Saturday, November 15, 2008

Pimp My Assets, Part 1

1. Short Timers

It was just a short time, barely two months into finance capital's Great Escape, with Wild Ben Bernanke and Ranger "Hank" Paulson betting the ranch on the Troubled Assets Relief Program (TARP), that is to say, betting the ranch on the growing number of foreclosed ranch houses, that Ben and Hank pulled up on the reins, stopping their twin greenbacked ponies, "T" and "Bill" dead midstream. Swinging around in his saddle, said Hank to Ben, "Let's change horses." Ben looked to the bank behind them. No horse there, just a half-dead elephant packing his trunk. Hank looked to the bank ahead of them. There were horses there all right. Old gray mules with names like Volcker, Rubin, and Summers that weren't what they used to be, but then again, nothing was what it used to be.

Ben thought for a short time, the water rising around him, "We need a special purpose vehicle," said Wild Ben.

"Right," responded Ranger Hank after a short time, "A special purpose vehicle! My kingdom for a horse. My horse for a special purpose vehicle!" he cried.

It was a short time, barely two months after placing Fannie Mae and Freddie Mac into conservatorship, barely one month after the Great Escape Redux with the US Treasury injecting, granting, bestowing $160 billion to banks mostly large, and some less large, through direct share purchase that Ranger and Ben decided to junk the asset and relief parts of the TARP, leaving just a troubled program.

The junking was pre-figured by extending and revising the terms of the deal bailing out AIG. The new deal, with cards dealt from the bottom of the deck, was a thing of wonderment. First, the US Treasury exchanged $25 billion of AIG's debt for 40 billion dollars worth of senior preferred shares of stock, thereby diluting the "value" (purely notional) of its original 79.9% portion of AIG's equity. Secondly, the Treasury reduced the rate of interest on AIG's outstanding debt from the 3 month LIBOR rate plus 850 basis points (8.5%) to the 3 month LIBOR plus 300 basis points (3%). The terms of the loan were extended to five years. The rate on portions of the loan not drawn upon would be reduced from the LIBOR + 8.5% to LIBOR +.75%

But wait. There's more. Two new special purpose vehicles were formed. One was called the Residential Mortgage Backed Security Facility (RMBSF for short?). Organized as a limited liability company with a $22.5 billion loan from the Fed, and $1 billion from AIG, the was designed to, in the Fed's words, "return all cash collateral posted for securities loans outstanding under AIG's U.S. securities lending program. As a result, the $37.8 billion securities lending facility established by the New York Fed on October 8, 2008, will be repaid and terminated."

The second vehicle, the Collateralized Debt Obligations Facility, was the big news, a real thing of beauty, bringing smiles, for a short time, to the faces of bankers everywhere. With $30 billion from the FRB and $5 billion from AIG, that is to say with $35 billion from the Fed, the CDOF would purchase the credit default swap contracts that AIG issued insuring debt instruments, the structured investment vehicles, bought (and issued) of, for, and by.....the banks. And insurance companies. And hedge funds. The CDOF will purchase the underlying CDOs at market value (approximately 50% of original face value), while the banks will be allowed to keep the collateral that AIG had to supply when the face values declined. The banks will be made whole. "Now that's what I call banking," said Andy Fastow, not a short-timer, a bit wistfully, from his prison cell.

Meanwhile, T and Bill paddled on gamely, going nowhere. Excess liquidity has its downside.

It was clear why Ben and Hank had decided to jettison their plans for the TARP. They had in fact already established the TARP by another name. Ben and Hank had turned the entire public treasury into a special purpose vehicle.

2. Black September

Eliot wrote that "April was the cruelest month." What did he know? Purveyor of structured banality, sterile verse, a bad poet, and obviously not a banker. September is the cruelest month. Ask any of the Lehman Bros. And October is just as bad.

Following hard on the takeover/collapse of Freddie and Fannie, the FRB initiated a series of actions broad in scope and substantial in depth to maintain "liquidity" in the credit markets. Broad and substantial and always a day late, and no matter how many billions were made available, always a dollar short.

