6 April 2009

The Shell Game

In my previous article I warned that the greatest transfer of wealth in recent history was about to get underway, with the announcement by Treasury Secretary Geithner of the so called Public-Private Investment Program, the PPIP, which aims to rid banks and markets of the distressed assets and toxic loans still ticking away like an inevitable time bomb on the balance sheets of major institutions.

The Shell Game in its original form involved 3 Walnut shells, under one of which a pea was hidden. Sleight of hand whilst the shells were swiftly moved around resulted in the other player, the punter, becoming confused as to where the pea lay and this game became a popular form of wagering and entertainment for the masses.

The modern version of the Shell Game, as used by the leaders of the Government’s financial team uses a much more sophisticated version but the basic purpose is the same. By homologating a number of government agencies together under the shells, the punters, in this case US taxpayers are prevented from seeing either the whereabouts or the size of the pea hidden within. For the average punter, the various rapid fire announcements of bailouts, transfers and recourse plans emanating from several Federal agencies together with an almost total lack of Congressional oversight have muddied this particular playing field, mightily.

$12.8 Trillion so far

If you think you have been keeping track of the various sums of bailouts and industry specific assistance handed out by the US Government and its various functionaries so far you are almost certainly wrong. I stated in an earlier article that the nexus between Treasury, the Fed and other government servants was muddying the waters, and obscuring the extent of the taxpayers’ largess to almost exclusively financial institutions. Bloomberg data now shows that the government and Fed have spent, lent or committed $12.8 trillion, an amount that approaches the value of everything produced in the country last year, to stem the longest recession since the 1930s. Did you get that number? That’s Trillion with a “T”. Bloomberg News 04/02/09

Internationally the world’s largest institutions have only written off $1.3 Trillion (“only” is a very relative concept here), so where has the rest gone? I have no reason to doubt Bloomberg’s data, indeed they are one of a very few who have the resources to collate the myriad of transactions that make up this total, but given the angst and gnashing of teeth that accompanied the TARP and other Congress mandated bailouts, you can see that like an iceberg, the vast bulk of these facilities are undertaken other than in the light of day and under Congressional supervision. A nice example of how these things happen is in the adventures of Maiden Lane LLC, an entity formed to fund JP Morgan’s liquidation of Bear Stearns. Now that entity is to be assumed by Treasury, from the Fed who used a doubtful legal authority to create and fund it initially, so the round robin, devoid of oversight, has accomplished the purpose of Fed and Treasury largely out of sight.

You recall that Treasury and the Fed have refused to disclose the details and circumstances of the payouts to AIG counterparties. Against this background of fiscal tricks, legerdemain and non disclosure, Geithner’s planned PPIP is going to make AIG’s antics look positively prudent.

The PPIP is a many headed monster in the cast of the mythological Greek figure Medusa. It seeks to do many things, but mainly to give the Treasury and US Government cover, as it again undertakes what Hank Paulson quailed at; the purchase by the public purse of toxic securities from banks and other institutions at many times their true value. Last September in my article “The Tinkerbell Treasurer” written exclusively for Financial Sense, I set out for you the simplicity of the proposition that Paulson faced and which eventually he failed to tackle, probably fuelled by a well honed sense of preservation.

That article argued that there were only two alternatives to the massive losses racked up by the marketers, primarily of mortgage backed securities although other asset classes found a place in the packaged CDOs that were cousin to the mortgage backed securities. Those alternatives were to allow the losses to be realised which was politically unacceptable as it would finally lay bare the true insolvency of numerous big name banks and other financial institutions; or for the US Government in one guise or another to purchase those toxic securities at many times their market value, thus handing a “get out of jail free” card to these already loathed institutions. At that realisation, even a giant of a man and Wall Street legend, Hank Paulson’s courage failed him. And thus it was left to the hapless Timothy Geithner to undo the gorgonian knot.

There is more than a touch of irony that this duty fell to Geithner, who as Governor of the NY Fed was the supervisor most absent from duty when these farces were being staged and played out, but in furtherance of the aims of his constituency, the major banks, Geithner has cobbled together a series of measures that aim to artificially inflate the price of residential housing, purchase the distressed assets from the chosen players at many times their market value and provide a screen behind which the Government can fudge accountability for this massive economic transfer which is just econospeak for “gift”.

While this is being trumpeted as no less than a win-win-win situation by Bill Goss of PIMCO, one of Treasury’s anointed, it is highly likely to be yet another loss-loss-loss for the US public, and that means you, sport.

