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In my last post, I set the stage for most of what happened last week in the stock markets as well as credit markets that led to the $700 billion dollar proposal (what I callRTC2) floated by Ben Bernanke (the Federal Reserve Chairman) and Henry Paulson (who heads up the Treasury Department).

The eventual program details have yet to be hammered out by the politicians - a very scary concept to me and I will outline some of my greatest concerns to watch out for at the end of this post.   It is important to understand the basic mechanics of this proposal, what it is and what it is not as well as a specific caution regarding the price/value of financial institutions going forward.

THIS SHOULDN'T BE A "BAILOUT"

I am certain, that as originally proposed, B&P (Bernanke and Paulson) are trying to create a short-term entity similar to the Resolution Trust Corporation of the 1980's.  The RTC was created to provide a market for illiquid assets held by the Savings and Loans as well as Thrifts (both of which performed much the same benefits to society that banks now perform).

The challenge today - as it was back then - is that banks hold some assets that are not productive.  They are worth less than face value or original purchase price.  We call these assets, "Toxic Waste."  These can be sub-prime mortgages that are in risk of default.  They can also be credit card debt balances (which will become a bigger issue sooner than later), CMO's, CDO's, SIV's or probably some derivatives (highly leveraged option strategies).  

For the purposes of the proposed $700 billion fund (at least for now), the primary concern is the "assets" involving sub-prime and alt-A mortgages.

BANKING REFRESHER

Remember that when a bank loans out money, the future streams of cash-flow from maintaining and managing that loan become an asset.  This asset was commonly used to collatoralize a loan where those funds were used to loan out more money and build more assets.  In essence, we have loans being used to fund more loans being used to fund more loans - a sort of leveraged game of piggy back.

This is how banks can say that they hold 14% of their depositor's assets in liquid reserves when they are actually leveraged at a much higher rate.  I just read one economist who suggests that some banks are leverage 100-to-1, but that seem's alarmist to me.  I mean, who would be that stupid?

On second thought, don't answer that question.

LIVE BY LEVERAGE - DIE BY LEVERAGE

One of my cardinal rules is a derivative (pun intended) of the old adage, "He who lives by the sword, dies by the sword".  That cardinal rule in the world of finance is:

He who thrives through leverage can be destroyed by leverage!

If you have 10% equity (90% loan) in a $500,000 asset ... and that asset increases in value by 10%, the resulting $50,000 gain constitutes a 100% gain on your original $50,000 investment.  This looks really good on your profit and loss statement.

This is all well and good as long as asset prices are going up.  But take the same scenario except that the asset price has dropped 10% to $450,000.  You have now lost ALL of your investment capital.

This is the position where the banks find themselves, except they weren't leveraged at 9-to-1, they were leveraged at 30-to-1 or 40-to-1.  This is how the sub-prime mess (which is really a very small part of the mortgage market) has had such a huge effect on the banking industry.

MARK-TO-MARKET USED TO BE GOOD

The banks loved the leverage when things were good.  Their balance sheets and profit and loss statements looked really good.

Banks also weren't complaining about mark-to-market accounting when everything was going well.  Mark-to-market means that any time the current fair market value of an asset changes, a company must revalue that asset on their balance sheet.  Banks could use mark-to-market accounting to inflate the value of the underlying "assets" (which has turned out to be toxic waste) as real estate prices continued to soar.  They could then borrow even more money to buy more risky investments.

Woo Whoo!  It's a Party!

NOW THE TURKEYS COME HOME TO ROOST

BTW - no offense meant to turkeys, here.

As the banks have been trying to undo all of this excessive leverage, they have run into a little snag.  Nobody wants to buy their "toxic waste." 

If there was a regular market for these assets, someone might buy them at 75 or 80 cents on the dollar.  That would mean a loss for the seller (the banks), but a chance to live another day.  But since nobody wants to get close to this toxic waste, there are no buyers until you get down to a price of maybe 20 cents on the dollar.

This is where "mark to market" accounting comes in.  Even though this is an illiquid asset, the fact that right now it is only worth 20 cents means the bank must immediately change it's accounting picture (balance sheet) and show those "assets" to be worth ... 20 cents.  Now the bank doesn't have near the value it used to have - which makes it a smaller company and bigger credit risk, so the availability of other forms of cash (loans especially) comes at a higher cost (much higher interest rates).

