Big TARP Over Credit Circus

As ubiquitous a word as it's becoming, the current state of affairs for the markets is unprecedented. We've grown accustomed to using the stock market as a guide for the economy's ups and downs, but this time is different. Since credit markets froze, the stock market has become the de facto place for investors to place their bets. But though important, the stock market is only one ring in the current financial circus (I mean crisis). In the other rings are historically mundane but now exotic acts. Among them: commercial paper, the London Interbank Offered Rate (LIBOR), credit default swaps and the so-called TED spread, which tracks the now historically large differential between three-month Treasury yields and the LIBOR. Now that the U.S. government has erected the "big TARP" (for Troubled Asset Relief Plan) over this circus, are we finally nearing the end? The stock market certainly doesn't think so.

After much drama, the Emergency Economic Stabilization Act of 2008, also known as the TARP, passed both the Senate and House, and was signed into law on October 3. For those blissfully unaware of the TARP, it empowers the U.S. Treasury to buy troubled assets (TAs) from financial institutions at distressed prices, or even make direct investment into the institutions. It's being broadly termed as a "bailout," but that's not a term we use to describe the rescue plan. The $700 billion is not being handed to these troubled institutions; it's being used to purchase TAs at distressed prices—and could ultimately make money for taxpayers.

The rescue plan's execution is key, of course. Given the outsourcing of the assets' management (excluding a bare-bones internal staff), the U.S. government is effectively forming, in short order, one of the world's largest asset management firms—with a lot riding on its success. It's expected that Treasury will buy its first distressed asset from an institution in four to six weeks, most likely after the election. The main mechanism for the asset purchases will be "reverse auctions," through which banks will offer their assets at discretionary prices, with Treasury buying the cheapest first.

If Treasury buys TAs at the lowest possible price, it will force banks into the self-defeating position of booking huge losses, meaning they won't be able to raise capital or lend. If Treasury buys TAs at a less-discounted value, taxpayers will take a hit. Needless to say, no plan can purport to benefit both buyers and sellers, and from the taxpayers' perspective, the onus should be on sellers to take the greater hit.

We believe the operations of the TARP stand a good chance of making a profit for the taxpayer, ultimately. Indeed, we don't yet know what price will be paid for the TAs, or what the default rates on the underlying mortgages will be. But even under aggressive default-rate assumptions, the difference between the prices paid and the ultimate prices received is likely to be wide.

On its own, the TARP won't recapitalize the entire banking system, nor will it prevent further massive write-downs. But it does create a market where none existed and, if executed properly, could entice private investors off the sidelines (Warren Buffett has already entered the field). Nor will the TARP erase the sense of building global panic or the near certainty of a global recession. But it may unclog credit markets, bring some much-needed confidence back to the banking system by removing questionable assets, and set conditions for banks to tap the private sector to boost their capital base.

The well-regarded research firm High Frequency Economics (HFE) uses this mathematical assumption: Suppose the Treasury uses the $700 billion to acquire mortgage paper at a 60% discount. Its purchases will have a face value of $1.75 trillion. Even if the default rate on the mortgages eventually reaches 40%—double the current rate—the long-term value of the paper will be $1.05 trillion, giving the taxpayer a profit of just over $300 billion. This would be a return on capital invested of 44%. Even if it takes five years to realize that return, it is a pretty good deal. HFE believes this operation will actually lower the net national debt, as the Treasury is swapping its notes for paper with a much higher economic value, even allowing for defaults.

The TARP could also generate a positive cash flow immediately. HFE assumes that if the Treasury's average funding cost is 4%, the interest cost of the TARP will be $28 billion per year. If the TARP buys TAs at a 60% discount, and if the income stream of the TAs is 7% of face value, the TARP would earn $123 billion in interest per year if there were no defaults. That is not going to happen, but the TARP would earn $74 billion even with a 40% default rate on the underlying mortgages, yielding a net $46 billion in incremental cash per year to the taxpayer.

First, let's look at recent new initiatives to see what's been added to the mix: The Fed doubled the Treasury Auction Facility from $450 billion to $900 billion, and said it's consulting with the Treasury on ways "to provide additional support for term unsecured funding markets." The Fed also announced it would use its new authority to pay interest on reserves, paying 10 basis points below the fed funds target on required reserves and 75 basis points below the target for excess reserves. This allows better management of the effective funds rate and an unlimited expansion of the Fed's balance sheet, which is already increasing from $900 billion to $1.5 trillion and counting.

Even bigger news was coordinated global central-bank rate cuts among some of the largest global economies, including the United States, the European Central Bank, the Bank of England, the Bank of Canada, Sweden's Riksbank, Switzerland's central bank and even China's central bank. This coordination was in reaction to the still-clogged credit markets, as well as the ongoing implosion in global stock markets—but also thanks to rapidly waning inflation risks. In addition, the United Kingdom announced it would invest $87 billion to buy preference shares (like U.S. preferred shares) in banks, and will make billions more available for borrowing and guarantees.

