, banks or some combination thereof. The markets clearly like the plan.

What does it all mean?

Whether it works or not in the big picture depends on whether or not the actual problem of credit is the fact that bank balance sheets are overburdened with bad assets or that many assets are systematically underpriced. You could argue that these are the only problems and if you believe that then this will probably go a long way toward restoring credit in the economy. There is a case to be made, however, that what has just happened has demonstrated to the worlds lenders generally that the levels of credit that have been extended lately are unlikely to be sustainable and will therefore result in a lower level of credit being extended generally. If that is the case then these programs will help but we will not go back to the status quo ante.

What does this mean for the markets?

The S&P is up 7% today to 822. Analysts estimate that the S&P 500 will earn $65 dollars in 2009 implying a P-E ratio of about 12.5, lower than the historical 16 but not unreasonable for where we are in the economic cycle. If you think this is over with and you agree with the $65 estimate then with a 16 PE you get to 1040 so there is still quite a lot of upside. Personally I think the $65 number is high and so far I don’t think the macro-data justifies a 16 PE. It is also my view that though the government’s plan will at least partially achieve the goal of freeing up bank balance sheets and restarting some closed markets I think the level of credit that will be extended in the economy generally will be limited. Given the big move we have had and the potential there is for things to go wrong I think the greater risk is to the downside.
I would prefer to stay on the sidelines until either 1.) the macro data indicates that things are turning around, or 2.) the first few auctions come off successfully and in such a way as to convince me that this is actually addressing the problem.


Adrienne said...

I'd be interested to hear your thoughts on the following: The PPIP gives a LOT of power to the FDIC, whereby first, the FDIC, through a third-party contractor, values the assets and decides what kind of leverage they are willing to extend; second, the FDIC will conduct the auction; third, once the assets have been bought, the funds will be subject to "strict FDIC oversight." I am not sure how hedge funds and private equity firms are going to feel about said oversight. Plus, banks don't actually have to sell anything, so you could, in theory, go through this entire exercise and still end up with nothing (speaking to your point about waiting and seeing if there are any successful auctions).

Additionally I would argue that the financial industry is feeling a little skiddish about the whole 90% bonus tax right now and might think twice about working with any government body. They've said investing funds wouldn't have their salaries capped, but there is a quote in the FT today in Clive Crook's column that puts it well: "The shredding of contracts and the use of the Internal Revenue Service as a bankers' punishment squad are hardly conducive to the 'partnership' the administration of Barack Obama seeks." Hmmm.

Ken said...

All good points. I think the fact that the government participation one for one in the equity of the funds is being sold as enough to blunt potential criticism. If the program works private providers of equity capital won't make any more than the government (not counting the 2 & 20 that is though my guess is that management fees will also be regulated.)

It does surprise me that the FDIC is so involved in this but I think that speaks to the political power of its chair more than to any particular expertise within the FDIC itself.