Is that all you got? There’s got to be a better way than TARP 1!

The whole idea of using taxpayer money at the Treasury to stabilize the economy and arrest the collateral economic damage which wall street has wrought on main street is either naïve or sinister. Naïve if Paulson and congress really thought this was the most efficient and effective way to restore liquidity and viability to the banking system and thus circumvent unnecessary business failures. But sinister if Wall Street intentionally conned congress into buying an economic Armageddon (by the time the Asian markets opened if we didn’t do this) scenario so they could effectively rob the Treasury.

Although they would never admit it publicly, you have to believe that these bank CEOs were smart enough to understand that they had screwed up the risk management and leverage to a point where they were in no position to use the lion’s share of the cash they received from Treasury to make loans. Surely they knew that this capital would be used to plug holes in severely over levered balance sheets and make good on some counterparty claims rather than make new loans in a stimulative fashion or renew revolving credit to creditworthy and current borrowers reliant on bank lines to run their businesses effectively.

Most of the $80B that AIG took went to counterparties like Goldman Sachs, UBS and Merrill Lynch and statutory capital requirements that should have been met all along. And most of the rest of the TARP money has effectively gone to bail out bond investors which made bad investments in over levered financials. Recall that in most of these instances, even though equity holders can slammed (and rightfully so), bondholders got taxpayer financed guarantees. Where are the anti-socialist free marketeers when you need them?

The reason banks haven’t loaned the TARP monies as expected is simple as I understand it: when you are way over levered and under provisioned and credit losses are surging, as your revenues are collapsing, you have to shrink your balance sheet asap or risk having the little tangible equity capital disappear as a result of additional charge offs. The problem with that is that shrinking your balance sheet is inconsistent with extending incremental credit. The math is in some ways simple and in other ways complicated. Simple because a bank levered 30 to 1 has little room for error before their capital is wiped out to an extent where solvency becomes an issue. But complicated due to a lack of transparency where assets had to be marked incorrectly, which distorted book values dramatically. Either way, the balance sheet got way too big, the assets way too risky and the transparency way too murky.

So the net of it is that most of our largest banks are in no position to lend more or take more risk; and the economic ramifications of what’s happened now make virtually all lending more risky. This should be clear as despite huge capital injections, banks struggle to meet regulatory capital requirements. And if meeting regulatory capital requirements are a priority, then how do you expect that capital to get translated into credit or investment that might mitigate the economic meltdown underway. So what to do now? More of the same? I don’t think so. We must do much better.

I understand that if the banks could shed some of the garbage assets they have on their books at above market prices then they would be in better shape to lend and I understand that given the lack of transparency and a most uncertain and dire economic outlook, that serious bids from the private sector are largely absent. So I understand the temptation to rationalize taxpayer financed welfare for the banking dregs amongst us; especially when you consider the audacity of these bank managements in the first place. This is not the best way to underwrite the costs of fixing our credit market problems, and its not the best way to get liquidity to the many solvent companies that need it to maintain employment and consumption (by both consumers and businesses. We truly need more novel approaches, so I thought I’d mention a few that I’ve thought of.

Now I’m not as smart as Paulson, Bernanke and Geithner so forgive me if this sounds a bit crazy or technically unfeasible. Although I’m not an expert here, I do have a cursory understanding of how the business and the economy works so here goes. You can always do conservatorship coupled with direct lending (which as far as the goal of increased lending is concerned seems to be a better option than TARP as its been administered to date). But I think present circumstances call for a more creative approach and probably more than one.

Why not have government employed securitization experts repackage some of the less than most toxic assets and couple them with a European style put option (written by the Treasury) which exercises a couple of years out. Or I guess it could be American style by application if necessary. Encouraging a longer term holder here would seem preferable so I think it makes sense to structure and incentivize accordingly. A sort of structured product priced to offer a chance to make a better than average return for a nominal but quantifiable risk and only make this available to banks that were responsible enough not to over leverage themselves in the first place. You could also incentivize and subsidize banks that put assets into such vehicles such that making new loans with their refunding was an attractive economic option.

