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Friday, February 6, 2009

Treasury to assume role of bad bank

According to the Financial Times, US officials are working on revised structure for their investments in banks.  Instead of preferred shares that carry a fixed dividend, they’re thinking of turning them into convertible preferred shares that could be converted into equity.  The benefit of this would be that if tangible equity ratios fell below a certain point, the Fed could convert their preferred and flood the equity side of the ratio.  Also under discussion is a plan to buy toxic assets at below market values and issuing a government security to cover the difference.

The Skew:

Ok.  So in order to make the bad debt problems less onerous they’re thinking of ballooning equity to make them seem less onerous per share.  This obviously will also directly dilute shareholders.  It also moves the government further down on the claims list should a bank go bankrupt – as preferred holders, they get paid before equity shareholders.  This would level the field in theory, though in practice I’m sure they’d take what they wanted and no one could do much about it.

The Fed and Treasury have been swapping toxic assets for government securities under revolving agreements via auctions.  It’s a temporary arrangement, trying to provide liquidity for illiquid assets so banks can stay afloat.  By buying the assets at a discount to market values and making good with government securities, they would be putting in a more permanent structure.  It’s an admission that the Fed thinks the credit problems have no short-term fix and that they expect it to take many years to correct.  Presumably once the government gets hold of the securities they would try to strong-arm the counterparties to more agreeable terms.  In a way, though, that seems impossible.  If the government is guaranteeing debt left and right, how can they turn around and devalue any of it?  Wouldn’t active devaluation of government-secured debt be like active destruction of the value of the dollar?  More than likely, the government would have to sit on these securities ad infinitum.

I will never like the idea of fighting excess liquidity problems with excess liquidity.  It’s gasoline on a fire.  I really do want to like one of these plans but it strikes me that its probably impossible.

The way to fix credit problems is through more stringent lending practices and higher down payments.  The origination market is moving in that direction… and the pool of eligible borrowers has thinned significantly as a result of higher standards.  Businesses and consumers will not invest in markets where they cannot predict a return on investment… and the ability to predict remains stymied for now.  This means that not only are businesses cautious about borrowing to expand (there’s plenty that want to borrow to catch up), but that banks will look at borrowers with increasing scrutiny and skepticism.  And let’s face it – they’re capped on what they can make anyway because of the securities dilution and the proposed pay caps.  Is there any incentive for a banker to take any kind of risk on a loan?  There’s no upside and the blank pink slips continue to pile up.

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