Relevant and even prescient commentary on news, politics and the economy.

TARP, Yet Again: Inflationary?

Back in the old days of derivatives (the mid-1980s), there was an international commercial bank that was famous for declaring how much good derivatives had done for it.

It was famous because it was common knowledge in the marketplace that the bank would have its swap counterparties “buy out” the positions where it was due money, while those on which it had a debit debit were kept on its books.

So I wasn’t exactly either surprised or believing when the NYT announced, to much fanfare, that there was a “profit” being made on the bailout funds. As Bruce Webb noted here at the time:

These early returns are by no means a full accounting of the huge financial rescue undertaken by the federal government last year to stabilize teetering banks and other companies.

The government still faces potentially huge long-term losses from its bailouts of the insurance giant American International Group, the mortgage finance companies Fannie Mae and Freddie Mac, and the automakers General Motors and Chrysler. The Treasury Department could also take a hit from its guarantees on billions of dollars of toxic mortgages.

But it got nice headlines at the end of August, when talk of “green shoots” and “inflation fears”needed to get momentum.

Featured less prominently is a now-week-old LAT article with a more realistic perspective:

The Treasury is unlikely to get back the full amount of money lent under the Troubled Asset Relief Program despite a recent spate of repayments from large banks, warned the program’s watchdog.

The program “played a significant role” in rescuing the financial system from a meltdown, Neil Barofsky, special inspector general for TARP, testified before the Senate Banking Committee on Thursday. But it was “extremely unlikely that the taxpayer will see a full return on its TARP investment,” according to his prepared testimony.

The official story remains that the large banks will be paying everything back. If that’s true, then the answer to Rebecca’s question of how to drain liquidity from the financial system is clear: take the paybacks and disappear the monies. It’s only if there is an excess shortfall on the securities that excess money will be in the system.

So, if the NYT was correct at the end of August, or the cheerleaders are correct now, there will not be an inflation issue, or an excess bubble, just a little “extra lubricant” making certain that valuable securities attain their full value that will naturally be removed from the system (both as cash and as Lines of Credit) as the value is realized.

Indeed, the only reason to fear inflation from TARP/TAF sources is if you expect a significant shortfall in the actual values, something for which you can only compensate by leaving a large quantity of excess lendings in the market. Which, by definition, will not and cannot happen if all the major players repay their allocations in full (let alone with interest).

Second derivatives don’t make inflation. And money loaned by the Fed that is fully repaid doesn’t make inflation unless it is loaned out (“multiplier effect”), which hasn’t been and still isn’t happening.

What there is is “excess” cash sitting on bank balance sheets in lieu of full repayments. But it’s not being used for other things—no multiplier effect—and it can be disappeared by the Fed as it is paid back.

So where is the inflation, unless money has been added to the system without there being value behind it?

Somewhere, an old derivatives manager is watching. Maybe he recognizes his strategy in the story unfolding. Maybe, just maybe, he also kept underlying deals that didn’t have losses as big as the gains he took.

It’s possible. But it was never the way to bet.

Tags: , , , , , Comments (0) | |

Draining liquidity from the banking system

by Rebecca
(cross posted at Newsneconomics)

Prof. Jim Hamilton at Econbrowser (thanks Mark Thoma for the link) addresses one of the Fed’s standard methods of draining liquidity from the banking system: reverse repurchase agreements. Basically, the Fed will transfer some of its assets to the banking system via short-term loans taken out with its Primary Dealers, presumably offering standard (Treasuries) and less standard (MBS or agency bonds) assets as collateral.

Reverse repurchase agreements simply slosh around the assets (MBS, agencies, and Treasuries) between the Fed and the Primary Dealers, rather than removing the assets from the Fed’s balance sheet permanently. Eventually, though, the Fed must sell the securities outright onto the open market – we are far, far from that!

This is all hot air for now. How can the Fed soak up the expansionary liquidity, let alone unwind $1 trillion in assets, when the banking system is still shedding pounds?

The Fed is considering another route, too: conducting the same repurchase agreements with the money-market mutual fund industry in tandem. An excerpt from the FT:

The Federal Reserve is looking to team up with the money-market mutual fund industry as part of its strategy to ensure that its unconventional policies to stimulate the economy do not produce a bout of post-crisis inflation.

