Bailout

Treasury?s Actions: Pros and Cons

By Admin

Tax attorney and former bond trader Hale “Bonddad” Stewart provides a concise explanation of the initiatives Treasury announced this week– the Capital Purchase Program, debt purchases, and load guarantees:

Troubled Asset Relief Program (Buying Debt/Loan/Mortgages)

Pros

• It gets the assets off the books. This prevents the assets from further hurting the financial institution.

Cons

• Define “troubled mortgage/loan”.
• The only way for this program to work is for enough of the bad mortgages/loans to be purchased to convince lenders that problem mortgages can’t hurt the system. Put another way, the government has to purchase enough of these asset to inspire intra-institution confidence. I have no idea what amount that would be.
• The only assets the institutions will sell are the ones that are probably going to remain depressed in value for the duration of their existence. No one is going to sell an asset that is or has a higher probability of making them money. This means the government stands a higher probability of taking most of the losses.

Capital Purchase Program

Pros

• The institutions gets cash immediately. In theory, this should encourage the institutions to start lending again.

Cons

• Why would they want to start lending? We’re at the beginning of a recession, defaults are increasing and other lenders have assets on their books that are increasing the possibility of default. This is not a pro-lending environment.
• With housing values still decreasing in value, anything related to mortgages will also be dropping in value. That means loans and bonds tied to loans will continue to drop forcing institutions to continue writing down the value of these assets. As a result, equity may go loan loss reserves. This means the government will have to buy a large enough amount of equity to encourage lending and possibly the increase in loan loss reserves coming down the pike. Put another way — expect multiple injections over the coming year or so.
• The government says it isn’t buying an ownership interest that will lead to directing bank policy. I’m finding that a bit hard to believe. Call me cynical. I don’t see how an investment of over a billion dollars in some institutions will not lead to meddling in the internal workings of these institutions.

Loan Guarantees

Pros

• Provides a seal of approval for intra-institution lending. This should help a great deal. So far this year we’ve seen 15 banks go into receiver ship. Remember — this does not mean the bank ceases to exist. It means the FDIC essentially runs the bank with an extremely conservative agenda. Therefore, loans taken out will still get paid.
• Other banks that are in trouble have been purchased quickly. The FDIC and the Federal Reserve are (so far) staying one step ahead of the problems.

Cons

• This could lead to big payouts in the event of systemic problems. My best guess right now is — given the other parts of the plan put in place — guaranteeing loans is largely symbolic.

Conclusion

It’s really looking as though it’s going to take a combination of both of these ideas to take care of this mess. Buying the worst assets will prevent them from hurting the balance sheets of these institutions anymore. Basically sequestering these assets in the long-term is a way to contain the damage.

Buying equity shares gives the banks money upfront which they can with use to bolster their balance sheets and/or make loans. But given the current macro-environment, don’t expect a plethora of lending to take place. We are in the middle of a recession after all.

The bottom line is this combined program has the potential to stop the bleeding.

Full post as published by Bailout Report on October 15, 2008 (boomark / email).