RTC II, $800 Billion? Then What?

It is too early to know what RTC II will look like, but $800 billion is the number being bandied about. The projected design raises some questions.

U.S. Treasury Secretary Henry Paulson is sending a financial-rescue plan worth about $800 billion to Congress as Democrats prepare to turn it into a vehicle to help people with high-cost mortgages stay in their homes.

The Treasury will run the program to take on illiquid mortgage-related debt [emphasis added], with the Federal Reserve consulting on its design, officials said. ...

Mortgage paper stuffed into derivative structures such as collateralized debt obligations are not trading and is contributing to the death spiral on Wall Street as continued markdowns or even the inability to price the structures have eaten away at the balance sheets of the companies which hold the products.  However, the problems extend beyond derivatives.  Banks hold vanilla mortgages on their books, and many banks have yet to mark down the value of these mortgages.  Writing down a bank's loan book impairs the bank's assets and it's ability to extend credit.  Will the program allow banks to offload their loan books to the Treasury?

The program may be worth about $800 billion, split into $50 billion tranches, said four people briefed on drafts of the Treasury's proposal who spoke on condition of anonymity because details haven't been finalized. The funds, which would last for at least two years, will likely accept mortgage-backed securities and collateralized debt obligations, they said.

The Treasury plans to hire asset managers to purchase the assets [emphasis added] through so-called reverse auctions, seeking the lowest prices, one of the people said.

The assets are for sale now.  The problem is that asset managers do not know what to pay.  There have been a few transactions, but not many.  The government is banking on the housing market and the credit markets stabilizing so that investors will have more confidence to buy mortgage paper. 

But what if home prices still have another 15%-20% left to fall?  Home prices are still over-valued, the economy still deteriorating, and the consumer over-leveraged with impaired cash flows.  If home prices continue falling, there will be further mortgage price deterioration, which will inhibit the buying of mortgage securities. 

Now, the government will be able to hold those deteriorating mortgage securities within RTC II until the market stabilizes.  However, the purpose of RTC II is to increase confidence in the financial system and to facilitate the increase of the flow of credit.  If home prices continue to fall, banks' balance sheets will remain under pressure and the creation of credit will be inhibited, even if the banks can offload their bad debt to the government. 

If this scenario plays out, as I expect it will, RTC II will still serve a meaningful and vital purpose.  Similar to automatic stabilizers such as social programs which cushion recessions, RTC II will cushion the problems in the credit markets and prevent an even worse outcome. 

However, social programs do not solve recessions.  Recessions come to an end when the market prices for labour and capital clears.  Prices for labor and capital have to fall to a level such that expected returns are high enough to entice investment back into the economy.  Government spending can cushion or stabilize the economy, but until the clearing price within the economy is at equilibrium, at best the economy will be sclerotic. 

The government, in fact, may inhibit the repair process if it endlessly delays the attainment of the clearing price within the economy.  This is what happened in Japan, and why many have made the Japanese analogies to America today.

In fact, one could make a cogent argument that we are in this mess because the government never allowed market prices to clear after the collapse of the Tech Bubble.  By inflating our way out of the tech collapse, we avoided taking the medicine we needed to clear out the excesses in the economy.   The secondary and tertiary after-effects of these policies created an even bigger asset bubble and more daunting problems in the economy, which almost certainly would not have happened had the Federal Reserve not kept interest rates so low and the government not run enormous deficits.  It is easy to be an arm-chair critic in hindsight, but by not taking our medicine, we merely delayed the inevitable and made the problem worse.

Similarly, If RTC II delays the attainment of the clearing prices within the mortgage and housing markets, economic growth will be slow at best and possibly delay and damage the economy at worst. 

Now, it may be that the alternative would have been worse, i.e. the collapse of financial system.  However, RTC II does not solve the underlying problems in the financial markets of too much debt and the lack of transparency.  Nor does RTC II solve the problems in the housing markets where prices are still too high. And it does not solve the problems of the economy, which is in a recession.

Until market prices clear, home prices come down and the consumer's balance sheet and cash flow repaired, economic growth will remain below trend and asset market returns will be sub-par. 