The central bank envisages eventually draining liquidity from the financial system by engaging in trades called “reverse repos” with the deep-pocketed money-market funds. In these, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds.

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets. By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure from regulators and investors to stick to low-risk liquid investments.

The Fed is solely attempting to assuage inflation angst at this time; it’s still very premature to talk about an exit of expansionary policies when credit markets still crimp the stimulus that the Fed so desperately wants to get into the open market (much of the base, roughly $855 billion on September 23, 2009 and up from $2 billion in August 2008, remains on balance with the Fed in the form of “excess reserves). Just look at the crunch in the consumer credit space (chart to left).

As Prof. Hamilton suggests, the mechanisms of the reverse repos should successfully sterilize the base before it starts to become inflationary (with either the Primary Dealers and/or the Mutual Funds industry). However, one of the programs through which the Fed utilized previously to sterilize its liquidity, and to which Prof. Hamilton refers, – the Supplementary Financing Program – is unlikely to be an avenue for removing liquidity.

In fact, it’s quite the opposite. The Treasury already announced its imminent plan to liquidate the bulk of its $200 billion account with the Fed. There’s another $200 billion in excess reserves with which the Fed must contend (see my previous post here).

It’s easy to get the liquidity into the financial system. But getting it out without collapsing the economy or allowing inflation pressures to build? Well, that’s a different story.

Tags: , , , , , Comments (0) | |

This Makes More Sense–or Does It?

Dr. Black (you know the site) links to AIG Strike Three. And unlike the Citi debacle previously discussed (relatively) positively and rather negatively here, this one makes some form of sense.

The difference comes down to the meaning of an accounting concept: ongoing concern.

More below the break (yes, this might get wonkish. It’s me, after all.)

The Big C and AIG are both large entities with several pieces. Some of those pieces are successful; some of them are AIG Financial Products. Some of them—Citibank branches and office space, for instance—fall somewhere in between.

What we do know is that it is currently not possible to slice and dice The Big C so that something would be left that would be an “ongoing concern.” Those assets that are part of the company are dwarfed by the liabilities, and run across business lines. It’s not as if you could just magically, say, sell Smith Barney, spinoff any remaining insurance business, and ritually execute Vikram Pandit and produce a working company from the remains. At best, it’s a Good Start. There’s a reason I refer to the company as The Big C: it’s in the lymph nodes, the brain, the lungs, and the brain. You probably couldn’t even survive with “just” the Retail and Private Banking operations.

Any auditor who releases The Big C’s next 10-Q and describes the firm as a(n) “(on)going concern”**—with the attendant implication that there is a functional business model there and that the firm can create the future unencumbered* cash flows to remain viable—should be barred from the accounting profession.

AIG is different. Think Enron: there are pieces of the business that are still viable (now, the insurance and re-insurance pieces; then, the power plants and transmission facilities), but they are dwarfed by the losses at AIGFP. So there is a viable, separable business that is making pennies while the rest of the firm loses Benjamins.

The difference is that there is a possible end in sight. AIG-Prime could go back to doing the things AIG knew how to do, and stay away from the things that made Hank Greenberg rich and pauperized U.S. taxpayers.***

So, if we were to assume that a leaner, less mean AIG will come out of this, can we look at the plan changes and say they point toward a goal?

Unlike The Big C, the answer is clearly “yes.”

Under the deal, the interest rate on AIG’s credit line from the government would be cut to match the three-month London Interbank Offered Rate (Libor), now about 1.26 percent, a source with direct knowledge of the matter said.

This is perfectly reasonable for the moment: AIG is a financial institution, the reconceived version will be a financial institution of respectable size and strength, and the current version has the strong support of the U.S. government, which can borrow well inside LIBOR. While I suspect the final company will end up looking more like State Farm than Morgan Stanley, it’s not out of the question that it could borrow at LIBOR, which is approximately a AA rating level anyway—a perfectly reasonable assumption for the reconstitution of a formerly-AAA company with some carryover liabilities.

The additional equity commitment would give AIG the ability to issue preferred stock to the government later, the sources said.

This would presumably be the reverse of the deal with The Big C: “equity” for debt. Again, a sign that regulators expect there to be a survivor/successor firm of the current mess.

The most interesting quote in the piece is:

[Robert Haines, senior insurance analyst at CreditSights] said. “The counterparties on most of the book are (European) banks that would be hammered if the U.S. walked away.”