Because the bank can't generate cash to run the business by selling assets (nobody will buy the toxic waste) and it can't borrow the money (due to analyst downgrades), the rest of the business operations begin to look risky ... which makes their portfolio of assets (including the toxic waste) look even riskier.  Now the price of their stock gets hammered.

Can you see how this can get ugly quickly?

But what is really happening is that we are starting to get a clearer picture of what these banks really hold and, I believe, are truly worth.  Things are coming into focus and we can tell the turkeys from the chickens and the foul (pun intended) from all the other animals on the farm.

In a quick summary - Banks have become the equivalent of a highly leveraged person who is "real estate rich and cash poor."

They hold toxic assets that aren't worth as much as they had originally booked.  These assets aren't particularly liquid anyway, and certainly not something they want to sell in a down market (and the real estate market is a down market).  The banks need money to operate and make new loans.  They can't sell their toxic assets because nobody wants to buy them.  Mark-to-market accounting requires that they revalue the toxic assets at lower prices which destroys their balance sheet (as they write it off).  Because their balance sheet has been so decimated, they lose their credit rating and so the cost of borrowing skyrockets.  And to add insult to injury, their stock price plummets.

The wheels come off the train.

WHAT RTC2 IS SUPPOSED TO DO

The proposed $700 fund was supposed to fill one simple function: create a market for this toxic waste.  The basic concept is to pay the banks some money (maybe 60 cents on the dollar) for their sub-prime laced loan portfolios.  This gives the banks the liquidity they need to keep up operations, make new loans (which are important to the daily operation of the economy) and live to make it up another day.

Meanwhile the RTC2 fund holds the toxic waste assets until there is market for them - probably in a couple of years.  The real estate market isn't likely to go down forever.  In time, it will stabilize at some intrinsic value at which point these loan portfolios, SIV's, CMO's, etc will be worth something - not $1.00 and not probably 80 cents, but likely 65 cents and certainly more than 20 cents.  Where the price settles isanyone's guess, but the consensus seems to be that real estate needs to fall about 40-45% off it's highs before a bottom is reached.  That is why we chose the 60% purchase price.

Done correctly, the taxpayers actually have a chance of making some money on this deal - depending upon how much the fund pays for the toxic waste today and how much it can sell the toxic waste for in a year or two.

In essence - the proposal was about buying time ... not about a bailout.

CAUTION #1 - THE PRICE

The price the RTC2 fund pays for the toxic waste is critical.  70 or 80 cents would indicate that it succumbed to pressure from the banks to bail them out.  Anything less than 60 cents would be a good deal for taxpayers.

CAUTION #2 - WHAT HAPPENS WHEN THE POLITICIANS GET INVOLVED

In a later article, I will discuss the moral hazard with having regulated banking industries.  I won't go so far as to say it should all be deregulated, but there are issues with this system that need to be discussed.

I will say right now that our representatives have NO CLUE about what is going on.

These folks are lawyers and laymen.  They are great at stump speeches and offering you and I all kinds of perks if we vote for them, but rarely have they ever run a business, much less spent time toe-to-toe with the financial geniuses who are behind the global financial markets.

DEMAGOGUERY

The first tack that most politicians take (and they already have on this issue) is demagoguery.  "Why should we save the fat-cat bank presidents but not save the homeowners who could lose their homes?"  This is Washington politics and pandering - pit one person against the other.  We're saving the big banks, so somebody else (the little lowly homeowner) is missing out (read "losing").

Maybe there should be a program to save homeowners ... maybe not (a topic for yet another post).  Adding a homeowner-in-distress benefit just made an already expensive proposal MORE expensive.

Besides, it will become impossible to tell whether or not the managers of this fund were able to operate for the benefit of the taxpayers (who are funding this program).  Saving the homeowners is a charity function.  This is supposed to be a business proposal with the US taxpayer being the shareholder and the RTC2 being the company.

OVERSIGHT

The second part of the counter-proposal was to insist on Congressional oversight.  I'm OK with someone reporting to Congress every month on the progress.  Congress is my representative as a tax payer and I do want them looking over the shoulder of whomever runs this monster.

