The Numbers - Hank Paulson, Secretary of the Treasury, is asking for $700 billion. It would start with $250 billion with the rest subject to Congressional veto. $700 billion is about 5% of the gross domestic product.
What would they spend the money on - Mortgage-backed securities and Collateralized Debt Obligations
- Mortgage Backed Securities - Cash flows paid out of principal and interest from mortgages. The buyers of these securities need to look at interest rate risk, prepayment risk, and default risk. They also need to look at the value of the underlying collateral in the event of a default in order to value these securities.
- Collateralized Debt Obligations - A special purpose entity created to buy fixed income assets(other structured securities, mortgages, bonds, loans). They are sliced up and sold to investors in tranches. The senior tranche receives payments first, followed by mezzanine, subordinate, and equity tranches. So, if the underlying asset does not pay off, investors in the equity tranche lose first.
What does it all mean? - Estimates of the actual cost of a bailout have varied. The securities that the government buys are probably worth more than zero. Some even say that the Treasury will make a profit on this deal like in the Mexican bailout. Some have asked where the government will get the money for this scheme. It will get money from where it always does: taxing, borrowing, or printing. At least right now, it is in a good position to borrow with treasury bond rates at very low levels. The Treasury can borrow at these low rates and buy these more illiquid securities, behaving like a very large hedge fund. Albeit, a hedge fund with other motives than return on investment.
If you have any questions about this situation or if you think I should cover more in this entry, post a comment or send me an email.
10 comments:
drew,
1. I need info (quantitative information) on what the probability of succes is for the TARP. Have you seen anything?
2. Who is going to be pricing these securities? i hope its not the so called "smart guys" from wallstreet. think about them buying the shit back from their old companies.
3. What is the probability of a profit for this plan (such as mexico's crisis) or at least how much money will we get back.
these questions probably have no answers as of now but have u seen anything????
thanx G
1. No idea. Plus, how do you define success?
Let's look at some of the possible goals.
*Shore up banks, so that there are not more failures than necessary.
*Provide liquidity, so that banks will lend to consumers, businesses, and each other.
2. I've heard talk of an dutch auction, but it is unclear what the Treasury would actually pay for these securities. They have talked about not buying them at fire-sale prices. Last I heard, Paulson said that they would buy the least complex securities first.
3. Of course, this question hinges on what these are worth in the long-run.(Is this an anti-bubble in mortgages and structured fixed income securities?) The prices for CDOs and mortgages may reflect a short-term panic and the long-run 'held to maturity' values may be much higher. Some of these securities are so complex, it is hard to tell. Perhaps, nobody has a good handle on what the equity tranche of a CDO comprised of subprime jumbo mortgages is worth at all. As an observer sitting here in Urbana, it's utterly impossible to know.
Drew since you can't answer my questions, haha just kidding. This guy is good, check out his blog.
http://time-blog.com/curious_capitalist/2008/10/more_bailout_questions_more_ba.html?xid=rss-curious
Who will the Treasury hire to price and purchase these securities? Will the really "smart guys" from Wall street be hired to price these securities and then purchase them from the company they came from?
They will in fact probably hire (or contract with) some "smart guys" from Wall Street. But I'm betting that they're far more likely to be looking for people from asset management firms like BlackRock and PIMCo--which have not made complete fools of themselves over the past couple of years--than from the banks that so desperately need to sell these securities. I could be wrong on that, though. So we should keep an eye on 'em.
Have you seen any quantitative forecasts of the probability of this plan actually working? Also how much of the $700 billion is the plan estimating to retain?
I haven't seen any quantitative estimates. Too many variables, I guess. And the guesses as to how much of the $700 billion will be earned back are all over the place. Warren Buffett and former hedge fund manager Andy Kessler have predicted that it will turn a huge profit. Others, such as derivatives expert Janet Tavakoli, are concerned that many mortgage-related securities--particularly collateralized debt obligations--will turn out to be nearly worthless, so if Treasury doesn't watch out, its losses could be huge.
Where's the fine print in regards to the plan recouping losses in 5 years from wall street? How will they do this (stock, warrants, cash)?
