Tuesday, March 24, 2009

The Game Changing Proposal

Finally, the US treasury has decided to pursue what has always been the least bad of all options - purchasing assets. Nobody knows what the unintended consequences of this is going to be. But nobody also knows what the impact of a $800 bn stimulus package is going to be.

Plunging asset prices were what started the crises, and stabilization of asset prices is what is going to cause the end. Once asset prices have stabilized, earnings will follow after a year or so. 

What is absolutely essential is that the plan gets implemented as proposed - otherwise Geithner will come across as extremely undecisive. There might be political opposition, but this is Obama's treasury first real proposal. So there is enough political capital to get it started. 

There are three tricky parts in this entire proposal:

a) Can the Treasury get private capital involved?  This is a heads I win, tails you lose situation. What will get investors really excited is if the first few deals are really sweet and the investors end up making boatload of money. I think people are going to be surprised by how much private capital will eventually get involved. And if Treasury were to give tax-breaks to retail investors investing in these PPIF's - that will cause a stampede. That way, the Treasury can also counter any cries of "the rich guys benefitting at the expense of the taxpayer". Get the taxpayer involved. 

b) Pricing of assets. Treasury is allowing the PPIFs to lever themselves up at extremely cheap leverage. This is crucial, as it automatically pushes up the pricing of assets in credit markets - many of which might be priced now an almost unlevered basis. Haven't we all heard of people talking of equity like returns in credit markets?

PPIF's don't really need to "overpay". A very important aspect of pricing of assets is - what is the leverage and the cost of funds of the investor buying those assets. The discount rate to calculate the "fundamental" value of any security is different for different investors. Even if PPIF's and I have the same outlook on the cashflows and default probabilities etc etc, they can pay more than me and still make more money than me because their ability to leverage is higher and cost of leverage is much lower than me.  An appropriately levered investor can always pay more than an unlevered investor.

Nobody is subsidizing anyone - if one assumes the prices in credit markets are fair value prices today for a relatively unlevered investor. Taxpayers lose if credit markets are overpricing securities for a relatively unlevered investor.  If the economy goes down substantially from here and indeed credit markets turn out to be optimistic, then Obama won't get re-elected for sure. The lynch mob will forget about AIG and focus on Geithner.  

If anyone is subsidizing, it is the investors in the bonds issued by the PPIF's and the Treasury to lever up the PPIF's - i.e the Chinese and the Japanese. But havent they been subsidizing the US for a long time now? 

c)  Exit plan: A successful PPIF will create its own exit plan, for e.g. list the fund on the exchanges, and Treasury sells its equity portion to other investors etc. An unsuccessful PPIF doesn't have an exit plan by the very fact of its failure. 

I think this is the game changer for banks. For any asset that has been written down to market value, selling into a PPIF will generate a higher price  (GS and MS have probably written down the most to market prices). This will free up the asset side and also create valuable equity capital. And as bank share prices go up, banks can also raise less expensive equity (compared to today) from the markets. 

This is not to say we are back to the races like 2007. That is unlikely to happen in our lifetime again, and there are too many problems in the world. But I think the time has come to become more aggressive than I have been in the last 18 months. Krugman is right when he says that Obama is risking his entire political capital on this - there are no second chances here. 

1 comment:

Econlogic said...

Do not agree with much in the piece except that prices would indeed be bid up.

Think of the following bet:

100 with prob=1/2
0 with prob=1/2

Assume no time lag, so no question of discounting and risk neutral investors.

Fair value for unlevered risk neutral investor = 50

If the investor was allowed debt:equity of 6:1

The equity investor would be willing to pay 87.5 for the same asset:

D: 75

Expected value for equity holder:

(100-75)/2 = 12.5

Risk neutral investor pays the expected value

Payoff to debt holder = 75/2 = 37.5
Debtholder pays 75 for expected value of 37.5 = Transfer of wealth to the holder of the asset.

1. "PPIF's don't really need to "overpay"."

My comment: Not true. PPIF = Equity holders + Bond holders

Creditors overpay.

2. "Nobody is subsidizing anyone - if one assumes the prices in credit markets are fair value prices today for a relatively unlevered investor."

My comment: Not true.

Bond holders providing subsidy.

3. "Taxpayers lose if credit markets are overpricing securities for a relatively unlevered investor. "

My comment: Not true.

Tax payers lose unless the govt. resorts to the printing press instead. In which case, the buyers of US Treasuries suffer.

The example is extremely simplified, but conveys the key point.

This is what I call Capital Injection by Stealth.

The fundamental value (if there is such a thing) does not change.

And, if PIMCO was to provide the leverage, the amount that equity holders could pay would have also not changed.

Just that here, bondholders do not have a say.