October 1st, 2008 2:20 PM by Lehel Szucs
Might Uncle Sam Make Money On The Bailout?
Gary D. Halbert
IN THIS ISSUE:
The Latest $700 Billion Bailout Package
What Could Go Wrong? Potentially A Lot
What Could Go Right, If We're Lucky?
What Would Happen To The Profits, If Any?
A "Main Street" Backlash To Come?
Like it or not, members of the House and Senate, with the approval of President Bush and both Senators McCain and Obama, reached a final agreement on the massive $700 billion mortgage bailout package over the weekend, with the much-awaited announcement on Sunday afternoon. Yet on Monday, the bailout bill failed to pass in the House of Representatives. As this is written, is not certain what will happen next. The next action probably doesn't happen until Thursday.
Assuming the latest rescue package (or some version of it) passes both houses of Congress, which is a real stretch at this point, it will give President Bush, Treasury Secretary Paulson and Fed Chairman Bernanke most of what they asked for. I'll discuss the details below.
Most Americans do NOT like the latest huge government bailout of Wall Street banks, brokers, etc. Some polls late last week and over the weekend suggested that 65-75% of Americans opposed the bailout. I can understand why, especially with millions of American families struggling to make their monthly mortgage payments.
One reason for this anger over the bailout is the widespread perception that the $700 billion (or whatever the number turns out to be) is money down a rat hole that the government and taxpayers will never see again. While there are numerous risks in the bailout, the odds seem low that the government will lose all or even most of the bailout money. I will discuss some of the main risks to the bailout as we go along.
Interestingly, there is a growing number of intelligent folks in the financial world that believe the government could actually make a lot of money on this huge bailout effort, especially if they play their cards correctly. As I will discuss below, some respected analysts believe the government could net $1 trillion or more off of its investment of $700 billion.
Don't count me among this group, however. While I would concede that there may be some potential upside in this massive bailout program, we have to keep in mind that it's the government, after all, that will be running the enormous and complicated operation. The government is not known for making money, especially in complex financial dealings.
In any event, I do believe that if more Americans understood there is the potential to get most or maybe even all of the bailout money back, they might not be quite so angry about the deal. We'll talk about all of this as we go along this week.
The Latest $700 Billion Bailout Package
As discussed at length in last week's E-Letter, the massive rescue package floated by President Bush, Treasury Secretary Paulson and Fed Chairman Bernanke on September 19 was fraught with problems. That plan would have us turn over $700 billion to the Treasury Secretary with no oversight, no transparency, no accountability and no legal challenge in the courts.
There was no chance that package was going to pass, as I pointed out last week. Yet over the ensuing week, all parties rolled up their sleeves, put in very long hours, made compromises on both sides of the aisle and came up with a much better rescue plan by last Sunday. Whether we like it or not, here is an overview of the latest massive bailout plan as we now understand it.
Doling the money out: The $700 billion would be disbursed in stages, with $250 billion made available immediately for the Treasury's use. More would be made available as needed. Authority to use the money would expire on Dec. 31, 2009, unless Congress certifies a one-year extension.
Overseeing the program:The bill would establish two oversight boards. A new Financial Stability Oversight Board would be charged with ensuring that the policies implemented protect taxpayers and are in the economic interests of the United States. The oversight board would include the Federal Reserve Chairman, the Securities and Exchange Commission Chairman, the Federal Home Finance Agency Director, the Housing and Urban Development Secretary and the Treasury Secretary.
Second, a congressional oversight panel would be charged with reviewing the state of financial markets, the regulatory system and the Treasury's use of its authority under the rescue plan. Sitting on the panel would be five outside experts appointed by House and Senate leaders.
Insuring against losses:The Treasury would establish an insurance program - with risk-based premiums paid by the industry - to guarantee certain of the companies' troubled assets, including mortgage-backed securities purchased before March 14, 2008. The amount the Treasury would spend to cover losses minus company-paid premiums would come out of the $700 billion the Treasury is allowed to use for the rescue plan.
