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Credit Crisis Bailouts Will Prevent Recession But Not Recession

Economics / Recession 2008 - 2010 Oct 16, 2008 - 01:03 PM GMT

By: Hans_Wagner

Economics Diamond Rated - Best Financial Markets Analysis ArticleThe rescue plan is now law. You might be wondering how this $700 (actually $850 billion) rescue plan will help improve the economy and help you beat the market. The credit markets remain tight and they are having repercussions across the US economy and throughout the world. Now that the government has arrived to help, will it work?


The Problem

As I have mentioned several times, the financial institutions have experienced significant losses and must deleverage their balance sheets. Those who cannot move fast enough, or have too many bad assets on their books are going out of business. There are three ways to lower the leverage of a bank.

The first thing banks can do is to make fewer loans, which reduces the size of their loan portfolios. Any new loans are made at higher rates and with much stricter conditions that lower their risk. This means that fewer companies and people can get a loan, causing many companies to no longer have access to credit for their operations. Over time, this will reduce the bank's leverage, as long as they have sufficient capital to cover their losses on the former loans they wrote.

Next, banks can raise additional capital by selling equity, often preferred, to investors. This is what Goldman Sachs and GE have recently down when they sold 10% preferred to Warren Buffett's Berkshire Hathaway. Berkshire also received warrants to buy common shares at a $115 strike price. This dilutes the value of the shares of existing shareholders. However, these institutions must add capital to cover earlier losses. Bank of America sold additional equity on the open market that ended up $9 less than the shares sold for just a couple of days earlier. Talk about dilution. Other banks have sold equity to try to shore up their capital positions. Additional capital improves the capital ratios for these banks, meaning they can cover the loan losses. If there is any money left over, they can lend to their best customers. Availability of credit will still be constrained.

Third, banks can sell their assets to someone else. The only assets anyone would want to buy are those that are completely transparent, so the buyer knows the risk they are taking on. These are the bank's best loans, the ones whose customers are current on their payments. The loans that are not current on their payments are much more difficult to sell. Then there are the collateralized securities, especially the ones backed by mortgages. This is where many of the mortgages that have been created in the last few years are now held.

These Collateralized Mortgage Securities (CMS) are comprised of many different types of mortgages including prime, sub-prime and alt-A. The problem is no one really knows that status of the payments on the mortgages in these securities. As a result, they are very difficult, if not impossible to sell, since no one knows how much they are worth.

This process of deleveraging has caused the banks to distrust each other. How do they know the money they lend to another bank will be repaid? What if there is a run on the bank and the lending institution cannot get its money back. This problem has extended into the commercial paper markets and is affecting the most credit worthy companies, such as General Electric. The result is companies find it very difficult to get credit. When they do, the rates are much higher. Even if your company has plenty of cash in the bank, your customers may not be able to buy your products, since they cannot obtain their normal credit. Now your company sees its sales fall.

This is the mess we are in throughout the world. If credit does not become easier to obtain, it will drive economies into a severe recession and possibly depression. Many companies are feeling this problem and it gets worse each day.

The Rescue Plan

So how does a country get out of this intertwined mess? There are two approaches that have been proposed.

The first one is to buy the troubled assets at some price to get them off the books of the banks. This will lower the leverage of the banks, freeing their capital to allow them to lend to their customers. This is the idea put forth by US Treasury Secretary Henry Paulson. There are several ideas on how to set the purchase price, the primary one is to use a reverse auction, where everyone would who offers securities for sale must accept the lowest sealed bid. To be successful as many banks as possible need to participate, so a “market” can be created in these securities. If only a few join, the plan will not work as intended.

The other approach is for the government, in this case the US Treasury to add to the capital structure of the banks, much like Warren Buffet did at Goldman Sachs and General Electric. With the added capital, the banks could resume their lending even though they still hold the CMS securities that are difficult to value. More on issue in a later paragraph. Congress authorized the US Treasury to carry out this action as well. It means the US government would become part owner of a number of banks. This approach further dilutes the value of the shares held by current shareholders.