Why not have the Treasury and/or Fed also subsidize restructuring and refinancing of mortgages such that the Treasury and the creditor share a principal reduction while the terms are extended a number of years AND a newly formed government agency funded by TARP money also subsidizes the mortgage rate for homeowners with cash flow sufficient to finance their primary residence if only the terms were better. Make it a needs based program with stiff penalties for fraud to prevent abuse. This would not only help lenders with more cash flow and less credit losses but also stabilize home values and residential mortgage backed securities valuations – which would buy extension lift the value of assets on bank balance sheet and their book values and thus not only lift capital ratios (which ultimately improve a bank’s lending capacity) but also make it easier and cheaper to raise additional capital from the private sector.

I thought this might be necessary a year ago and I’m shocked that it hasn’t been seriously considered. The reason it hasn’t is due to political ideology related to contract law. What’s crazy is you could have made this voluntary – some smart banks would do it and others would follow if/when it proved successful. The charges wouldn’t be as great because the treasury or fed would take half the hit so the bank’s book value, capital ratios etc. would be impacted substantially less, and the banks liquidity position would be better than otherwise the case. Loan to value ratios would also improve so credit worth would improve. And the incentive to not walk away would thus also be strengthened. The irony is that by not doing something like this the damage to creditors has been magnitudes worse as cash flow has disappeared and collateral values pummeled. It’s also ironic that the only way a bank would be otherwise worse off is if borrowers became healthier quickly and/or home values surged – both high class problems in comparison.

Another option I thought of was allowing substantial holders of U.S. Treasuries to swap Treasuries at bubble like valuations for bank asset pools with puts attached that would again limit losses in return for a chance of a reasonable return commensurate with the risk that would be realized if the buyer would have to exercise their put option. This too should not be structured in a risk free way but some risk would be necessary AND this risk could also be collared in a way that the Treasury would realize upside beyond some predetermined level in the event that the structured product performed exceptionally well. This would free up capital banks could lend and transfer some re-priced risks to foreign central banks with stronger balance sheets.

All of these things can be done with more direct government lending. The direct government lending should be underwritten sensibly (such that the taxpayer cost is minimizes yet borrower capacity to remain current maximized. And any such direct government lending could be done in a way that minimizes potential competitive damage to private sector lending by allowing banks to either participate in syndication or by subsidizing the loans to some degree so that the private sector can take down such loans at say a percentage point above where the government would do it and that extra percent would be paid by the government. This would incentivize the private sector to lend more because they would get better than market terms. In instances no private sector offers came to the market, the government would do the lending. Thus more lending would occur and it would get done on better terms with or without private sector participation.

Subsidies should not be permanent -they should remain in effect only for such time as necessary to restore the banking system. Congress could set up an agency to administer this for say a 2 year period and it could be renewed if necessary. And discretion should be paramount – although increased lending is necessary the last thing we need is more “unintended consequences”. Underwriters should be compensated and incentivzed accordingly – with back end bonuses to the extent that they increase lending and the loans perform such that cost to taxpayers is minimized. One way or another we need to try to stabilize home values, support solvent businesses with credit and create jobs. Drastic times call for drastic measures; but the more creative the measures then less drastic they might be. We must do better than we’ve done thus far or we’ll face a depressed lost decade.

The Ultimate Game Changer: Why 2009 Will Be Worse Than 2008 (Part 2)

I don’t want to belabor the point but wanted to stress the fact that credit, saving spending and investment will be changed for a generation. People will be forced to save more to buy stuff they could previously buy with little or no money down and low interest. Frugality will be a way of life, not just in consumer sector, but also in the business and government sector. And the government (federal that is) can not create enough jobs to mitigate the economic pain in any meaningful way b/c the private sector is likely to cut another 6 million jobs this year and state and local governments will cut more than the federal level is apt to create. I can’t see how and when consumers and businesses will be willing AND ABLE to spend more. Generation X & Y have pulled forward a lifetime of sales. Many hundreds of billions of dollars worth of stuff bought on credit in the last few years would have been bought in the period ahead if folks had to save for it. Instead, consumers and businesses alike have to retrench in order to pay overwhelming debt service burdens. And one man’s spending is another man’s revenue; and so it goes, the multiplier effect in reverse. These dynamics don’t change overnight.
And to the extent that you buy into the bull crap (pun intended) spoon fed to you by CNBC pundits employed by fees on your assets your net worth and quality of life will suffer for it. Understand that the Abby Joseph Cohen’s of the world will never implore you to take your money out of the Goldman Sach’s of the world because it means they get paid less or fired altogether. It’s not good business as they say; but if you ask me its bad business. Strategists putting a 1100 and 1200 targets on the S&P500 as 2009 started was flat out irresponsible at minimum and probably disingenuous as well. I say that because not only are they clueless about what the earnings on the S&P500 might have been if the constituents remained the same; but many names are being changed to protect the guilty as they say, so what does it mean to the market that the new constituents earn whatever. If I recall correctly, they mentioned $53-$55 in EPS this year (which interestingly was at the low end of the street) and $60 next but many of the top market caps have will have been replaced with companies with better balance sheets and earnings. Who in their right mind would take a skewed sample and put a high teen multiple on it and say that’s what they honestly expect. I’ll tell you who – its people with a vested interest in you not allocating capital away from equities.But that’s exactly what you ought to do.