Finally, of course, we also eventually need a reversal in house price declines (the original cause of the disease). Although we're making mild headway in reducing inventories, a stall in that process may be under way in light of the ever-deteriorating economic situation.

Indeed it has. In the 1980s, several economies were in dire straits in terms of indebtedness, including Mexico, Brazil, Argentina and the Philippines. The countries set up a program to buy back their own debt from distressed small banks at an 80% discount to par value. On 9% and higher interest rates, these purchases allowed the countries to save, annually, 45% to 60% of the money invested in these programs. Effectively, the countries paid down $5 billion worth of debt with only $1 billion of investment and recovered the expense in less than two years on interest savings alone.

For a more recent comparison, consider the establishment of the Resolution Trust Corporation (RTC), which inherited toxic commercial real estate assets from failing savings and loan operators. The recovery rate on the assets purchased and ultimately sold by the RTC in the early 1990s was a healthy 85%. Even reportedly conservative assumptions point to a TARP recovery rate of at least 100%.

No matter what happens, the United States is almost certainly heading for its first outright contraction in bank credit in the post–World War II period, according to BCA Research. As you can see in the "Bank Credit Set to Sink" chart, the ratio of bank credit to GDP has soared in recent years to more than 10 percentage points above its long-term trendline. Returning that ratio to the trendline in a short period would require a nearly $1.5 trillion drop in bank credit outstanding. However, the credit ratio could undershoot the trendline on the downside if banks aggressively reduce their leverage ratios in the coming quarters—a distinct possibility.

Many are still asking what happened during the four-day span from September 29—when the TARP failed to pass in the House—to October 3, when it succeeded overwhelmingly. Pictures paint $700 billion worth of words, so let's look at the internal nervous system of the credit markets and the complete malfunctioning that woke Main Street up to Wall Street's crisis during that fateful week.

The credit markets are like the economy's internal nervous system. As humans, we know we have one, but when it's functioning properly, we don't really notice or understand its inner workings. When something goes wrong, though, we sure feel it. A message now ringing loudly to politicians et al is that pitting the interests of Main Street against Wall Street was ill-advised, as ultimately the credit markets affect everyone and every business. Rates on loans to most consumers and companies are set with reference to the rates banks charge each other—higher rates for banks mean higher rates for all. Even a week of credit blockages can result in companies being unable to finance their operations at any price, leading to job losses at best and bankruptcies at worst.

The problems erupted in July 2007, when two Bear Stearns hedge funds imploded due to exposure to subprime mortgages. Since then, central banks across the globe have been intervening, but in piecemeal terms, with a series of liquidity schemes such as the U.S. Term Auction Facility, which was expanded again on October 6 and is getting close to $1 trillion, not to mention a variety of rescues and unprecedented federal loans. But it was the collapse of Lehman Brothers, allowed by the U.S. government, followed by a series of rescues in Europe and the United States that brought the credit market to its knees.

Banks have always generated profits by lending money long-term while financing their operations in the short term through borrowing and deposits. Banks typically borrow from each other at about 0.08 percentage points above official rates. Yet on September 30 (the day after the initial failed House vote), they paid more than four percentage points.

It's often assumed that central banks set interest rates for their own markets. However, the rate central banks announce (like the fed funds target rate in the United States) is the rate at which they will lend to the banking system. The rate at which banks borrow from each other is set via a poll of participating banks and published as, for instance, the LIBOR. The "Ted Spread Kicks Into New High Gear" chart shows the spread between the LIBOR and three-month Treasury bill yields, and you can see we've even exceeded the spread associated with the crash of 1987. It shows that for banks the relative cost of raising money has risen more than 19-fold in the past 18 months. Companies don't have to borrow from banks; they can raise money from the markets by selling commercial paper, a type of short-term debt. During this crisis, investors' preference for debt issued by nonfinancial companies had made commercial paper a source of cheap financing ... until recently.

As you can see in "Commercial Paper Outstanding Takes a Dive," the volume of commercial paper outstanding has dropped precipitously. Some are pointing back to the collapse of Lehman Brothers as the source of commercial paper's angst. The government's willingness to force Lehman into bankruptcy (cognizant of the "moral hazard" involved in bailing out a badly managed business) seems to have had unintended consequences, including the recent "breaking of the buck" by a large money market fund that owned a lot of Lehman debt. That made other funds more cautious and led them to steer clear of bank loans and commercial paper. Alarm over counterparty risk (that those dealing with Lehman might fail too) became outright terror, which paralyzed the credit and even cash markets.

