FYI | Oct 01 2009
By Greg Peel
When the Obama Administration took over the reins in January, having been handed the ultimate hospital pass of a Global Financial Crisis, the first and most pressing emergency requirement in the eyes of new Treasury Secretary Timothy Geithner was to do something about so-called “toxic assets”.
It seems an eternity ago now, and indeed it is over two years ago, that two Bear Stearns hedge funds went down holding swathes of sub-prime collateralised debt obligations (CDOs) which the market now valued at zero. It took more than another twelve months, but this little butterfly flap was the precursor to the tsunami created by the fall of Lehman Bros over one year later. Realistically, the fall or rescue of Bear Stearns, Countrywide, Washington Mutual, IndyMac, Wachovia, Merrill Lynch, Fannie Mae, Freddie Mac, AIG and Lehman Bros (among others) was precipitated in November of 2007 when the US Federal Accounting Standards Board tightened its credit derivative valuation rules to ensure CDOs, related credit default swaps (CDSs), and other forms of asset-backed security were “marked to market”. As there was no demand for such products from a terrified global financial system, the answer to FASB’s valuation question was effectively “zero”.
Not that the investment banks were in any rush to mark what were now known as “toxic” assets down to zero, because in a normal world such assets still had value. But the banks were forced, each subsequent quarter, to start writing down the value of such assets on their books. As such assets were not exchange-traded, but created and sold “over the counter” in undisclosed transactions, the world had no idea who was holding what, and how much, and so came the great credit freeze. If you want to point at “which idiot” caused the GFC, you could, among others such as complicit ratings agencies, point your finger squarely at the FASB.
Had the FASB been sensible enough to enforce stricter valuations on over the counter products before 2007, then we may not have had a GFC. Or at least such a sudden GFC. Because by reacting too late to the situation with its rule changes, the FASB simply precipitated the very disaster it should have otherwise prevented.
All through 2008, the forecast value of expected, total global write-downs of toxic assets grew – from US$500bn, to a trillion, then two, three, and finally four trillion. These were numbers Average Joe could not even contemplate.
Last night the International Monetary Fund released its semi-annual report, which contained the first post-GFC reduction in the expectation of total write-downs – from US$4 trillion to US$3.4 trillion. In other words, the IMF now thinks all those toxic assets are worth US$600bn more than they had previously assumed.
But in January 2009, Timothy Geithner was desperately attempting to come up with a plan to sterilise the effect of toxic assets on bank balance sheets, at least temporarily, in an attempt to stem the world’s decent into economic Depression. The initial plan touted around was that of “good bank/bad bank”, in which the US government would take toxic assets off each bank’s balance sheet and warehouse them for sale at a later date. The reality was that while no one in the market was prepared to risk buying said assets in the short term, they actually still had value. Many were indeed “prime” mortgage-backed securities which had simply been tainted with the same brush of fear created by the “sub-prime” crisis.
So the plan was for the Treasury to create the “bad bank” in which toxic assets would sit, while the remaining US banks such as Citigroup, Bank of America, JP Morgan, and the newly commercialised former investment banks Goldman Sachs and Morgan Stanley, would remain as “good banks”.
But this plan was never put into practise, given Geithner learned from various respected investors – Warren Buffet among them – that there was indeed a private sector demand for “toxic” assets (at least the less toxic ones) at the right price. Hence “good bank/bad bank” was scrapped, and replaced by the Public-Private Investment Partnership or PPIP, known to all as the “pee-pip”.
The idea was that the government would match private investors in funding and provide leverage to acquire toxic assets from banks desperate to sell them and get back to normal business. It seemed like a good idea at the time, but there was one small flaw. There was always going to be a yawning gap between what private PPIP participants would be prepared to pay for toxic assets, and what the banks thought such assets were really worth, despite the FASB’s new mark-to-market rules.
But just when it looked like a complete stalemate would eventuate, the FASB stumbled back into the frame and decided to ease the strict rules it had imposed in November 2007. Rather than “marking to market” assets for which there was no market, banks could now mark to an assumed valuation if they could realistically justify such a valuation. Overnight, banks began to “write back” the value of their toxic assets.
Not only had the FASB helped to set up for a GFC by allowing relaxed rules in the first place, then accelerated its eventuality by shutting the gate after the horse, they had now as good as derailed the PPIP but moving the goal posts yet again. Now able to write-back asset values and thus replenish effectively bankrupt balance sheets, most banks were no longer desperate to sell out of toxic assets at fire sale prices.
And so we have heard no more of the PPIP ever since.
But while we might be heartened by the IMF subsequently reducing its forecast of likely write-downs from US$4trn to US$3.4trn, in the same report the IMF warned that US banks have still not recognized, or written down, 60% of the new total, and UK and European banks 40%. In other words, the toxic assets are still out there, and while they may no longer be considered to be all worth zero they are certainly not worth face value. And they’ve being sitting in a dark corner of bank balance sheets ever since, staying quiet and hoping everyone will forget they’re still there.
And then lo and behold, last night the PPIP was resurrected, seemingly out of the blue.
The US Treasury Department announced last night that the PPIP had indeed begun, about nine months after it was first proposed. About US$500m has been raised by the first two private investment firms willing to participate, to which the government will top up to US$1.13bn, and then gross up with debt to US$4.52bn. The government then hopes to add seven more approved participants, eventually creating a PPIP fund of about US$40bn.
The amount of US$40bn seems a bit like a drop in the ocean against the US$3.4trn of IMF expected write-downs of which half have yet to be written down, but it’s a start. The idea is that once the PPIP gets the ball rolling, and assuming credit markets continue to ease as they have in 2009, then the government can eventually sell out and let the private sector go back to valuing and trading these assets all by themselves.
It’s all part of the emergency program, of which there are many facets. All of which cost the US taxpayer.
The fact that some 40-60% of asset write-downs have not yet occurred suggests that banks across the globe are crossing their fingers that a global crisis has truly been averted and an economic recovery is definitively at hand. To that end, the IMF is expected to shortly announce that it has revised up its global economic growth forecasts from negative 1.4% to negative 1.1% in 2009, and from positive 2.5% to positive 3.1% in 2010.
But overhanging the potential revaluation of US dollar-denominated toxic assets is the fate of the dollar itself. If the dollar tumbles, such assets are again worth less in relative global terms. As the US government pours more money into rescue efforts, the fear is monetary inflation will send the greenback on an ultimate downward spiral. The US Fed recently announced it would maintain the originally set limits of its major rescue programs (including quantitative easing) but has already wound back some smaller initiatives. So the Fed is looking ahead to its final “exit strategy”, but all the while Obama’s fiscal deficit grows. And the longer the world keeps buying US Treasury bonds and other securities, the more money is being lent to US consumers to exploit and thus strain a current account deficit which should otherwise be contracting. The Treasury has held unheard of record auctions of government debt over the past few months, and all have been willingly snapped up both domestically and by foreign central banks.
The flipside is that the Fed continues to point out the extent of current “slack” in the US economy – being idle production capacity and workers out of a job – such that inflation is not a threat at all, at least for a while. To that end the Fed cash rate will be kept at near zero at least into 2010, providing base funding for the private sector to, for example, buy up toxic assets.
If ever one needed a clear definition of “smoke and mirrors”, it’s all of the above.