Treasury is supposed to demand warrants or senior debt in exchange for buying more than $100 million worth of securities from any financial institution, but the law gives it a lot of leeway on how much of a stake to demand. That's one way to recoup any losses on the securities it buys. The bill also says that if, after five years, the $700 billion hasn't been earned back, the president is supposed to submit a legislative proposal to recoup the shortfall by charging some sort of fee to the financial industry. Congress can decide not to pass such a proposal, of course, but that seems unlikely. The bigger issue may be that the financial industry will surely raise the money by--you got it--taking it out of customers' pockets.
Who is this by the way?
....illllll never tell
drew,
I'm not fully understanding the auction process which took place today on Fannie and Freddie outstanding CDS. How does this auction process work? If you have any info i would appreciate it, thanks!
http://www.reuters.com/article/rbssFinancialServicesAndRealEstateNews/idUSN0640944820081006
http://www.guardian.co.uk/business/feedarticle/7845325
I'm trying to find a more technical article about all this.
drew, drew, drew,
I'm desperately waiting for new articles! I was thinking we could enter a CDS contract, here's the provisions: You insure my T-bills in case of a nuclear winter, while I'll pay you semi-annual payments of 23 bp. Whadda say??? Of course thats kind of creepy thinking of the end of the world but.....
Anyway, heres a few interesting links:
information on CDS and the effect on the market:
http://biz.yahoo.com/ap/081007/meltdown_insurance_or_bets.html
AND here's info on the auction process of CDS, starts on page 2 the guys blog name is dhalc2 pretty interesting
http://www.tickerforum.org/cgi-ticker/akcs-www?post=65283&page=2
Say the buyer of protection has entered into a CDS with a seller of protection, referencing, for example, a notional $10,000,000 of Freddie Mac bonds (the buyer is not required to actually hold such bonds).
The buyer pays quarterly premiums of, say, 125bps = $125,000, to the seller of protection. The buyer stops paying protection on the occurrence of a credit event.
On the auction date, firm bids will be requested from a consortium of Wall Street banks on a certain notional amount of Freddie Mac bonds and then the recovery rate on those bonds will be calculated. Because firm bids are requested from the banks, the hope is that the prices they receive will be prices the other party is actually willing to pay for these bonds.
The articles indicate that the recovery rate will be high (i.e. the bonds have not dropped much in value). For most of the credit events I have seen, the recovery rate has been in the 30%-50% range (and it is likely that the Lehman and WM CDSs may have even lower recovery rates).
As the recovery rate is high, the sellers of protection are going to have to make smaller payouts in comparison to other credit events. Additionally, the purpose of the auction procedure is that all the amounts owed by sellers will be netted off against each other where possible (i.e. if bank A owes bank B $100, and bank B owes bank A $60, bank A pays over $40), reducing the amount of $$$ that will have to be paid. On the other hand, as the outstanding notional amount of CDS on Freddie and Fannie is so large (and since Settlement Amount payable by seller = (100% - Recovery Rate) * CDS Notional Amount), it is therefore possible that even with the high recovery rate, the settlement amounts will wipe out many sellers of protection.
From the ISDA website, it looks like the cash settlement date will be Oct 15 2008, so the sellers have until then to come up with the cash.
One other important point is that these Fannie and Freddie CDSs were put into synthetic CDOs. The investors in those CDOs (hedge funds, insurance companies, banks etc.) are effectively sellers of protection, so those investors stand to lose $$$, depending on how leveraged those CDOs were. Therefore it is not just the banks which wrote CDS contracts that lose $$$ here, but many investors who invested in synthetic structured finance instruments.
23bps, sounds like a good deal to me. You'll run into issues with your counterparties though, if such a credit event happens.
Did you read about Iceland today?
"Iceland is being treated like one big toxic hedge fund. It's a tiny country whose corporate and banking sectors have leveraged up to get better returns and punch way above their weight. That leverage is now magnifying their losses. The story doesn't make sense any more. Nobody wants anything to do with it."
I'll have more stuff soon after I'm done doing research that I have to do for other obligations outside this little blog of mine.
I know my readers around the world are counting on it.
Well drew, your readers are anxiously awaiting for your new postings. Good point on Iceland the country is so highy leveraged with debt they have to ask another country for an injection of $$$. So who do they turn to? You would think a highly repsected, stable, and capitalist society right? Wrong, for the first time in history Russia will take over a country without invading and destroying the underlying asset! This new country which will be called "Glorious nation of irerussoland" it will be a legitimate threat to take over the U.S. as the worlds new superpower.
http://www.themoscowtimes.com/article/600/42/371508.htm
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