Let's combine the effects on the cash and credit markets with what's happening in the stock market. A great proxy for that is the newly created Bloomberg Financial Conditions Index—with components extending from the cash market to the bond market to the stock market—which measures both yield spreads and volatility. As you can see in the "Financial Conditions Implode" graph, this measure of overall stress now stands at nearly five standard deviations (measuring the dispersion of a set of data from its mean) below the norm of the past 16-year history of Bloomberg's index calculation ... which may explain the equity market's recent dive below 10,000.

Aside from possible "buy on the rumor, sell on the news" trades related to the TARP, the market's weakness may also reflect the reality that a large portion of economic and earnings growth over recent decades was due to falling interest rates and easy credit. Consumers went on a bigger debt binge than businesses, and that's why this recession is being felt and driven by the consumer.

But one silver, albeit tarnished, lining is that the U.S. stock market has fared relatively well during this crisis. In fact, it's at the top of the performance rankings of major global developed and emerging markets. As we've pointed out before, the U.S. market had been the ugly stepchild compared to its international, emerging market and commodity siblings when they were on fire. Remember, momentum investors tend to chase performance on the upside and flee asset classes when they're imploding. In recent months, we've seen record-breaking outflows from global equity funds, while the U.S.-oriented funds have been relative winners. A one-year high in the U.S. dollar is also reflective of America's relatively better economic position.

In absolute terms, of course, U.S. equity investors are suffering ... and panicking. Although we have yet to see the kind of contrarian pessimism we like, we are seeing signs of a potential turnaround in the CBOE Volatility Index (VIX). As you can see in the "VIX in Uncharted Waters" graph, the VIX has never scaled its current heights and, for what it's worth, that may eventually be a good sign. Only four times in the VIX's history has it traded above 40—now it's above 50. Following each move above 40 since 1990, the S&P 500® had consistently positive returns one month (8.7% average) and one quarter (11.3% average) later, although the performance was mixed in the very short term.

For centuries, we've had financial crises, and although each is unique in its own way, there are always common threads of irrational exuberance and unchecked greed. These undoubtedly lead to abuses. Cries are everywhere for more regulation. But in addition to being thorough, new regulation needs to be thoughtful. We need comprehensive regulatory reform (not just new regulations) that convinces the public that the financial system will become fairer and that strong-enough steps have been put in place to prevent a crisis like this from happening again. We need to do with the credit cycle what we've already done with the business cycle—develop the tools to manage and contain it, thereby reducing the frequency and duration of the downturns.

Let me close with another analogy to the human condition. When we get sick, we often get a fever. That fever is a symptom of our illness, but it's also part of the cure, as a fever is what the body brings on to heal itself. Think of the credit crisis as a fever. It's causing great pain now. But as we deleverage our overleveraged economic system, I expect we will eventually come out of this healthier.

This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. The types of securities and investment strategies mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Past results are not indicative of future performance.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and are not representative of intended results that a client should expect to see.

>U.S. equity investors are suffering...<

investors that support the economy are getting screwed,

while the politicians that created the mess are making

their careers.

For once, we need to hold the politicians accountable for allowing this mess to occur. We need to rid ourselves of career politicians and get the money out of politics.

Term limits? Yes. They are long overdue.

I’m not sure about public financing. The thought is not appealing but we are in desperate circumstances. There needs to be a way to completely remove special interest money from politics, i.e. Unions, PACS, etc. These clowns are bought and paid for before they even arrive in Washington.

As you can see in the "Bank Credit Set to Sink" chart, the ratio of bank credit to GDP has soared in recent years to more than 10 percentage points above its long-term trendline. Returning that ratio to the trendline in a short period would require a nearly $1.5 trillion drop in bank credit outstanding.

It's not clear to me why the treadline should be anything but flat. Why should the fraction of debt be ever increasing.

Returning that ratio to the trendline in a short period would require a nearly $1.5 trillion drop in bank credit outstanding. However, the credit ratio could undershoot the trendline on the downside if banks aggressively reduce their leverage ratios in the coming quarters—a distinct possibility.

I suspect it *needs* to drop below the trendline, back to healthy levels of debt relative to GDP.

You ask good questions. When I think about it, what pops into my mind is how the Fed treats economic growth and pay raises as bad things. When the Fed throttles growth and pay people need to borrow more.

There's nothing wrong with special interests financing their favorite politicians. It's called freedom. However there needs to be full accountability, with a glaring light of easy access to the accounts.

The only real problem I see is that of "hidden donors", hiding their large donations in with some, maybe not all that many, much smaller ones, bundled into a group with a name that tells nothing about the group.

For example, The and the International Associations of Chiefs of Police and the Law Enforcement Alliance of America might have similar positions and goals, but that is far far from the case.

Perhaps a requirement to name the top 10 individual contributors to the group?

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