Another reason why I doubt equities can snap back a lot anytime soon is because I can’t recall a time when equities have gotten pummeled to the extent they have and other assets are as attractive as they are. Investors that lost 50-60% in what was supposed to nimble “HEDGE” Funds (which didn’t hedge well) are going to be done with them in many cases and shift money back into the mutual funds (which have much less leverage) which never lost that kind of money for them. They will also buy debt securities, corporate bonds, munis, converts and real estate among other things. Sure there’s a lot of money that will come out of treasuries but it aint going into equities to the extent that it has historically. And that money on the sidelines is not all going back into the market either. Much of it will go to redemptions and other asset classes – I doubt many will underweight cash as much as they had in the past, regardless of what yields are.
As the market rallied a couple of weeks ago, I was shocked to see how many were sucked into the idea that the worst was over. Well educated money managers bought into the company line.

Many remain in a state of disbelief and think it can’t get much worse now. They think “I can’t sell now, it’s too late”. Wrong again, uncertainty has never been greater, our financial system is melting down and the meltdown is creating massive collateral damage. Otherwise good companies are seeing credit issues impair their operations; which are already under duress on the demand side. As corporate profits slide and the outlook for growth deteriorates so too will equity valuations. Earnings and Multiples will remain under pressure and equities will decline – if you don’t reallocate out of a long only overweight equities portfolio, the market will do it for you.
So the decline is apt to be more protracted than most think and the downside will be such that the comps can’t be easy enough. Retailers are a good example of this – things got bad retailers almost 2 years ago, they’ve been up against what should have been easy comps but still comping the high teens NEGATIVE for many. Sure we may be approaching a point where its hard to get MUCH worse (much being the key) but I think the disconnect here is that everyone is assuming that things bounce back as they did in past cycles when consumer balance sheets weren’t decimated and banks were healthy and lending. Generation X & Y have pulled forward a lifetime of sales (which would have gone to sales in the period ahead and would have been more money with interest instead of deficits and unmanageable debt service burdens. One consumer’s/business’ spending is another consumer’s/business’ revenue and the multiplier effect you heard about in econ 101 (when the butcher buys baked goods and the baker then buy candles etc.) works in reverse. That’s how a mild recession turns into a really bad one – the butcher and the baker cut back the spending and employment and the candlestick maker goes out of business.
My point in all of this is not to be doom and gloom for doom and gloom sake – I’m not trying to be Marc Faber or Jim Rogers talking my book on Bloomberg or CNBC. I’m saying all this to impress upon you how important it is to worry more about containing he risk in your portfolio than missing out on a rally that has a very low chance of happening in the first place. That Goldman Sach’s S&P500 target is now almost 45% away and the hurt is palpable. It’s not too late to reduce exposure to equities and increase exposure to cash, and high quality/much less risky debt. That doesn’t mean you shouldn’t hold equities at all, it means to hold less. Avoid the temptation to bottom-fish banks, brokers, cyclicals, industrials, transports, materials, techs and other relatively high beta, economically sensitive sectors and instead focus on well managed, well financed less cyclical names likely to survive this hell of a cycle. I think a names like DE and NUE are still good shorts. And am likely to put FSLR on short as well. I’ll be back to you soon with more names both short and long. But first I’ll tell you why I think TARP is a joke and I’ll suggest what I think is a much better way to stabilize the financial system in a much more cost effective way.