I don't want those yahoo's sticking their fingers into business operations though.  With only a few exceptions, none of these politicians has ever run a multi-million dollar business for profit.  Absolutely, none of them have run a multi-billion dollar business for profit.

Who should run it?  I don't believe Ben Bernanke or Hank Paulson should be operating this fund.  I believe it should be an autonomous entity where those two can't mess it up, either (can you tell I don't have a lot of respect for them, either).

I would propose a board of retired CEO's and finance wizards.  Tap the brightest minds in US banking and finance.   Make a few of them operate as a board with one incentive - get a return on value for the tax payer.  Heck, if they succeed, you can even pay them a few million.  One percent of $700 billion is a cool $7 billion - enough for the mother of all incentive pay packages.

It might give these guys a chance to redeem themselves in the public eye for the giant mess that they made.  It sure would work better than sending those people to rot in jail and with this kind of incentive there is a much better chance of the taxpayers getting out of this alive than if we let the politicians try to manage it.

BLAME THE SHORTS

This is the third mistake (I won't say the third strike - Oops, just did).

This is actually part of the demagoguery issue.  When things go wrong, the media and everyone in Washington DC want someone to blame.  But they cannot point the fingers at themselves (even though they should).  The media is a cheerleader when things are good, but do almost no investigative reporting.  Nobody in Washington would dare blame their own laws encouraging looser lending standards or requiring a certain percentage of loans to below-prime lenders (both of which still exist).

They wouldn't dream of pointing a finger at Alan Greenspan or Hank Paulson or anyone else who has been the object of systematic pandering by the lobbyists and special interests.  Today, banking is a "regulated" industry where the primary purpose of the regulations are to create barriers of entry for competition and help the remaining entities (ie: Fannie Mae and Freddie Mac) grow to massive size and make money for their investors.

Nope!  They blame the shorts and put a "no short selling limit" on the market.

THE TRUTH ABOUT SHORT SELLERS

Short-sellers place bets that a particular stock or sector or market is going to see the price of their shares drop.  The "shorts" do this when they find a piece of information that implies that the share price is over-valued.

Short-sellers don't cause problems in the market - they identify problems in the market.

CEO's don't like short-sellers because they don't like being called on the carpet for potential problems with their balance sheets or business operations.  Too bad.  In this day in age when information is so readily available, they had better get used to it.

Short-sellers don't cause panics.  They account for only a small percentage of market activity.  Short sellers do identify places in the market where people should be concerned, questions should be asked and valuations reviewed.  This is healthy in a mature, efficient market.

Most short-sellers are hedge funds.  These are high-powered funds that take excessive risks in order to achieve excessive gains.  They also pay a high price for the best analysis on Wall Street (analysis that used to be provided by the big wirehouse firms - analysis which was eventually compromised by the wirehouse sales model).

The hedge funds will just find another way to put their analytic information to use.  The problem is that now we won't know what it is and we won't see it until long after it is in place.  The advantage to allowing short-sellers to exist in the market is that their activities are relatively transparent.  You can at least see when a company or sector is showing signs of distress (questions needed to be asked) because their stock gets shorted more. 

Now that short selling is prohibited - that form of transparency is gone.

FINAL WORDS ON VALUE

We have a long ways to go before this is all wrapped up.  The real estate market has more downside.  The equities markets have more downside.  The bond markets have more downside.

In my mind, nothing has more downside, though, than the banking industry - here is why:

Banks are still way over-leveraged.  Getting from 30-to-1 down to 10-to-1 is a long process and is going to mean a continued devaluation of bank assets.  Remember he who lives by leverage, dies by leverage.  Nothing is more true than this statement in a down market for the underlying asset.  It won't help to prop them up here when their intrinsic value is lower, either - that will only cause more pain across the spectrum and the pain just last lots longer. 

I wouldn't be surprised to see banks end up valued at 60% of their value today.  30% is in the realm of possibilities.

You had better hope that the RTC2 proposal goes through with as little "help" from the politicians as possible.  The more it is like a business and the less like government, the more stability it will provide to the global marketplace and hence, the security of our families' financial futures.

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