A Loan or a Giveaway?
Wednesday March 12, 12:25 pm ET
By Dirk van Dijk, CFA
Yesterday the Fed announced that it will start a new program to lend $200 billion to the primary dealers. It was a move that made the market very happy. This is sort of like the term auction facility (TAF) that it has, which was significantly increased last week.
What it is is sort of complicated, but I will try to simplify it as much as I can. The key difference is that while the TAF is geared towards banks -- which as depository institutions, the Fed has to be a lender of last resort to -- the new program, the TSLF, is aimed at the big investment banks (IB's) like Goldman (NYSE: GS - News) and Bear Stearns (NYSE: BSC - News).
Essentially what the Fed is doing is allowing the IB's to borrow T-notes and Bills and put up mortgaged-backed securities (MBS) as collateral. The MBS's do not have to be backed by the government or the GSE's, but have to be rated AAA. But in today's market, what does AAA mean?
There is a haircut on the amount that the Fed will lend, but the precise amount of the haircut has not been disclosed. However, in principal, it works something like this: the IB puts up $1 billion in MBS and in return gets $900 million of Treasury bills in return. The IB can then go and sell or borrow against the T-bills to raise cash. The loan is supposed to be for 28 days, which incidentally will be past 3/31, when the 1st quarter ends. This helps the IB's from having to recognize that the MBS on their books are not worth anything close to face value.
It is very unlikely that the money will be repaid 28 days from now; it will simply be rolled over. There is a huge risk that these 'AAA' MBS's remain on the Fed's books for good.
One of the big questions is: Is the haircut big enough to reflect the true value of the MBS? Think of it this way -- if someone were to offer a non-recourse loan to you using your ten-year-old Ford Taurus -- and base the amount of the loan not on blue book, but to a 10% discount for what you bought it new -- is that a loan or a giveaway?
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Currently, MBS's are not trading very much. The market has turned as illiquid as the Sahara. Quite frankly, it's not that there are no bids, but that the holders of these MBS's just do not like the prices that are being offered.
These assets are still being valued on the bank's balance sheets based on models of what they 'should' be worth. If they sold $1 million of them at the prices people are currently willing to pay, they would have to write the remaining $1 billion they hold on their balance sheet down to that level.
That would make the bank insolvent, so they must keep the fantasy alive. Is there a good proxy for what the true value of these MBS's is in the market? Yes -- it is found in the credit default swaps market, roughly the price that it costs to insure these bonds against default. These are known as the ABX indexes. The implied price for AAA mortgage bonds of 2007 origination is now below $0.60 on the dollar.
Does this make sense (after all these are AAA, right)? Well this little item that came across the Bloomberg wire yesterday should answer that question:
'Even after downgrading almost 10,000 subprime mortgage bonds, Standard & Poor's and Moody's (NYSE: MCO - News) Investors Service haven't cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.
'None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG (NYSE: DB - News) in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.
'Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that's triggered $188 billion in writedowns for the world's largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group (NYSE: CS - News)...
'The 20 ABX indexes are the only public source of prices on debt tied to home loans that were made to subprime borrowers with poor credit histories. About $650 billion of subprime bonds are still outstanding, according to Deutsche Bank. About 75 percent were rated AAA at issuance...
'Within one AAA index, the $79 million Deutsche Bank bond, known as ACE 2005-HE-7 A2D, is rated AAA by S&P and Moody's even though 18 percent of its loans are in foreclosure, 15 percent of the properties have been seized by lenders and about 10 percent have been delinquent for more than 90 days. When the bonds were created, Moody's and S&P required capital support to cover a loss rate of no more than 7 percent for all three loss categories combined. Fitch doesn't rate the debt.'
Gee, 43% of the underlying mortgages are delinquent -- including 18% in foreclosure and 15% already in the hands of the lenders -- and it's still rated AAA by S&P and Moody's. Why should anyone take any of their credit ratings seriously? Well, the Fed is, and is willing to use it as collateral with only a small haircut. Arms-length transaction or a flat-out bailout of the big boys on the street?
I have to give the Fed points for creativity, but in the long run it might just be easier for the Fed to cut charitable donations of a few billion each to the major players on Wall Street. That, however, would be too transparent and would cause political problems.
Still, unless these MBS's are permanently taken onto the Fed's balance sheet, these steps only address the liquidity problems of the financial sector, not the underlying solvency problems. Continue to avoid the sector, particularly mortgage related firms like Fannie (NYSE: FNM - News), Freddie (NYSE: FRE - News), MGIC (NYSE: MTG - News), PMI Group (NYSE: PMI - News) and banks/thrifts like Washington Mutual (NYSE: WM - News), Citigroup (NYSE: C - News), Wachovia (NYSE: WB - News) and Fifth Third (NasdaqGS: FITB - News).