Protecting taxpayers: One provision requires the President to propose legislation to recoup losses from the financial industry if the rescue plan results in net losses to taxpayers five years after the plan is enacted. In addition, Treasury would be allowed to take ownership stakes in participating companies.
Limiting executive pay: Curbs would be placed on the compensation of executives at companies that sell mortgage assets to the Treasury. Among them, companies that participate will not be able to deduct the salary they pay to executives above $500,000. They also will not be allowed to write new contracts that allow for "golden parachutes" for their top five executives if they are fired or the company goes under. However, the executives' current contracts, which may include golden parachutes, would still stand.
Like it or not, these are the highlights of the latest proposed massive government bailout of troubled financial institutions which may yet be signed into law this week. While leaders of Congress praised themselves for acting quickly, it is indeed a very sad time for America.
What Could Go Wrong - Potentially A Lot
Let's be clear from the outset: this is the largest and most complex financial rescue plan in history. Given that fact, some argue that Treasury Secretary Hank Paulson is the right man for the job. Paulson was Chairman and CEO of investment banking giant Goldman Sachs from 1999 to June 2006 when be became Treasury Secretary. While Paulson may be very qualified to head-up this massive financial operation, we must keep in mind that the rescue plan will hardly be off the ground by January 20 when the new administration takes over.
Perhaps the new president will keep him on, but there's no guarantee. So, leadership of this massive, complex operation is a big, big question mark as we begin our summary of the possible risks and problems.
The next fundamental risk is this: the banks, brokerages and others will be trying to unload the worst of the worst of their mortgage-backed securities on the government for the best possible price. The question is, will the government pay too much?
The mortgage-backed securities (MBSs) that the Treasury will buy from the various financial institutions that hold them are in many cases very complicated instruments. Space does not permit a discussion of all the intricacies and the various combinations and mutations of these complex packages of MBSs (not to mention that I don't fully understand them all myself).
Suffice it to say that even the supposedly brilliant minds of Wall Street cannot determine how to value many of these securities today, so why should we think that government bureaucrats will know how to value them correctly? Why would we not assume that the Wall Street banks and brokers will convince Treasury to pay more than the securities are really worth?
And as I discussed briefly last week, the government has some incentive to pay more than these assets are really worth. After all, the supposed purpose of this massive bailout is to allow the banks and other financial institutions to recapitalize and resume lending and unfreeze the credit markets. If the government buys these MBSs at even further discounted prices, the banks would have to book even more losses, and more banks would fail.
The thinking is that since Uncle Sam has the deep pockets and the ability to hold these securities for a long time, it can pay the banks somewhat more than today's crisis values, thus allowing them to recapitalize. Presumably, the government can hold the mortgage securities long enough for them to recover and make at least a decent profit on some of them. That remains to be seen, of course.
I think we can all agree that the government has the deep pockets, at least as long as the world is willing to buy our Treasury bills, notes and bonds. But my question is whether the Treasury, the Congress (and the public for that matter) will have the patience to hold these distressed securities, potentially for years for them to recover. Or will there be pressure on the Treasury to dump these securities prematurely?
Patience is not a commodity that is in heavy supply in today's debt-laden, entitlement-oriented society in America. Baby Boomers need a renewed bull market in stocks to fund their retirement, which may be postponed due to this massive pool of MBSs hanging over the market.
Bottom line: if the Treasury is pressured into unloading these mortgage-backed securities before the economy and the debt markets have recovered, then we should expect to incur potentially huge losses and possibly yet another credit crisis.
Next, there is the question of how will the Treasury determine which banks and other financial firms get to participate in the bailout, especially in the first $250 billion tranche (assuming that is the final deal). One possible mechanism that has been discussed by Paulson and others is a "reverse auction." However, a traditional reverse auction may not be effective in this situation where the government is not necessarily looking to purchase the MBSs at the lowest possible price. The objective of the enormous bailout is not to drive more financial firms out of business, but to help them recapitalize, stay in business and resume normal lending.