The US Treasury has said they are looking at both approaches. On Tuesday October 14, 2008, the Treasury announced that they going to spend $250 billion to add to the capital of the banks in the United States. Essentially this is the same thing Warren Buffet did, who invested $5 billion in Goldman Sachs and what the United Kingdom did when they invested in several of their large banks, including the Royal Bank of Scotland. Investing in banks increases the capital base which should help them offset the loan losses they are experiencing. The credit market's psychology should also improve, since now the banks that participate in the equity investment program are less likely to go out of business. The down side to the government investing in banks is it will dilute the value of the stock of existing shareholders. Existing shareholders could see the value of their shares actually fall.

The program announced by the Treasury is to issue preferred stock that pays 5% for the first three years. It then rises to 9% dividend rate, which is designed to encourage the banks to buy back the shares once they are able. The Treasury will also receive warrant to purchase common stock. So far, the top nine banks are participating, representing about half of all deposits in the US.

In another move, some countries are now guaranteeing all deposits of their banks. This move causes large depositors to move their money from a country that does not have unlimited deposit insurance to banks in countries that do. These large fund flows can cause banks to fail, when they see a run on their bank. This is why there is a coordinated effort by the leaders of many countries to put in place the same policies. We should expect all deposits of banks in the US to soon be insured, not just those at $250,000 or less.

Congress added some features to the plan to “protect” the taxpayer. These include oversight and transparency which are necessary. They also require any banks that participate to give the government warrants, which give the government the right to buy shares of the bank. This provision would dilute the value of the stock for existing shareholders. Congress also put a limit on the pay and golden parachutes bank executives can receive if they participate in the program. It is interesting to note that the big banks are participating despite this requirement.
Speaking of hard to value, a much discussed issue is the requirement for banks to use mark-to-market accounting. This requires banks to value their loans and securities at their fair market value. Fair value is the price you receive if you sold them. If there isn't a known price, then it is up to management's judgment to value the securities. Of course, this is subject to much interruption.

If a similar security sold recently at a discounted price, then that is the price the accountants require you to use. For example, in the last few months Merrill Lynch sold some distressed CMS securities for $0.22 on the dollar. This sale set the price for many banks on their difficult to value CMS securities, causing them to incur significant loan losses, as they had to write off the drop in the value of their securities. Now these banks need to raise more capital to cover these losses. If they are unable they could be taken over by the FDIC.

Many people in Congress want to eliminate the mark-to-market rule, believing it will help overcome the problem. In a way it does. However, the reason this rule was put in place stems from Savings & Loan crisis. Then many S&L's held mortgages on properties that were over valued. The value of many of these properties fell in another real estate bust. When the owners could not or would not make the payments, the S&L's foreclosed. They valued the properties at their former high value, even though they could not sell them for that price. Eventually this caught up with the S&L's and the government had to step in to take over the S&L's. The government formed the Resolution Trust Corporation (RTC) to take over the properties and eventually sell them. The problem was many of these properties were worth much less than they were carried on the books. The accountants were blamed for not properly valuing the assets of the S&L's. This resulted in the creation of mark-to-market accounting. Interesting how what was once consider a good thing by government officials is not consider a bad thing by some government officials.

Removing the requirement to mark-to-market inflates the value of the assets. Doing so creates an accounting gimmick that would shield the banks from their real economic problems. An alternative is to value the assets over their expected life. In essence, that is what an investor would do if they were to buy these securities on the open market. If the US treasury buys these securities, they are assuming they will have value over time. Depending on the price paid, they are likely to have a higher value as 90 to 95% of all people pay their mortgages on time. This means that these securities should be valued based on their long-term value, not just what they can be sold today. This would bring the economic value of the assets in line with the way accountants could value the assets. The Securities Exchange Commission is investigating this issue.

The financial accounting Standards Board (FASB) has released some further guidance on mark-to-market accounting. “In determining fair value for a financial asset, the use of a reporting entity's own assumptions about future cash flows and appropriately risk-adjusted discount rates is acceptable when relevant observable inputs are not available," it said. This means the banks should consider the long-term value of the security.