The PR version of the game goes like this:

April 2 (Bloomberg) Geithner’s Public-Private Investment Program, or PPIP, promises to boost prices enough to encourage banks, insurers and hedge funds to sell their mortgage holdings, freeing them to make loans while creating a potential windfall for investors. Geithner’s plan encourages investors to buy as much as $1 trillion of real-estate assets by using $75 billion to $100 billion provided by the Treasury and government loans. The goal of the Fed and the Treasury since September has been to cleanse banks of troubled assets. The Treasury would match the money asset managers raise to join them in public-private funds. The Federal Deposit Insurance Corp. would guarantee borrowing offered to funds buying loans, while the Treasury and Fed would offer financing to mortgage- securities buyers. The Fed loans may be made available to investors that are not part of the public-private funds.

The real world version has a number of less palatable levers that are telling because they continue to highlight the mindset that leverage is the best tool and crony capitalism the best way to dispense patronage. Just the mindset that the myopic Greenspan and Bernanke relied on in their belief that major banks and other financial institutions were smart, trustworthy corporate citizens who knew how far they could push the accelerator. Consider some of the less reported features of the PPIP:
Purchasers will contribute very little equity or “skin”. Perhaps as little as 3% of the purchase price.
Purchasers will be paid unspecified fees for bidding, cynically perhaps close to the equity value they provide.
Sellers will be paid fees for selling, cynically perhaps as much as their realised losses on the transaction in one guise or another. The stated aim, after all, is to make these institutions whole and replenish capital so nothing is off the table.
95% of the purchasers’ obligations in buying these assets will be provided by Treasury on a non-recourse basis. That means that any losses, and there will likely be plenty of those, are for your account as taxpayers; no risk to the purchasers.
Unlike Geithner’s plan for loans, the public-private funds for securities will be limited initially to only five managers, such as Pimco and BlackRock, already overseeing $10 billion of the assets targeted. That program will buy securities from holders of toxic assets other than banks.

With recourse loans, “toxic” mortgages which have a hypothetical 40 percent annual default probability and only 10 percent expected recoveries, would be worth only 19.7 cents. The type of loans that may be sold, New York-based Citigroup analyst said in a March 27 report, include $93 billion of commercial mortgages that are probably carried on the books of banks at 65 cents to 75 cents on the dollar because they were meant to be packaged into bonds.

As usual the sensible calls of alarm from knowledgeable dissenters only made the fine print. Nobel prize-winning economists Paul Krugman, a professor at Princeton University in Princeton, New Jersey, and Joseph Stiglitz, a professor at the Business School of Columbia University in New York, blasted Geithner’s plan for putting the taxpayer on the hook for losses with what they say is little likelihood of success. “The Geithner plan works only if and when the taxpayer loses big time,” Stiglitz wrote in the New York Times this week. “With the government absorbing the losses, the market doesn’t care if the banks are ‘cheating’ them by selling their lousiest assets, because the government bears the cost.”

The valuations of these securities with or without recourse funding is stupefying and doesn’t advance the argument. In essence what Geithner has constructed for his mates, is a premium free option on a bunch of toxic assets if they will but warehouse them to get them off the banks’ books. That mechanism allows vastly inflated prices to be paid which enhances the fiction that the bank losses are far less than reality. And it gives the anointed players a risk free carry that may well pay off and at any rate earns substantial fees.

Hidden quietly in the middle of the AIG shouting match was the quiet roll over of the Financial Accounting Standards Board to the demands of House Democrats:

March 30 (Bloomberg) -- Four days after U.S. lawmakers berated Financial Accounting Standards Board Chairman Robert Herz and threatened to take rulemaking out of his hands, FASB proposed an overhaul of fair-value accounting that may improve profits at banks such as Citigroup Inc. by more than 20 percent. The changes proposed on March 16 to fair-value, also known as mark-to-market accounting, would allow companies to use “significant judgment” in valuing assets and reduce the amount of write downs they must take on so-called impaired investments, including mortgage-backed securities. FASB’s acquiescence followed lobbying efforts by the U.S. Chamber of Commerce, the American Bankers Association and companies ranging from Bank of New York Mellon Corp., the world’s largest custodian of financial assets, to community lender Brentwood Bank in Pennsylvania.

Former regulators and accounting analysts say the new rules would hurt investors who need more transparency, not less, in financial statements. Companies weighed down by mortgage- backed securities, such as New York-based Citigroup, could cut their losses by 50 percent to 70 percent.

So if you are wondering what is inspiring the present US Equities rally, look no further. A little massaging of balance sheets and the transfer of shareholders’ losses to the American public will always be looked on as a good deal for Wall Street. Assurances that the same old Shell Game will continue as before, were of course heart warming news to the same old players who but for the Government’s insistence in avoiding the intended consequences of the bankruptcy laws would long ago have departed.

America, UK, Europe and the great Lands Down Under enjoy characterising themselves as countries of laws. Indeed the Rule of Law is the backbone of civilised nations. That the laws are selectively applied at the highest levels is one of the principal understandings of promoters of the Shell Game. Despite protestations to the contrary, the game never changes. Just shells and a pea.


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