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My perspectives as an investor and consumer

Stressing out the banks

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One of the programs created under the TARP is the Capital Assistance Program (CAP).  The CAP was designed to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  A stress test, called the Supervisory Capital Assessment Program (SCAP),  was crafted and implemented by the Federal Reserve and the Treasury to aid them in assessing said capital cushion.  Details of the stress test were released to the public by the Federal Reserve on April 24th, through a 21-page white paper.  I present here a synopsis of the white paper.

All domestic bank holding companies (BHCs) with year-end 2008 assets exceeding $100 billion were required to participate in the SCAP.  According to ProPublica, 19 firms fell under this requirement.  They are listed in the second table below.  These 19 firms hold 66% of the assets and 50% of the loans in the US banking system.  They were asked to project their losses, and available resources for absorbing these losses, for 2009 and 2010 based on two economic scenarios — a baseline scenario and an adverse alternative.  The table below lists the components of the economic scenarios and the effect of the baseline and adverse conditions on each of them.  The supervisors, then, assessed whether their capital was adequate for them to function during this period.

fedeconomicscenariosfor2009_2010

Step 1: Loss Projections. BHCs were asked to project losses for 2009 and 2010 for 12 separate categories of loans held in the accrual book, for loans and securities held in the available-for-sale (AFS) and held-to-maturity (HTM) portfolios, and in some cases for positions held in the trading account.  The losses were to be consistent with the economic outlooks in the baseline and more adverse scenarios.  The BHCs were instructed to estimate forward-looking, undiscounted credit losses, that is, losses due to failure to pay obligations (“cash flow losses”) rather than discounts related to mark‐to‐market values.  The required assessments were broadly classified as:
19largestbanksbyassets20091

  • First and Second Lien Mortgages: institutions provided detailed descriptions of their residential mortgage portfolio risk characteristics – type of product, loan-to-value (LTV) ratio, FICO score, geography, level of documentation, year of origination, etc.
  • Credit Cards and Other Consumer Loans (e.g., auto, personal, student): portfolio information included FICO scores, payment rates, utilization rates, and geographic concentrations.
  • Commercial and Industrial Loans: based on the distribution of exposures by industry
  • Commercial Real Estate Loans: included loans for construction and land development, multi-family property, and non-farm non-residential projects.  Information such as property type, loan-to-value ratios, debt service coverage ratios, geography, and loan maturities was provided.
  • Other Loans: farmland lending, loans to depository institutions, loans to governments, etc.
  • Securities in AFS and HTM Portfolios: majority are public-sector securities such as Treasury securities, government agency securities, sovereign debt, and high-grade municipal securities. Private-sector securities include corporate bonds, equities, asset-backed securities, commercial mortgage-backed securities (CMBS), and non-agency residential mortgage-backed securities (RMBS).  Supervisors focused on evaluating the private-sector securities.  Loss estimates were based on an examination of 100,000 of these securities.  Loss estimate, and subsequent “write-down” to fair value, for each security was determined based on credit loss rates on the underlying assets, consistent with loss rates for unsecuritized loans listed above.
  • Trading Portfolio Losses: estimated by applying market stress factors to the firm’s trading portfolio based on actual market movements that occurred between June 30 and December 31, 2008.
  • Counterparty Credit Risk: the risk that an organization is unable to pay out on a credit-related contract when it is supposed to, which directly impacts a firm’s earnings and the value of its assets.  The action taken by the firm to account for this risk is referred to as credit valuation adjustment (CVA).  Supervisors focused specifically on a firm’s loss estimates for mark-to-market losses stemming from CVA associated with market shocks applied to assets in trading books.

Step 2: Resources to Absorb Losses. Institutions were also instructed to provide projections of resources available to absorb losses under the two economic scenarios.  These include the pre-provision net revenue (PPNR) and the allowance for loan losses over the two-year horizon.