Will it solve the Problem?

So will this solve the problem? Certainly, the global effort to fix the credit problem is unprecedented. This is the opposite of what happened during the depression of the 1930 era. Actually, there are several problems to consider. First, will the efforts correct the credit freeze? Second, if the credit problem is overcome, will it correct the problems in the economy?

As already mentioned, investment by the government in the equity of banks will have two outcomes. First, an investment by the government will improve the capital position of the banks, which could allow them to lend again, if the level of investment overcomes their loan losses. That is the problem. It depends on the level of investment that is made. If it is too small, then the capital structure of the bank will not be sufficient to cover losses. If it were large enough, then it would dilute the stock of existing shareholders. In order for an investment in a bank to work, it must be enough to reduce their leverage, so they can lend again within proper capital ratio rules.

Should the government choose to buy the hard to value assets; it would remove the performing assets from a bank's balance sheet. Remove enough of these assets and it lowers the banks leverage position to the point where it can lend again and stay within the capital ratios. Essentially, this solution could unfreeze the credit problems, similar to an equity investment into the banks.

Each of these approaches could overcome the credit freeze problem, if sufficient money was committed to the problem. So far the Treasury is going to purchase $250 billion in equity many banks. In addition, to get inter-bank lending restarted, the Federal Deposit Insurance Corp. (FDIC) would insure new senior preferred debt for three years. If they can get inter-bank lending shored up, it should help improve the credit crisis.

The original weakness in the economy was causing many companies and consumers to reduce their spending, as they worried about their jobs and a slow down in growth. Add in the credit crisis and you increase the problem much further. A number of companies, both large and small, have seen their sales drop as their customers cannot afford to buy their products and services since their working capital has shrunk due to the unavailability of credit. Employees are being laid off as companies reduce their costs to try to balance their business with their sales. Once a company cuts back due to lower sales, it normally takes a while for it to recover the confidence that it lost. At this point, it is difficult to tell the full impact of the credit problem on companies. We will get a much better idea during the current earnings conference calls, especially from the guidance and the question and answers. I suspect that the euphoria from seeing the credit crisis being solved, will give way to concern over the economy and company earnings.

The Bottom Line

So, to answer the question, will the rescue plan for the financial sector solve the problem? It will correct the freeze of the credit markets and help us avoid a depression. However, the damage done in the mean time will cause the US to experience a deeper and more prolonged recession than many originally thought. The affect of the large amount of debt that many companies and people have assumed will take time to work itself out. While the government can throw money at the problem, they still do not get at the root cause of the problem, to much debt that people and companies cannot afford.

As a result, the economy will not recover as quickly as many hope. The politicians do not want to say it, but the economy must take its medicine before it can properly recover. Additional government spending will just increase the deficit further with very little stimulus. More deficit spending will increase the risk of higher inflation.

As investors, we need to keep this in mind as we formulate our investing themes. We will be in a bear market for longer than many think. In the mean time, we need to take advantage of bear market rallies when they take place. Some will last for a few weeks, while others will last for a few months. It will be important to remain flexible. After all, the government is here and they want to help.

For those interested in learning more about global economics might want to read: When Markets Collide: Investment Strategies for the Age of Global Economic Change by Mohamed El-Erian a co-CEO and co-CIO of PIMCO, one of the largest investment management companies in the world. He formerly served as president and CEO of Harvard's $35 billion endowment.

By Hans Wagner
tradingonlinemarkets.com

My Name is Hans Wagner and as a long time investor, I was fortunate to retire at 55. I believe you can employ simple investment principles to find and evaluate companies before committing one's hard earned money. Recently, after my children and their friends graduated from college, I found my self helping them to learn about the stock market and investing in stocks. As a result I created a website that provides a growing set of information on many investing topics along with sample portfolios that consistently beat the market at http://www.tradingonlinemarkets.com/

Copyright © 2008 Hans Wagner

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