US bailout fund is a gamble

US bailout fund is a gamble
22/09/2008 5:49:00 AM. | AIR

So now we have the mega US government fund that will save the markets from imploding.

It has stopped the rot in sharemarkets, but credit markets remain wary and uncertain.

But for the time being, we have to assume that the bailout is going to work and it could even allow some of the folk who caused the current crisis, to keep ducking reality and avoid taking their lumps.

So it's no wonder there are mutterings about the fates of Lehman Bros, Merrill Lynch and AIG: the usual collection of opportunists and lurk merchants want to know why the bailout came Friday and not last Sunday when Lehman failed, and then AIG was taken over and Merrill Lynch sent hurrying into the embrace of Bank of America.

Lawyers are being assembled and loopholes looked for.

So the cynics and smarter investors are asking who gets to bear the cost in the long run.

The answer is the American taxpayer is the only one who will pay.

So the poor American taxpayer is paying two ways for the housing crisis: losing their homes in three million cases, facing that prospects in millions more, losing their jobs (an extra 610,000 so far this year) and now having to stump up well over $US800 billion, and well over a $US1trillion if the costs of early support moves are added in.

What about shareholders and managements of the institutions being supported by the Treasury plan?

On all the evidence so far, it will do nothing to help end the root cause of the problem, the continuing decline in US home sales, new home starts and house prices.

Until that happens, the cost to the US Treasury and to US and other financial groups will continue to escalate.

It's going to do nothing to stop that, or change the direction of the US economy which is sliding remorselessly towards an increasingly nasty recession.

An announcement is due from the US government shortly, led by Treasury Secretary Hank Paulson, Federal Reserve chairman Ben Bernanke and US Congressional leaders, detailing some sort of agreement and the scope of the legislation for the fund and its rules and regulations.

The fund will be around $US700 billion, but that considerably underplays the true cost of the debacle so far.

Since March Mr Paulson and Mr Bernanke have spent $US29 billion guaranteeing the bailout of Bear Stearns, $200 billion at least on the bailout of Fannie Mae and Freddie Mac, $85 billion on the bailout of AIG (the big insurer which wrote credit default swaps on a range of debt that it had no idea about) and at least $US50 billion guaranteeing money market funds.

That's $US364 billion.

Seeing financial institutions around the world have already written down or lost over $US500 billion (and have raised around $US360 billion in new capital), the cost so far of the debacle that started with dodgy subprime mortgages and associated credit derivatives is well over $US800 billion (including Fannie, Freddie IAG etc).

If the $US700 billion is for new purchases of bad securities (and it could be extended to non-US groups at the decision of the Treasury secretary), the cost will balloon. That will allow the likes of Deutsche Bank, UBS, Credit Swiss and French and UK banks to unload their dodgy securities in certain cases.

Assuming that the $700 billion is spent on new securities, the cost could be well over $US1.1 trillion, excluding already announced losses (and over $US1.6 trillion if they are included).

Remember that a lot of analysts and commentators, plus bankers and their mates laughed at the International Monetary Fund when it said earlier in the year that the losses could be $US1 trillion.

It was obviously very conservative.

We are yet to see whether the debt to be bought will include non-mortgage related debt, say CDSs (Credit Default Swaps) and other dodgy credit derivatives issued over the debt of groups like General Motors or healthy US or foreign corporations' debt.

Will it include leverage buyout debt for the likes of private equity groups like Blackstone, KKR, CVC and the like?

And on top of all the spending so far on the likes of Bear Stearns and AIG, there's the $US500 billion spent or being spent a day by the Fed funding the markets in the US, Europe, Japan, Canada, Switzerland and other areas.

There's the $US180 billion swapped last week, there's the monthly $US200 billion being lent to banks and other groups in the US each 28 days and there's the daily $US33 billion being injected into US commercial banks each day and the $59 billion primary dealers last week (investment banks).

Even in a US economy that produces $US14.4 trillion worth of goods and services a year, that's a lot of cash.

In fact a working paper from two IMF economists estimated that banking crises chew up an average of 16% of the GDP of an economy. That's based on looking at 42 major banking crises around the world from 1970 to 2007 (and not including the current problem).

Spending all that money will intensify long-standing questions about America's fiscal health, possibly at the expense of another drop in the value of the dollar.

No wonder the US dollar blew out on Friday, sliding to over $US1.44 on the euro (the Australian dollar rose by more than 1.5c in offshore trading on Friday night).

To mitigate the cost and make for a more brutal (to the selling groups) and equitable arrangement for US taxpayers, the purchases could be made by the US Treasury through a bidding process.

Companies that want to offload their dodgy assets would bid to sell to the government at a huge discount. The company willing to sell at the lowest price wins. That's a reverse auction.

The government would then be able to sell the assets back into the market when it wanted: the government could give the banks a share of the upside if there are any profits.

The Fed lent that $US85 billion to AIG at a margin of 8.5% over the rate banks lend to each other internationally (so-called 3 month LIBOR). That's around 11% or a bit more in normal times outside of last week.

Using that as a yardstick, the pricing by the Fed could be brutal indeed.

So far it seems like the purchases will be aimed at dodgy housing-related debt of varying kind, but you can bet there will be pressure to offload corporate and buyout loans that are going bad. The property related debt specified in the proposed bill is residential (AND) commercial.

That alone will limit the Fund's ability to concentrate solely on residential debt.

And what about personal loans, credit card and car loan debt tied to foreclosures and home equity loans which is another disaster area?

The idea seems to be that the US government will buy at below-market rates and sell for a gain when the housing market recovers: when that will happen, no one is willing to say.

The problem is that the dodgy housing-related assets have proven extremely difficult to value as the demand for them has disappeared.

And there is a nasty message there: those banks and financial groups that stayed away from this sort of toxic debt are being punished. The incompetent and imprudent will be rewarded by being bailed out. This is what moral hazard is all about.

The strong stock-market rally late last week reflects the belief that companies have been saved from the cost of making dodgy decisions on these loans from incompetent and risky decisions to speculate and gear balance sheets to generate big earnings for the company and themselves.

The inevitable death of weaker firms will be delayed, and in turn that will delay the reckoning that must occur before a sustainable economic recovery can take shape.

The US government is seeking to eliminate legal challenges by making the Treasury the sole and final arbiter and not allowing any legal challenges, a move that has upset Americans in the legal field (naturally).

While the proposal calls for the purchase of as much as $US700 billion of bad loans, it's unknown what taxpayers will ultimately pay for the bailout.

The Bush administration's proposal requests that the US Congress authorises an increase to America's debt ceiling.

That's set to rise to $US10.6 trillion for fiscal year 2009 - which runs from October 2008 through September 2009, to accommodate a Federal Budget deficit already estimated at some $US580 billion.

But now the Administration wants to lift the ceiling to $US11.315 trillion to allow for the purchases of these dodgy mortgage-backed assets.

US commentators say that it's unclear at this point if it will help homeowners.

If the Treasury buys an entire securitized loan, it could help struggling homeowners by modifying the terms. This could include reducing a loan's interest rate or principal balance to help prevent foreclosure.

But if it doesn't buy all the securities. It could be held to ransom by the other holders.

The bottom line remains: if the plan doesn't stem the tide of foreclosures, home prices will not stabilize and the economy will not recover and banks and other financial groups will still be on death watch.

It will not help them lend more money for housing business, credit cards and the like.
Information provided to you by the Australasian Investment Review (AIR).AIR publishes a weekly magazine. Subscriptions are free at aireview.com.au

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