Here’s the Deal…

Okay…I wanted my first post to be in an organized fashion with flashing lights, fireworks and loud bumpin subs with the newest kanye track…but this will have to do…

I am definitely not a fan of the new proposed toxic bank plan that got unveiled today.  Basically, the plan went something like this:

1. Highest bidder “wins” the honor of obtaining a particular batch of assets at a deemed highest market value

2. FDIC backs up loans and TARP contributes $100 billion with total purchasing power of $500 billion for now and up to $2 trillion in the future.

3. Treasury matches 50/50 for equity capital.

4. FDIC loans out at maximum 6 to 1 debt-to-equity ratio.

5. Private investors facilitate mortgage-backed asset disposition in a timely manner.

6. Private investors incur 100% of the downside risk and tax-payers share in the profits 50/50.

This is the outline for this “Toxic Bank” proposal and I’m telling you right now…it’s far from good.  Let’s delve into this a little deeper…

At its peak crisis, the US economy was running at an astounding 30:1 leverage of its debt to equity.  Since then, real GDP was approximately flat at $11.5 trillion between 2007 and 2008.  However, if we look at the S&P500, we have decreased an astounding 60% to its lows the past couple of weeks.  Derivatives markets, on the other hand, have been a whopping $280 trillion or more industry in the US (www.bis.org).  Now, in terms of leveraging, 280 / 11.5 is still on the lines of 24x what we got.  Think of it as for every $1 worth of equity we got, we have 24 pieces of paper for people who own some sort of right to that property in various type of contracted situations.

Now, imagine that we’ve stretched as far as we can go with that dollar and someone defaults on their contract.  Suddenly, everyone wants a piece of the equity (for liquidity sake) and everyone wants to cash in on their contracted pieces of paper (whether by default, etc).  Now, there’s not enough real equity to go around because everyone’s in-debted to each other and liquidity is even more constrained compared to the amount of equity in this country (11500/800 = 14.3x Equity to M1).  So, it starts the downward spiral with people cashing in shares of stock, selling houses, etc to make up for this difference.  Okay, so whats the solution?

There are TWO that they teach us in macroeconomics:

1. We can increase the perceived value of the equity by either creating a scarcity in supply or excessive demand OR

2. We can flood the market with a bunch of money so that we lower the “cost” for keeping illiquid and thus keeping the equity.

However, macroeconomics doesn’t take into account secondary and tertiary effects…it is a very short-sighted, limited view of the world.  The first alternative is difficult to accomplish because people’s risk aversion and ignorance plays a large part in the “fool me once, shame on you; fool me twice, shame on me” mentality.  Therefore, excessive demand would be very difficult to instill and with the fight for liquidity, there will be a whole bunch of equity left by the wayside to de-value at uncanny rates.

If we pick #2, we are basically digging our own long-term grave.  Even if the rest of the world does the same, then we collectively dilute our currencies and bring the economy back to its bubble state.  However, since we are the 2nd largest producing nation (I count Euro together even though they aren’t really one country), we would effectively be playing the currency game at a higher level than most of the rest of the world.  What I must note is that Euro, Japan and the US (and Britain I believe)–60% of the world’s GDP– have the largest debt-to-equity (which can be thought of as an average of  price-to-earnings and thus derivatives-to-gdp over time) at >30:1.  Thus, diluting the currency, if done collectively, would do nothing but decrease the equity-to-dollar ratio such that equity would cost less (take more dollar bills but effectively be less in price).  This would be perfect to stimulate outside trade because not all the emerging markets (ie China and Brazil etc) have been affected by over-leveraging and thus would find US goods cheap (currency-wise, since they probably wouldn’t have to print as much). And thus you think…GREAT! Smaller trade deficit, we grow faster, and we become a super power again!

Ahh…but what will happen in the long-run…will be exactly what happened in this short-run…except worse.  The fact of the matter is…we are trying to promote an unhealthy growth in the derivate asset market and cover it up by “buying” our way out of it. Furthermore, if the government owns large percentages of a particular stock, it will have to relinquish it eventually unless we want to limit growth to the portion that consumers own (remember consumers have the biggest multiplier effect, not government).  Therefore, growth in the subsidiary years will be flatlined to negative because the Government owns a portion of the GDP portion of goods.  Furthermore, due to the nature of the leveraging we have currently, $24 will go to paper for every $1 of real good produced.  What a bunch of crock!!  And even if that debt-to-equity ratio has significantly lowered now that derivatives have decreased dramatically, I can’t imagine having something on the lines of $8 trillion un-loaded from our economy…even if it’s in a timely manner.  Not to mention the fact that we have a public debt that’s in crisis mode…sigh…

Okay…so what does this have to do with the toxic bank idea.

I have 2 big problems with it:

1. 6:1 debt-to-equity leverage with a Treasury 100% match of equity stake means the the government is subisidizing ~92% of this thing.  Therefore, private equity company, which is buying a depreciating asset at this point, would have to be at most willing to risk 8% – interest rate (say 5%) = 3%.  That means if these assets depreciate more than 3% from their so-called “market” value, you’re at a loss AND you got a freakn 90/10 amortization on your hands… (not to mention what I think these companies would actually do with this stuff which is find the sub-primes that were previously out there, excerise the expiration ARMs for a handsome interest rate and flip the bitch for a profit when the owner’s default and you can sell the property since most of the sub-primes will default at the end of this year and next year).  Now, the other problem is…ISN’T THIS THE FUCKING TYPE OF LOANS THAT GOT US IN TROUBLE IN THE FIRST PLACE?!?!?! Non-standard, minimum down payment, sketchy asset pricing, and let’s face it…the type of private institutions that will volunteer for this won’t be idiots and will most definitely have something up their sleeves!

2. $500 billion to $2 trillion purchasing power. Seriously?  You realize that at 92%, that’s like…$450 billion to $1.8 trillion.  That’s a lot of money for FDIC to pony up and insure on top of the $250,000 jack-up to insure everyone’s accounts. Oh, but of course, just print more money and cash more bonds and buy more gold…do whatever you gotta do to make sure that we can spend our way out of it.

In conclusion, this plan is ridiculous. It’s good for now…and even THAT is a far stretch… Definitely, in the long run, just let the markets be.  GDP has been consistent thru this tumultuous time and even if you say its because of all the government-aided money…i mean…come on…we hit S&P500 at 650…thats down 60%…that’s just ridiculous in the span of 5 months!!!…since i’m a semi-believer in efficient market theorem…and GDP is still fairly even…it’s gotta be the credit market contracting drastically…which inevitably would be the reason for these hedge fund implosions, short squeezes, and daytrades to last a year (ridiculous implied volatility).  Therefore, we’re just reverting to a slower, healthier growth that’s backed up with less fluff and more stuff…

I just hope the US Government realizes what they’re really up against.  This ain’t a basketball game, Obie.  Sometimes, forfeiture is the best strategy.