  • PPNR is the income after non-credit-related expenses that would flow into the firms before they take provisions or other write-downs or losses.
  • BHCs supposedly had some allowance for loan and lease losses at the end of 2008.  They were required to estimate what portion of this allowance would be required to absorb potential future credit losses on their loan portfolio under each economic scenario.  This calculation could either result in depletion of the year-end 2008 reserves (if there is adequate allowance) or indicate the need for building the reserves (if the allowance is inadequate).

Step 3: Determination of Necessary Capital Buffer. Supervisors examined two main elements as indicators of capital adequacy – pro forma equity capital and Tier 1 capital.

  • Pro forma equity capital was estimated by rolling tax-adjusted net income (PPNR minus credit losses minus reserve builds) for the two-year horizon through equity capital.
  • Tier 1 capital is composed of common and non-common equity, with the dominant component being common stockholder’s equity.

The initial assessment of the capital adequacy, or lack thereof, was conveyed to the BHCs in late April and is expected to be released to the public on May 4th, 2009.  As yet it is uncertain whether the publicized results will reveal much about the banks.

Filed under: Business, Economy, Government, , , , ,

Understanding the PPIP

davidellis-flow1-07sOn March 23, 2009, the Treasury Department released details of the Public-Private Investment Program (PPIP), which is one of the programs under the TARP aimed at restoring financial stability.

The details of the program were complicated enough to elicit a standalone post.

The Problem. According to the Treasury, one of the problems plaguing the financial system is that of legacy assets – real estate loans held directly by the banks (“legacy loans”) and securities, or tradable financial instruments, backed by loan portfolios (“legacy securities”).  The true value of these assets has been brought to question. As a result, there is uncertainty surrounding the balance sheets of the institutions holding these assets.  Markets don’t like uncertainty as is evident from their performance, especially that of bank stocks, over the last 12 months.

Proposed Solution. The program’s intent is to repair the balance sheets of these institutions by moving the legacy assets off the hands of banking institutions and into the hands of investors.  Cleaner balance sheets could make it easier for banks to raise capital and increase their willingness to lend.

Principles of the Proposal. Treasury will use $75 – $100 billion in TARP money to become co-investors with the private sector, with backing provided by the FDIC and the Federal Reserve.  The “investment partnership” will, thus, be able to purchase $500 billion to $1 trillion of toxic mortgage assets (both residential and commercial) from banking institutions that currently carry them.

There are two separate approaches, one for legacy loans and the other for legacy securities.  Initially, Treasury will share its $75 – $100 billion equity stake equally between the two programs with the option of shifting the allocation towards the option with the greater promise of success with market participants.

  1. Legacy Loans Program: Suppose a bank has a pool of mortgages with $100 face value that it wants off its hands.  It approaches the FDIC, which determines whether it wants to leverage the pool at a 6-to1 debt-to-equity ratio.  If it decides to go ahead, the pool is auctioned by the FDIC.  Several private sector investors are hoped will bid.  The private sector bidder with the highest bid would be the winner and would form a Public-Private Investment Fund to purchase the pool of mortgages.  Let’s say the highest bid is $84.  Of this purchase price, the FDIC would guarantee $6 of every $7 in investment, or in this example, $72.  This is debt financing.  The remaining $12 is equity financing, which is shared equally by the private investor ($6) and the Treasury ($6).  The private investor would then manage the servicing of the pool of purchased assets.  The private investor and the Treasury would each be able to purchase $14 worth of assets for every $1 of their own money (14-to-1 leverage).
  2. Legacy Securities Program: Treasury will approve up to five fund managers for this program.  A fund manager, for example, submits a proposal and is pre-qualified to raise private capital.  The Treasury plans on being a joint-venture partner.  Let’s say a fund manager is able to raise $100 of private capital for the fund.  The Treasury will co-invest $100 in equity financing along side the private investor and will provide an additional loan of $100 (debt financing) to the “partnership” fund.  Additional requests for loans up to $100 will also be considered by the Treasury.  As a result, the fund manager has $300 – $400 in total capital for purchase of securities.  The fund manager has full discretion in investment decisions.  This program will be incorporated into the previously announced Term Asset-Backed Securities Loan Facility (TALF) whose original goal was to provide debt financing (non-recourse loans) to buyers of newly created consumer and small business loans.