Note that Mr. Haines does not speak of AIG as an independent entity. Note also that, in supporting the AIGFP fiasco/deals, the U.S. can reduce the overall size of the bailout needed while ensuring that domestic entities retain full access to capital markets. It doesn’t make anyone happy, but the option is worth keeping open.

Then we get to the meat of the deal:

AIG will also give the U.S. Federal Reserve a preferred interest in its American Life Insurance Co (Alico), which generates more than half of its revenue from Japan, and Hong Kong-based life insurance group American International Assurance Co (AIA) in return for reducing its debt, they said.

The U.S. doesn’t really want to own either of these, but they have a promise to be valuable assets.

The government likely will get a 5 percent cumulative dividend on its ownership stake in Alico and AIA, said one source. AIG had been trying to sell Alico and part of AIA in a bid to raise money to pay back the government.

Sales of these assets are still a possibility, with some bids already received, said one person. [italics mine]

Think very carefully about the italicized part above. Markets clear—but they don’t always flow well. Combining the two, it appears that the government is effectively giving AIG a bridge loan on those two entities. In the worst case, it will become a “pier loan” (h/t CR), but that’s not the way to bet, especially if others follow the Chinese model of buying international assets while they are cheaper.

The rest of the moves look as if the outlines of the new company are already falling into place:

AIG may also securitize some U.S. life insurance policies and give them to the government to further reduce its debt, the source said.

The company may securitize up to $10 billion under that plan, one of the sources said.

The debt-to-equity swap would help AIG repay much of the roughly $38 billion it has drawn from its government credit line, the source said.

Translation: we know this business, and can do it well and continue it.

Last year, AIG said it planned to sell all assets except its U.S. property and casualty business, foreign general insurance and an ownership interest in some foreign life operations, to pay back the government.

While the company has announced some sales, it has found it difficult to find buyers and get a good price for assets amid the financial crisis.

Translation, again: if the market ever comes back, this is what we plan to look like. And we will again be a “going concern.”

In short, unlike The Big C, there is a plan, there are moves afoot to move closer to the end game, and targets by which they plan to keep the viable parts of the business going. For instance,

The company now plans to spin off up to 20 percent of the property-casualty business in an initial public offering, said a person with direct knowledge of the plans.

The business would be renamed to differentiate it from AIG, and have its own board of directors.

So long as that board doesn’t include Hank Greenberg, I’ll be cautiously optimistic. The other piece of spinoff is more problematic:

To aid the auction of at least one major asset, the government could help potential buyers of aircraft lessor International Lease Finance Corp with financing, the sources said.

ILFC has some debt coming due in 2009 and, if needed, AIG could use its new equity commitment to help potential buyers with that, one of the sources said.

This is a piece that probably still needs to exist for non-business reasons, at which point we might be able to argue that there could be a Public Good in government support of its sale. Under any condition, it doesn’t fit into the trimmed-down model of AIG-Prime that appears to be envisioned.

None of this means there won’t be another round—asset sales are very dependent on buyers—or that they should be paying non-contractual bonuses this month (which they are). The company still needs to reach its full restructuring, and this is not exactly a prime time to be a seller in the marketplace. But at least this restructuring/new bailout has a clear Endgame in sight.

*I use “unencumbered” in place of the usual “free” for the sake of clarity.
**It appears that “Ongoing concern” is used in the U.K., “going concern” in the U.S. I won’t pretend to know which will be the standard as accounting standards are weakened standardized.
***This is, of course, another case where I will point to the results and ask how anyone can take “we’ll get 2/3s of the money back” seriously. But that dead horse has been soundly beaten for the moment, so I’ll leave the tanning of the hide to Yves (She likes the new deal a lot less than I do) and Paul (who hasn’t discussed it yet, since he’s still rewriting 2 Henry VI and checking out The Great Solvent North) and the rest.

Tags: , , , , , , Comments (0) | |

Sterilized intervention?

Paul Krugman at Economist’s View appears to be saying the TAF is a sterilized intervention by the Fed. He uses an analogy of twenty people (the financial markets) and one bad apple being saved in order to help the other 19.

Our own save the rustbelt (missing now, sadly, due to work. So much for loyalty.) and reader Idaho Spud make their own assessments there in comments.

Tags: , Comments (0) | |