Monday, 23 March 2009 00:00

The Great Government Induced Bubble, part 2

The high leverage, low cost loans provided to buy the dead assets from the resultant bubble stemming from offering high leverage, low cost loans (just a year or two ago) will create another bubble that is destined to pop. The optimal solution is to let this current bubble pop. It appears that the powers that be really don't want the bubble to pop and fully deflate. The problem is that bubbles cannot be inflated in perpetuity. I think that's why they call them bubbles!

Pray tell, what happens to the toxic assets prices after the private sector overbids for them using excessive, low cost government leverage (or collusion, which is possible when the bank can turn around and sell a swap to the buyer to cover losses on the miniscule equity at risk) when those purchasers then attempt to resell them to normal buyers who don't have access to 6:1, sub 2% leverage on a non-recourse basis (or the cooperation of the bank to cover their equity losses)? No banks or brokerages that I can think of are offering terms anywhere near this level. Will our government continue to play Global Prime Broker ad infinitum by supplying margin to everyone who asks for it, forever? Highly doubtful!

Well, just like with the subprime crisis, once reality hits the fan, and that cheap and easy credit is no longer available, asset prices will fall - and they will fall hard - just like they did last time. Just like they will do every time. It is the the nature of a bubble. They get popped! The market can rally all it wants on the news of this latest bailout, natural market price discovery has yet to take place, and when it does, downward pricing pressure will rear its ugly head again. Only this time, the assets will fall in price after the government would have spent $100 billion to $1 trillion to buy them, and eat up tax payer monies directly. Natural market price discovery is the endgame, and the only way the bear market turns to a real, full-fledged bull market. I can't give you timing on this, but I can give you the parameters.

Now, many may be saying that the assets are now off of the bank's books so they can resume doing business. Well, that statement first assumes that all banks will sell all of their assets at that optimal price. It also assumes that there is a lot of business to be doing. We still have too many banks crowding into the same markets for one, and most importantly in terms of lending, the only retail and corporate borrowers who are crowing for debt right now are the ones that shouldn't be lent to in the first place. Back to the bubbly days of giving people and companies credit that really shouldn't have it? How fleeting is YOUR memory? Think about it. If you are a very good risk and have the capital and resources to repay loans easily, have you thought about buying a new home lately? You have a lot of people who are in trouble trying to refinance, but then again they are in trouble aren't they? I don't see prudent banks rushing out to lend to them at attractive rates. The same goes for the corporate sector. There are a lot of GGPs out there who need loans, but who really wants to lend to them? They want to lend to Berkshire, who doesn't seem to be in the market for loans right now.

We also have the issue of what happens to the losses. No amount of chicanery, engineering or magic will eliminate losses. Losses are losses and they need to be taken. It appears as if an overbid for assets with losses embedded will simply transfer those losses to the winning bidder. If the winning bidder has a super sweet deal, with nearly no risk, financed by the tax payer, then the losses are transferred from the winning bidder to the tax payer. If there is no winning bidder, then the losses remain with the bank. If the bank and the bidder collude in hiding the losses through inflated prices that are made to look profitable, ex. Mega fund buys the assets from the bank at the Truth + X percent, then turns around and buys a swap from the bank paying off X percent +1 to cover their exposure (which in reality is a guaranteed loss), then things look hunky dory until the underlying assets and or the cash flows start breaking down. Then the losses become apparent somewhere, most likely to the detriment of the taxpayer.

You see, no matter which way you slice it, if there are substantial losses in the system it will surface somewhere and somehow - and there are substantial losses in the system. The market is rallying as if the losses have evaporated. This is a profit opportunity, but you will have to be able to swallow a lot of volatility (or be a lightning quick trader) and have a minimum 3 month to 1 year horizon. Even if the bank and the fund make it look all hunky dory, when the losses do surface and the tax payer ends up biting it, and it will be manifested in lower consumer expenditure due to lower discretionary income which will be felt directly and immediately by the banks and the banks biggest customers. Hence, the losses will come round robin.

My suggestion??? Let's stop playing these games and force those who created the losses to take them now and we can all get back to the business of being the world's pre-eminent global economic superpower. Otherwise, that title may very well be up for grabs.

I will have objective analysis of the most recent bailout plan and its potential upside and fall out very soon and will post it accordingly.

Last modified on Monday, 23 March 2009 00:00


  • Comment Link Reece Wednesday, 01 April 2009 03:37 posted by Reece

    Since these toxic assets are guaranteed by the FDIC, wouldn't they be classified as AAA, little to no risk? what would stop the Hedge Funds or P.I firms from using the assets to borrow more money to invest in other areas while charging their normal 2 to 5% management fees while they sit on these "Toxic assets" for 3 to 5 years....