The PPIP program has thus far met with lukewarm reception from the private sector, which is noteworthy given the necessity of their participation.  On a conference call to analysts and investors last Thursday, Jamie Dimon, the CEO of JP Morgan and, currently, the go-to guy for the US government on financial mergers/takeovers, said that they will not take part in the PPIP.  “We’re certainly not going to borrow from the federal government because we’ve learned our lesson about that,” said the Chief Executive.  Wells Fargo and US Bancorp are noncommittal.

It remains to be seen whether the Public-Private Investment Program will succeed in getting credit flowing again or further reveal corporate fear of business decisions driven a government that’s looking solely in the rearview mirror.

Filed under: Business, Economy, Government, , , ,

Take a look under that TARP

barsness_bigbluemountainIntimidated and confused by all the programs initiated by the government within the past 12 months?  Don’t beat yourself up.  We are in the majority.  Let’s try and shed some light on these programs and gain some understanding into the allocation of our taxpayer dollars.

On October 3, 2008, the Emergency Economic Stabilization Act of 2008 (EESA) was signed into law amidst a tailspin in the financial markets.  The Troubled Assets Relief Program (TARP) was established under the EESA with the goal of stabilizing the financial system of the country and, hopefully, preventing a systemic collapse.  Under this law, the Treasury was granted authorization to spend up to $700 billion towards the purchase of troubled assets and the injection of capital into banking institutions.

The TARP has several programs under it:

  • Capital Assistance Program (CAP): to promote confidence in the financial system by ensuring that the nation’s largest banks have sufficient capital cushion against larger than expected future losses.  Financial institutions have to undergo a supervised stress test to be deemed eligible.  The stress test requires these institutions to make some assumptions. The banks would have to assume that the economy shrinks by 3.3 percent in 2009 and remains flat in 2010.  Assumptions will also have to include a decline in house prices by 22 percent this yearUnemployment should rise to 8.9 percent this year and reach 10.3 percent in 2010.  Big banks – those with consolidated assets greater than $100 billion – are required to carry out the test by the end of April.  If regulators assess that an institution does not have enough capital under these assumptions, they would have to raise the required capital either in the private markets or from the government.
  • Consumer and Business Lending Initiative (CBLI): a joint initiative with the Federal Reserve.  The goal of this program is to unfreeze consumer and business credit markets by providing financing to private investors willing to purchase assets backed by auto, student, small business, and credit card loans.  Under this plan the Federal Reserve will provide $200 billion in lending and the Treasury will support it with $20 billion in credit protection.
  • Making Home Affordable Program: an effort to stem the tide of foreclosures and declining home values through the employment of three initiatives:
    1. A refinance for 4 to 5 million people who took out loans owned or guaranteed by Freddie Mac and Fannie Mae
    2. A $75 billion loan modification program aimed at preventing foreclosures by targeting 3 to 4 million at-risk homeowners
    3. Support low mortgage rates by strengthening confidence in Fannie Mae and Freddie Mac through increased funding commitments to the two entities
  • Public-Private Investment Program (PPIP): to repair balance sheets throughout the financial system through the Legacy Loan Program and the Legacy Securities Program.  The loan program will facilitate the purchase of troubled loans from banks while the securities program will attempt to move the highly illiquid securities (such as mortgage-backed securities and collateralized debt obligations) off the balance sheets of banks and into the hands of investors.  The PPIP is conducted in conjunction with the FDIC and the Federal Reserve.  $75 to $100 billion in TARP capital is combined with private capital.  FDIC and the Federal Reserve will provide leverage for the private capital thereby increasing purchasing power to $500 billion-$1 trillion.  Remember how excessive leverage was our financial system’s undoing?  Looks like we’re going back to the same well in order to rescue the selfsame.  I may have to post another article just on the intricacies of the PPIP.
  • Capital Purchase Program (CPP): created in October 2008 to provide immediate capital to stabilize the financial and banking system, and to support the economy.  It is a voluntary program in which the US Government, through the Department of Treasury, invests in preferred equity securities issued by qualified financial institutions.  The goal is to invest up to $250 billion.  As of the April 10th report by the Treasury, $198.8 billion has been invested.
  • Asset Guarantee Program (AGP): under this program, Treasury will guarantee certain assets held by systemically significant financial institutions. Assets to be insured are selected by the Treasury and must have been originated before March 14, 2008.  In return for this assurance, the government collects a premium from the financial institution, the value of which is determined through actuarial analysis.  Citigroup seems to be the only institution so far to have qualified, and tapped into, this program or forced to do so.  It has received a guarantee on up to $5 billion of its assets to date.
  • Targeted Investment Program (TIP): the goal here is to stabilize the financial system by reducing the chance that one firm’s distress will threaten other financially sound businesses, institutions, and municipalities.  The program is implemented through investments in these unstable institutions.  Citigroup and Bank of America are the lucky ones chosen for this program, each receiving $20 billion through investments in preferred stock with warrants.
  • Automotive Industry Financing Program (AIFP): instituted to prevent a significant disruption of the American auto industry.  Most of the aid has been through the issue of loans, which have so far totaled $24.7 billion.  $5.5 billion has gone to Chrysler Holding and Chrysler Financial.  $19.2 billion has gone to General Motors and GMAC.  The notable exception is Ford Motor, which stayed away from government support and has taken this opportunity to separate itself from the other two.  New York Times has an article on how this company managed to stay independent.
  • Systemically Significant Failing Institution Program (SSFI): to prevent disruptions to financial markets from the failure of institutions that are critical to the functioning of the nation’s financial system.  This domain is reserved for those rarest of institutions – ones that made the worst business decisions of, at least, the past decade, and threaten to cut us all off at our knees.  The lone inhabitant of this realm is American International Group, Inc. or fondly referred to as AIG.  The taxpayers have used $40 billion from this program to prop up this company.  This is in addition to the ~$90 billion it has drawn from the credit-liquidity facility created for it by the Federal Reserve.