Another tricky part of determining which banks and financial firms get to unload their bad debt is as follows. As noted earlier, everyone will likely try to unload the worst of the worst MBSs on the government. Some firms that are in better shape and have limited MBSs may be in a position to take less for them just to get them off their books, whereas firms that have much higher exposure to MBSs could yet go out of business were they to unload their toxic positions at further discounted prices.
The bottom line is, the process for determining which firms get to unload these securities, and at what prices, will be extremely complicated and risky. A lot could go very wrong.
The discussion just above is by no means a comprehensive summary of the possible risks to this massive mortgage bailout. In fact, it is overly general, but I think you get the idea that we are far from out of the financial crisis, even if the massive bailout becomes law later this week.
What Could Go Right, If We Are Lucky
As noted in the Introduction, there are some very smart people that believe the government could actually make a profit on the bailout, perhaps a lot of money if managed effectively. Bill Gross is one of the most highly respected money managers and financial writers around. He is the portfolio manager for the largest bond mutual fund in the world, PIMCO's Total Return Fund. He is also the author of two very popular books on investing.
Last Wednesday, Bill penned an editorial in the Washington Post in which he made it known that he was in favor of some form of the government rescue plan that was being debated in Congress last week. Furthermore, he made it clear that he believes the government could make a lot of money on the mortgage-related assets the Treasury intends to buy. He said of the bailout plan:
"The extreme measures [needed] are extended government guarantees and the formation of an RTC-like holding company housed within the Treasury. Critics call this a bailout of Wall Street; in fact, it is anything but. I estimate the average price of distressed mortgages that pass from ‘troubled financial institutions' to the Treasury at auction will be 65 cents on the dollar, representing a loss of one-third of the original purchase price to the seller, and a prospective yield of 10 to 15 percent to the Treasury. Financed at 3 to 4 percent via the sale of Treasury bonds, the Treasury will therefore be in a position to earn a positive carry or yield spread of at least 7 to 8 percent.
Calls for appropriate oversight of this auction process are more than justified. There are disinterested firms, some not even based on Wall Street, with the expertise to evaluate these complicated pools of mortgages and other assets to assure taxpayers that their money is being wisely invested. My estimate of double-digit returns assumes lengthy ownership of the assets and is in turn dependent on the level of home foreclosures, but this program is, in fact, directed to prevent just that…
Today, the purchase of junk mortgages, securitized credit card receivables and even student loans will be bought at prices significantly below ‘par' or cost, and prospectively at levels allowing for capital gains. This is a Wall Street-friendly package only to the extent that it frees up funds for future loans and economic growth… The Treasury proposal will not be a bailout of Wall Street but a rescue of Main Street, as lending capacity and confidence is restored to our banks and the delicate balance between production and finance is given a chance to work its magic."
So, Bill believes the government should be able to make 10-15% on average on the distressed mortgage and related securities it purchases – IF the massive operation is managed well. Interestingly, it was reported in the media late last week that Bill offered to manage the government-owned mortgage/securities portfolio himself for free. Who knows if this offer is for real, but PIMCO manages over $825 billion in assets now, an amount similar to the size of the proposed bailout, so…. Hank, are you listening?
The next example of a savvy market maven who thinks the government could make some serious dough on the bailout package is Andy Kessler. Andy is a former hedge fund manager who made his claim to fame by reportedly taking $100 million in his fund's assets in 1996 to $1 billion by 2001. He has since written several popular books on investing and business.
Andy believes the government could make far more money on this mortgage rescue package than Bill Gross envisions. Here are excerpts of what Andy offered up last Thursday in his latest Wall Street Journal editorial (emphasis added):
"There is a saying on Wall Street that goes, ‘The market can stay irrational longer than you can stay solvent.' Long Term Capital Management learned this lesson 10 years ago when it got its portfolio picked off by Wall Street as its short-term financing dried up. I had thought the opposite -- hedge funds picking off Wall Street -- would happen today. But in a weird twist, it's the government that is set up to win the prize.
Here's how: As short-term financing dried up, Fannie Mae and Freddie Mac's deteriorating financials threatened to trigger some $1.4 trillion in credit default swap payments that no one, including giant insurer AIG, had the capital to make good on. So Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship. This removed any short-term financing hassle. He also put up $85 billion in loan guarantees to AIG in exchange for 80% of the company.
