Exploring The Turmoil II -- Uncle Sam's toxic asset scheme

Before I start off with this post, on the contrary to what I had mentioned in my earlier post, I will not be talking about how well is President Obama doing with his efforts in getting the American economy off the floor again. That may not only take a few posts as there are so many different areas of concern which require to be and are being focussed on at the moment that this blog may turn to be terribly boring after a point. So, let's just talk about the toxic asset scheme unveiled by Mr. Geithner last month. Again, a word of caution, i hadn't exactly been reading a lot in the last couple of months. So, i may have missed some of the more significant (and insignificant) aspects of the scheme. In that case, my apologies to you all.  

The toxic asset scheme talks about the government tapping close to 100 bn dollars into its emergency bailout fund  and matching it "dollar-for-dollar" with private investment that would include hedge funds, private equity funds and other private sector investors in buying out mortgage-backed securities, derivatives and other troubled financial instruments. Infact, with the FDIC providing a guarantee for any debt issued by these entities to pay for their toxic purchases, they expect them to be able to leverage the capital by a 5:1 ratio, if not more. What this basically means is that if the private money is matched dollar for dollar by the government@100 bn dollars, we are talking about a capital of close to 200bn dollars which again can be leveraged 5 times or more leading to a sum of close to 1 tn dollars to be used to buy toxic assets. I was talking to zi and he raised a very valid point here -

The private sector will be buying these assets at substantially marked down prices. This would mean that the banks will have to bear losses in their balance sheet for these sales. Let's try and quantify these figures. If the assets were bought at 30% "discount", this would mean a cumulative loss of 300 bn dollars on a purchase of 1 trillion dollars! Now, what this would mean is that some of the major banks in the US may be close to folding operations if a significant portion of these losses were to show up in their balance sheet......quite the opposite of what the Obama administration wants really!! So, in order to cover these losses, will the administration recapitalize the banks with 300 bn dollar of taxpayer money? We haven't heard anything of the kind as yet. So, this whole toxic asset buyout program does not seem to have laid out all it's chips on the board as yet. We need to wait and see what comes next.....

We have already heard what Paul Krugman had to say about this bailout plan where the private sector seems to be in a win-win situation while the government just seems to be covering up the risks for them. It is a valid concern. No doubt about that. 

Now, let's look at a "happy-day" scenrio - what happens if the toxic asset buyout scheme does ease up the liquidity crunch...

1. Banks are in a position to lend. The question is - with a rapidly contracting economy, whom do you want to lend to?Automotive businesses, hotels, travels and several others don't sound such a good idea. Alternative energy......probably ( i am a great fan of this line but again, you cannot close your eyes to the fact that this source of energy is probably twice as expensive as that produced using fossil fuels etc.)
2. Now, a bank's job is not to hoard but to distribute the cash (especially when your largest stakeholder wants you to :-)). They will and with the no one being sure where the economy is heading,you may just end up creating more non-performing assets. What we see is that even with the scenario being good, the money may just have a negative impact on the whole scenario. 
3. We must not forget that a significant portion of 787 bn dollar fiscal stimulus package is coming from printing of new money. What does than mean? More money in the market in addition to the easing up of the liquidity crisis. This would lead to inflation in a contracting economy. Possibly, value of the dollar dropping. Is that good? To a certain extent, yes as it will help the exports but don't you think some of your good friends (read: China and the persian Gulf) may find this a little discomforting as the value of their investments may come down.       
   

   Well, the "rainy-day" scenario would simply mean that the liquidity crunch remains as it is. No change. Either way, what we are seeing is that this package may not really do all the good it is supposed to. I don' think what i have said really is a stretched reality. So, in all proabability, we will see some good coming out of the fiscal stimulus package and the toxic asset scheme together but probably not to the extent that the adminstration is hoping for.

Ladies and gentlemen, look forward to some more measures in the coming months...

Having said all this, let me now go to a more personal front.....having being fortunate (isn't this exciting???? Almost gives you a hard-on!!!!) enough to see a financial turmoil of this magnitude, I am yet not able to decide whether i am a liberal or a conservative. Somewhere I have believed that these interventions by the gov't will only prolong this crisis. If you let the too-big-too-fail organizations go down, the dust will settle rather quickly (with a lot of casualties) and we will see new opportunities rising faster. But then there are just too many variables in this equation to solve. If you let Freddie Mac and Fannie May fail, China won't spare you. Putting that aside, there will be millions on the street. Civil unrest looks like a plausible scenario. Not that easy. I had always believed that I was a conservative but we've all seen what free markets can do. Regulations? yes.....but then they are not free any longer and more importantly, I am not a conservative any longer either...sigh.....

I am still working on my inclinations....but yes, a state is expected to take care of it's citizens and rather unfortunately, the Americans lost the plot at the beginning of this century. 

Finally......Amit, Shandy, Aseem - miss you all and the vociferous  discussions we used to have for hours on such (and many other) topics. We need to connect. 

Let's talk about the Persian Gulf the next time.....hmmm.....may be not....probably what I am currently watching on TV these days....we will see.....