  • Comment Link Reggie Middleton Tuesday, 24 March 2009 15:11 posted by Reggie Middleton

    [url=]From Bernstein's Bloomberg Interview:[/url]

    [quote]Removing devalued loans and securities from banks’ balance sheets is a short-term solution that will delay the problem’s ultimate solution, which is bank takeovers, Bernstein said. The government won’t be able to inflate the prices banks receive for selling bad assets indefinitely, he added. [/quote]

    This is exactly what I was alluding to. The prices will fall once the cheap leverage is stopped. You need secondary sales in a secondary market.

    [quote]“The history of bubbles shows quite well that financial sector consolidation is inevitable,” Bernstein, Bank of America’s chief investment strategist, wrote in a research note. “Financial stocks will be attractive when the government tries to speed up that inevitable process. However, to the contrary, the government continues to attempt to stymie that inevitable consolidation.”[/quote]

    Well spoken my friend. You must read my blog!

  • Comment Link bobsell Tuesday, 24 March 2009 12:47 posted by bobsell

    [quote]A similar move was done India about in 2001-2 where the govt. took over the assets and issued govt. backed bonds in lieu.[/quote]

    India at the time benefitted big time from the USA's policy of allowing outsourcing of American jobs. This has resulted in the US IT sector being decimated, and many other industries slammed as a result. We basically fell on a knife for them.

    What do we have to look forward to? Our manufacturing sector is dead. Our government is hell bent on screwing over the taxpayer. Our corporations are sending out pink slips to Americans while H1B's get to keep their jobs.

    Unless we can find a large enough outside economy willing to fall on their knife for us, we will never be as lucky as India.

  • Comment Link NDbadger Tuesday, 24 March 2009 12:27 posted by NDbadger

    I agree with your analysis Reg. Basically, the plan is designed to allow banks to move their toxic crap off their books at inflated prices and pays off the investment manager handsomely for acting as the middleman. The community bank (more likely the taxpayer) will eat the losses. Heads the banks and investment manager wins, tails the taxpayer pays. It's even worse than this because banks can game the system, also acting in the role of the investment manager themselves.

    This is actually a lot worse for the taxpayer than the original bad bank scenario in which the taxpayer directly negotiates for the assets of the bank.

    The only question is will it work?

    To answer this question, the key questions are:

    Will the banks participate? I think so, because they can provide swaps eliciting a higher price than otherwise, and substantially
    reduce their losses. And the plan is designed for investors to overpay for the assets. Although in a perverse way, the changes to MTM probably make it somewhat less likely to work.

    Will the investment manager participate? Yes, because he is being bribed to participate.

    And will the taxpayer participate? Yes, because he isn't being given a choice. Bend over and take it like a man.

    But they currently don't have enough funds to really get the job done, and Congress is unlikely to give them any more $$. Although I have heard some claims that if the plan looks like it is working, then Congress will probably come up with more $$. I don't know the likelihood.

    But I also agree with tradingbr. How can we be short the banks if the plan is to clean the banks, and the participants incentives are in place to clean them? We should short the taxpayer (which I guess is the gold play). But gold is so weird as it doesn't generate any cash.

  • Comment Link ariel Tuesday, 24 March 2009 11:35 posted by ariel

    Though a complete beginner at addressing myself to macro economic matters, I find myself amazed at how simple are the underlying fundamental dynamics of asset and profit flows (read capital). Accordingly, your views concerning a government induced bubble as well as “market natural price discovery” appear to me well taken (isn’t this economics 101). The brainiacs with Geithner know this stuff… what’s driving their policy…. Is it politics… namely no president would risk a message of “for the sake of our children…. Let’s pay the piper” as it were? Wouldn’t it be preferable to capitalize new retail banking ventures? Wouldn't the current format would produce more accurate asset pricing if the non-recourse component of the current asset transfer format were modestly modified in favor of the lender?

  • Comment Link Tradesense Tuesday, 24 March 2009 09:45 posted by Tradesense

    A similar move was done India about in 2001-2 where the govt. took over the assets and issued govt. backed bonds in lieu. No private partner or leverage was used (indirectly it was through govt. deficit financing - burden was ultimately on taxpayers). In the subsequent bull run of 2005-7 these were slowly liquidated as prices moved up and the govt. made a reasonable profit. I presume the same may apply here. Currently the value/price pressure is because of its distressed nature. Once these assets hopefully move out and calm the system, in time the markets probably will start pricing them in a more efficient manner and these then can be liquidated at a reasonable profit or breakeven levels hopefully.

  • Comment Link tradingbr Tuesday, 24 March 2009 07:26 posted by tradingbr

    This move will transfer some losses from US banks to the taxpayer, if the RGE estimage of $1.8T losses to banks is correct, the taxpayer might endup getting a chunk of that. This is bad for the short-seller, period

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