Taxpayers will get their money back on AIG. My models suggest that Fannie and Freddie, on the other hand, are a gold mine. For $2 billion in cash up front and some $200 billion in loan guarantees so far, the U.S. government now controls $5.4 trillion in mortgages and mortgage guarantees.
Fannie and Freddie each own around $800 million in mortgage loans, some of them already at discounted values. They also guarantee the credit-worthiness of another $2.2 trillion and $1.6 trillion in mortgage-backed securities. Held to maturity, they may be worth a lot more than Mr. Paulson paid for them. They're called distressed securities for a reason.
Now Mr. Paulson is pitching Congress for $700 billion or more to buy distressed loans and CDOs [Collateralized Debt Obligations] from the rest of Wall Street, injecting needed cash onto balance sheets so that normal loans for economic activity can be restored. The trick is what price he will pay. Better mortgages and CDOs are selling for 70 cents on the dollar. But many are seriously distressed (15-25 cents on the dollar) because they are the last to be paid in foreclosures. These are what Wall Street wants to unload the quickest.
Firms will haggle, but eventually cave -- they need the cash. I am figuring Mr. Paulson could wind up buying more than$2 trillion in notional value loans and home equity and CDOs for his $700 billion...
It's not without risk, but the Feds, with lots of levers, can and will pump capital into the U.S. economy to get it moving again. Future heads of Treasury and the Federal Reserve will be growth advocates… This is a huge change. Plus, a stronger U.S. economy, with its financial players having clean balance sheets,[the U.S.] will become a safe haven for capital...
You can slice the numbers a lot of different ways. My calculations, which assume 50% impairment on subprime loans, suggest it is possible, all in, for this portfolio to generate between $1 trillion and $2.2 trillion -- the greatest trade ever. Every hedge-fund manager will be jealous. Mr. Buffett is buying a small piece of the trade via his Goldman Sachs investment.
Over 10 years this could change the budget scenario in D.C., which can also strengthen the dollar. The next president gets a heck of a windfall. In the spirit of Secretary of State William Seward's purchase of Alaska for $7 million in 1867, this week may be remembered as Paulson's Folly."
What exactly does this mean? Kessler believes that the Treasury will recover at least $1 trillion off of the investment of $700 billion – even with some of the mortgage securities fetching zero – and quite possibly as much as $2.2 trillion. Only if the operation is bungled should the government lose a dime, so Kessler believes.
Finally, I'm seeing more and more analysts come to increasingly positive conclusions about how the government ought to be able to make money – and not lose money – on this massive mortgage rescue package.
As for me, I'm not drinking the kool-aid just yet, but then again, I'm willing to admit that there's potential if a lot of things happen right. But a lot could go wrong as well. We are talking about the government after all, and one that may well be controlled by a liberal Congress and a liberal president for the next four-to-eight years. So I would not bet a dime that this massive bailout will end up being profitable. On the other hand, I do hope that it will.
No doubt we will all rejoice if the $700 billion bailout reaps some big profits in the next 5-10 years (not that I am convinced, of course). As thoughts of some sizeable profits have become the talk of the town in recent days, questions have arisen as to what the government would do with the windfall should it happen.
Would Uncle Sam issue checks directly to the taxpayers? Not hardly! That would be seen as a tax cut, when in fact the taxpayers never had to loan the government any money directly to fund this massive $700 billion bailout.
Some intelligent observers have suggested that the government could use the potential profits from the giant bailout to pay down the national debt. This is precisely what Andy Kessler refers to above when he writes: "Over 10 years this could change the budget scenario in D.C." He is suggesting that the government could use the profit he projects (up to $1.5 trillion) to pay down the national debt.
Others have suggested that the potential bailout windfall could be used to help shore-up Social Security and/or Medicare. A trillion dollars, they suggest, could go a long way toward keeping these giant entitlement programs solvent in the years ahead.