Now that you’ve taken a look under the TARP what impressions are you left with?

Filed under: Economy, Government, , , , , ,

House of Cards

3008220063_3399805fc0_medHave you had a chance to see the new CNBC documentary, “House of Cards,” by David Faber?  If not, I recommend catching one of the reruns.  Faber presents the various elements that contributed to the housing-induced credit crisis and recession.  It is evident that there is plenty of blame to go around.  Factors include, but are not limited to:

  • historically low interest rates
  • consumer desire to fulfill the dream of home ownership at any cost
  • congressional legislation to facilitate that desire
  • Wall Street salivating at the prospect of additional revenue streams through formulation of loosely regulated/unregulated structured products
  • rating agencies operating under conflict of interest
  • investors reaching for the holy grail of high yields and “no risk” which they thought were encapsulated in these structured products

One element which was not covered in the documentary but, in my opinion, should share responsibility is the National Association of Realtors, led by David Lereah, which kept trumpeting the “buyer’s market” mantra.  Such rhetoric only exacerbated renters’ fears that they were going to miss out on the greatest real estate boom in history.  Now, as a private consultant, he admits he was wrong.

As consumers, we need to develop the ability for critical thought.  We need to learn to ask the right questions:

  • Is this in my family’s and my best long term interest?
  • Can I truly afford this?
  • Do I really understand what’s in this document?
  • Can I trust someone who benefits from my signing the document when they tell me not to worry about the fine print?
  • Am I making this decision based on fear or greed?

The primary interest of publicly traded companies is not necessarily the consumer.  They are beholden, first and foremost, to the shareholders.  Consumers need to be cognizant of this fact and hold themselves and the counterparty accountable.  Otherwise, we will find ourselves exhibiting the same systemic problems down the road albeit in another form.  Alan Greenspan, the former Chairman of the Federal Reserve, even states this as a foregone conclusion:

There is no doubt that somewhere in the future we’re going to have this conversation again.  It will not be for quite a period of time.  But, it will occur because the flaws of human nature are such that we cannot change that.

Filed under: Economy, Real Estate, , ,