On September 14, Wild Ben relaxed the rules on the securities that could be pledged as collateral by investment banks for Fed funds at the Primary Dealers's Credit Facility. The new rules accepted as collateral securities that were generally accepted as collateral by the two major clearing banks in New York. Prior to this change, only investment grade securities was accepted as collateral by the PDCF.

The Fed also relaxed the requirements on collateral at the Term Securities Lending Facility. The new rules allowed all investment grade securities to be utilized as collateral. Previously only US Treasury instruments and AAA rate asset-backed securities were accepted.

On September 16, the Fed issued a statement fully endorsing the actions and decisions of the US Treasury to 1) let Lehman Bros, with a balance sheet of $630 billion in "assets," meaning debt exposure, collapse with the thud heard 'round the world; 2) initiate Rescue Plan 1 for AIG, involving an $85 billion dollar dedicated loan facility, and the initial 79.9% equity stake.

It is this date that marks the end of the "stabilization" focus of the Fed, the ECB, the US Treasury, the Bank of England. This date marks the beginning of the "desperation" focus. What followed upon the heels of the decision to let Lehman Bros. sink was, and remains, nothing short of a dash for cash, and if, as a European banker put it, "you don't have dollars, you're screwed."

On September 18, the dash for cash had become so acute that,in order to increase dollar liquidity in the lending markets abroad, the Fed authorized expanding its reciprocal currency arrangements (swap lines) by $247 billion with the European Central Bank, the Bank of England, the Bank of Japan, the Swiss National Bank, and the Bank of Canada.

On September 19, the Fed announced the creation of another special purpose vehicle, the Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF). The AMLF was intended to increase liquidity in the money markets by loaning money to depository institutions and bank holding companies to buy asset backed commercial paper from money-market mutual funds. The AMLF would make the loan and the Fed would indemnify the bank purchasing the ABCP against any loss of value of the ABCP until its maturity.

At the same time, the Fed announced it would purchase the short term debt instruments of the FNMA and FMAC for the "primary dealers" with which it conducted its business.

Two days later, Goldman Sachs and Morgan Stanley, having caught a glimpse of its own mortality in the death agony of Lehman Bros., decided to seek protection under the Fed's spread, and increasingly threadbare wings, by reincorporating themselves as bank holding companies. The Fed accepted the applications and also authorized loans to the London operations of Goldman Sachs, Morgan Stanley, and Merrill Lynch which, the stronger chick in the nest, had been rescued by Bank of America at the same time as Lehman Bros. was fed to the cat.

On September 24, again attempting to "unfreeze" the credit markets in Europe, the Fed authorized another $30 billion increase in its currency swap lines, this time extending the dollar funding to Australia, Denmark, Sweden, and Norway.

On September 26, the Fed added $10 billion to the swap lines with the ECB, and $3 billion to its line with the Swiss National Bank

The derivative world, the world of collateralized everything and nothing, was ending all right, with a bang, and a whimper. The decision to allow Lehman Bros. to seek bankruptcy protection while defending AIG was the worst move made in the assessment of the strength of real estate and finance since that of September 2001 cancelling the evacuation of the South Tower of the World Trade Center after the North Tower had been struck.

The collapse of Lehman Bros. was no less noisy, dirty, and terrifying to the world financial markets than of those 100 stories of concrete and steel.

Wild Ben and Ranger Hank had apparently forgotten that markets are their own special purpose vehicles, generating an "average rate of social profit" throughout the system of capital; transmitting the success, and failure, of the reproduction of value to every participant; consummating not just exchange, but transmission, interpenetration, and... infection. AIG was "rescued" because its exposure, its liabilities in the credit default swap market were so immense that its collapse threatened all of capital's financial network. Yet, AIG's exposure was based on the liabilities it had assumed on exactly the type of securities issued by Lehman Bros. Once Lehman Bros. collapsed, AIG could not be insulated from the collapse in market value of the securities it had insured for all issuers. The wheels began to fall off the special purpose vehicle.

Next: Pimp My Assets 2

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