That's a nice idea, assuming such a windfall profit actually occurs. But even if you assume that there will be some large profits some years down the road on this huge bailout, which I don't, what do you think Congress and the Administration in power at the time will do with the money? Three guesses, and the first two don't count.
They will spend it and delight in doing so. They will not send us a check or even cut taxes. They will not pay down the national debt. They will see it as a green light to increase the budget and thus the size of government. Just keep this in mind in a few years – if there are any profits to be dealt with.
Thus, I would insist that there should be clear language in the bailout bill, assuming one passes, that specifies exactly what would be done with any profits that might result from it. Yet that is not likely to happen.
A "Main Street" Backlash To Come?
As noted earlier, some polls over the last two weeks suggested that two-thirds to three-fourths of Americans were opposed to the Wall Street bailout. Clearly, millions of Americans are downright angry about it. A few polls indicated that the numbers were not as negative as 65-75% opposed, but clearly there are far more Americans who oppose the bailout than are remotely in favor.
This indeed raises the question of whether there will be a Main Street backlash if the $700 billion bailout is voted into law. Clearly, millions of Americans see this massive bailout as nothing more than the government's willingness to spend historic amounts of taxpayer money to bail out the Fat Cats on Wall Street.
Along this line, let me remind you of something I wrote last week: "the current financial crisis and the enormous $700+ billion government bailout virtually assure that, if elected: 1) Obama will not be able to push through his aggressive spending plans; and 2) McCain will not be able to push through any tax cuts. Realistically, the money for either of these proposals is no longer there."
Let there be no mistake, millions of Americans have been counting on the promises made by these two candidates. Most of Obama's supporters have bought into his promises of wide sweeping social reform, including nationalized health care, lower taxes on the middle class, and higher taxes on those making $250,000 or more a year. Likewise, many McCain supporters are banking on him extending the Bush tax cuts and other tax cuts he has promised.
If sound fiscal minds prevail, in light of the latest $700 billion spending bailout, neither candidate will be able to pursue these campaign promises. If people are angry today, they are likely to get even angrier in the months and years ahead. Why?
Despite the dire warnings of financial calamity from the White House, the Treasury Secretary, the Fed Chairman and some high-profile business leaders, much of Middle America wasn't buying the story that their own livelihoods were linked to the fate of the rescue package. Instead, average workers read the plan as the big guys in Congress bailing out their friends on Wall Street.
A majority of Americans didn't want Congress to use taxpayer dollars to bail out financial institutions, even if their collapse meant a rocky ride for investors in the stock market. A few congressmen and women admitted publicly that their calls from constituents were running as high as 100-to-one against the bailout plan.
Never mind that the collapse of Wall Street will almost certainly result in a recession, or worse, that will affect virtually all Americans. Never mind that the credit markets have seized up, and that lending for such things as home mortgages had ground to a virtual halt. Never mind that credit card spending may actually be at risk next.
I am reminded of the 1970s the movie "Network" which featured a news anchor who lost control and exclaimed, "I'm mad as hell and I'm not going to take it any more." I think that many in our country today have similar feelings, and no one knows at this point exactly what the eventual consequences will be.
Will there be a major backlash against the big Wall Street banks, brokers and others? Will Americans opt to move their money and their business to local banks that never participated in subprime mortgages, CDOs and other complicated mortgage backed securities? Will they move their investments from the Merrill Lynches of the world to local investment firms?
In my opinion, this suggests that big banks, big brokerage firms and multi-million dollar executive big bonuses may be in big trouble. We may well see a return to local community banks, many of which are in fine shape and have no subprime/MBS exposure at all. Local investment firms, financial planners and the like may benefit from a migration from "big box" brokerage/investment firms that were big players in toxic mortgage securities and still paid their CEOs and top execs multi-million dollar bonuses.
Unfortunately, we'll also likely see a move toward populist political candidates, who are far less friendly to big business – that being the Democrats. For example, Senator Obama has seen a big bounce in the polls over the last two weeks as the credit crisis worsened and the massive bailout was concocted.
If there is a further trend toward populist politicians, that will mean more spending and higher taxes, which will be bad for our economy over the long-term. But then, that's a subject for another E-Letter.