Tuesday, July 14, 2009

Anatomy Of A Bailout - The Great Debate.

Bailouts for Dummies - The Real Problem.

At the heart of each problem is to reconcile the facts. At the core of the bailout process is to try to reconcile the balance sheet of the banking/financial system. The biggest concern is the roughly $8 Trillion in loans currently resting on the asset side of the equation. We cant ignore the $2.8 Trillion in securities and $2.5 Trillion in other assets that also reside on the asset side. When I say loans, this is where the vast majority of "Toxic" assets reside. So the $50 Trillion question really is: What is the true value of this $8 Trillion number? Because Banks have only taken collectively $1.2 Trillion in total write downs against these assets. As it looks write now, the system still has total net exposure of $6.8 Trillion in toxic paper, this could be a higher number as the economy contracts further, credit quality weakens, and unemployment drags further.

The next question to ask is: Is that $1.2 Trillion in write downs enough? Here is the great debate.

On one side we have Geithner/Bernanke/Obama/Wall Street/Public Policy, who seem to believe that the write downs will continue but at a much smaller pace. That any further write downs will be smaller in scale, as the government has enacted these programs to stabilize the secondary loan market.

1-Quantitative Easing
3-Treasury Buy Back
4-Open Mkt MBS Purchases
6-Debt Guarantee

They also seem to believe that the recession we are having will be severe but shows signs of abating. Well I sure hope they are seeing signs, I wouldn't want the $3 Trillion that they have already spend to go waste.

Obviously the other side thinks this is bullshit.

The $1.2 Trillion write down figure is not enough by a long shot.

For accounting purposes, the Assets, by definition, should equal the Liabilities plus Shareholder Equity. As nobody even now currently knows what the true value of the assets really are, the various Bail Out support programs listed above are designed to provide the backing to make it seem like the almost $8 trillion in deposits, the core of bank and thrift liabilities, are not supported by toxic assets.

Currently the Bail Out programs now support over 72% of the total liabilities on the balance sheet. This figure is truly staggering. Dr. Doom-Nuriel Roubini anticipates the total amount of write downs (US) will reach $3.6 trillion, or another $2.4 trillion to go. The revised IMF estimates $3.1 trillion in total US losses, or another roughly $2 trillion to go.

These estimates are actually optimistic, because through its various implicit and explicit guarantees the administration is saying the total pain could potentially reach $8.8 trillion. The Fed and Treasury are also providing support for up to 20% of the bank system shareholder equity through TARP preferred stock, some of which has already been converted to common equity, some paid back.

As the government has the best information about the true depressing state of affairs, it is likely that as more and more information about the weakness of the financial system comes to light, more of these support guarantees will become utilized to their full extent. This also means that the asset side of the balance sheet is potentially inflated by almost 75% and the net result could be the most dramatic collapse in a banking system's assets in record history as over $8 trillion in "assets" are reevaluated.

The logical question to follow up on is what is the collateral that is being used to prop up all of these government programs?

If you notice below, the amount of Quantitative Easing the Fed is using is increasingly using any asset class to used as collateral.

In the past with most open market purchases, The Fed has made counter parties use the least risky of assets, such as AAA rated ABS and CP, and Treasuries. It is becoming the norm that virtually any security, regardless of risk will be "eligible" collateral for Fed backstopped guarantees. The recent transformation in the TALF & PPIP support is just such an indication.

Ultimately, as additional Bail Out programs are enacted, it is likely that they will have no practical collateral threshold whatsoever, as more and more assets of all types are perceived to be dramatically impaired and which need systemic support. We may very well see Sub Prime garbage being used as collateral.

The Balance Sheet of the Treasury has exploded. At last count it is close to $2 Trillion. Combined with the U.S. deficit which is increasing at a dramatic and unprecedented pace. The bulk of these expenditures are currently going merely to fund the Bail Out program, in essence transferring U.S. sovereign issuance to the Fed's balance sheet which uses the newly minted cash to fund all the incremental and growing support programs. The Fed/Treasury currently only has a small % of the guarantees ($8.8T) totally funded. So eventually there will be in excess of $7 Trillion of new Treasury issuance bleeded into the system. So in broader context, the debate should not be over Mark-2-Market, FASB, write downs, and PIPP, but how in the world can we continue to issue this level of debt?

We cant go on printing money without dire consequences:

2-Liquidity Traps
3-Reserve Currency Change
4-Dollar destruction

As more data is released, the real risk for the Bailout program is in fact the liability side of the balance sheet. The bottom line is that every dollar printed by the Treasury directly goes to fund (and dilute) a dollar in deposits, bypassing M1-M3. If the $8 trillion pool in total deposits realizes that it is supported by assets which even the government is saying are worth fractions on the dollar, the risk of a wholesale systemic bank run becomes unstoppable even with all the government backstops in place.

You're debt is only good as long as people are willing to keep buying it. How much more can China buy at this point?

Its all contingent on continued willing recipients of those rapidly devaluing pieces of paper known as U.S. Treasuries.

We have heard some grumblings about China and reserve currency change. Its all talk as China has more to lose at this point, but this is truly serious time in our history, as the whole planet is still betting that US Debt is the safest play, but once that assumption is questioned or outright proven false, there will be major regime change.