Comments

[psychodave]

Your well thought and intensively informed post contained many statements that caught my attention.

"the purpose of RTC II is to increase confidence in the financial system and to facilitate the increase of the flow of credit"

"Recessions come to an end when the market prices for labour and capital clears"

"If this scenario plays out, as I expect it will, RTC II will still serve a meaningful and vital purpose. Similar to automatic stabilizers such as social programs which cushion recessions, RTC II will cushion the problems in the credit markets and prevent an even worse outcome."

I believe your expectations for RTC II will be proved wrong.

I see nothing in RTC II discussions that prevents the investment banks from selling their "deteriorating securities" for taxpayer cash and just sitting on the cash, maintaining a stranglehold on credit in order to wait for asset prices and economic activity to fall to a multigenerational low. Its really a two-fer for the investment banks. They exacerbate a credit crunch, and, thanks to the prodigious size of the funding, simultaneously debilitate any future ameliorative government actions.

[Toro]

You may very well be correct Dave. Nobody really knows at this time. We're in unchartered waters.

T.

[kerry]

Hey, I know!

For starters, these securities are strangling Wall Street, etc, but also are indub. UNDERVALUED based on most recent transactions. I think this is the dynamic that people don't seem to understand, and is much of the flaw in arguments against RTC II. Given they are ABS' where the asset is unlikely to fall more than 50% tops these horrible things are not as horrible as junk bonds were (unless there is something I don't understand here related to cash flows coming through when the property is sold). These things are already horrendously undervalued based on a rational evaluation of value. If the guv starts buying these, vulture funds/PE will get the impetus to come in and buy alongside. (imo this is the key. PE still has a lot of money and they are dumb money.)

All of this said, you gotta see how it all plays out. LEH should not have gone under. AIG should not have gone under. However, with subprime so illiquid, with leveraged balance sheets, with limited access to credit, with hedge fund momo against them, (with shocking crisis mismanagement) and with loss of counterparty/client/etc confidence, their failure WAS basically guaranteed.

Also, disagree completely that the tech bubble did not completely burst.

(btw, all of this was sortof true when the FRE/FNM transaction went down, although they should have included the non-agency MBS buy back provision there. Dumb they didn't.)

I THINK that we are finally at the point where our financials survive, we get a nice little bounce as other countries ease and stimulate, financials recapitalize, and we wait for the next shoe to drop.

etc

[kerry]

For psychodave, the odds are 100% the IBs are going to deleverage. That process started 6 months ago for the smart firms.

Look at MS:
http://finance.yahoo.com/q/bs?s=MS

Look at GS, not quite as remarkable:
http://finance.yahoo.com/q/bs?s=gs

Of course Lehman added 12B in cash, and easily could have survived if they had been aggressive like MS/MER. Given that they and AIG did dumb deals well after the crisis started, I guess they deserve to die... although there's a chance that AIG will try to get $85B elsewhere with Greenberg.

etc.

[kerry]

One more for ya. (I was in CA this week, couldn't stalk the blog/blogger.) You should call this the Kerry bailout, btw, given my decision late June, early July to go long financials, financial debt, and subprime debt.

from wiki:
According to Joseph E. Stiglitz in his book, Towards a New Paradigm in Monetary Economics, page 243, the real reason behind the need of the Resolution Trust Corporation company was to allow the United States government to subsidize the US banking sector in a way that was not very transparent and therefore avoid possible resistance from people opposed to the plan. According to Stiglitz, this is supported by the fact that the banks had better information relating to the loans than the RTC.

[anonymous]

Toro, everything you said is 100% correct.

[psychodave]

@kerry | September 20, 2008 at 05:57 PM
Your
"the odds are 100% the IBs are going to deleverage"
ranks as downright P R E S C I E N C E
in my book.
Thanks to both you and Toro.
- Dave

[Air Jordans]

I love your blog! You will be in our prayers and thoughts! Nice and informative post on this topic thanks for sharing with us.Thank you!

[Cheap Jordans]

It's great to hear from you and see what you've been up to. All of the projects look great! Thanks!