As the current financial crisis unfolds, the media continues to bombard the public with a seemingly endless supply of headlines regarding the economy and the stock market. Due to the overwhelming volume of information coming from a sensationalistic and irresponsible financial press, it is very difficult for investors to distinguish between meaningless noise and truly important news. This update will highlight and attempt to explain three recent efforts by the federal government that we feel will have a genuine impact on the current banking crisis and the eventual economic and capital market recovery: The Treasury Department plan to use both private and public funds to remove toxic assets from bank balance sheets, the Financial Accounting Standards Board (FASB) vote to let banks exercise more judgment in using mark-to-market accounting, and the Securities and Exchange Commission (SEC) meeting on the potential reinstatement of the uptick rule and implementation of circuit breakers.
On March 23rd, the Treasury Department unveiled a plan to bring private investors into partnership with a new federal entity that could eventually buy up to $1 trillion in toxic assets to help unclog banks’ balance sheets and free up the credit markets. The financing package will involve $75 billion to $100 billion in capital from the $700 billion Troubled Asset Relief Program (TARP) fund created last October, along with money from private investors and loans from the Federal Deposit Insurance Corporation (FDIC). Through the program, private investors will form a series of 50/50 partnerships with the Treasury department. These partnerships will then borrow up to six times their initial investment from the FDIC in order to leverage their ability to buy the toxic assets. Competitive auctions amongst these private/public partnerships will establish the most appropriate pricing of the assets and will reduce the likelihood that the Government will overpay. If the partnership is profitable, the Treasury and the private investors share the profits evenly. If the partnership is not profitable, the Treasury and the private investors share the initial losses evenly, and the FDIC bears the remaining losses. This last part is what is most appealing to the private investors: if the assets that they purchase turn out to be a bad investment, they are not required to repay the FDIC loans, which leaves the government with 100% of the remaining losses.
Thus, while the media has for the most part presented this program as an “investment partnership,” it is simply a bailout in disguise. The program offers a very attractive risk/reward tradeoff to the private investors, but it will only work if the banks agree to sell their assets at prices that the private investors are willing to pay, which is highly uncertain. What is truly encouraging about the plan is that it marks a creative solution to a complicated problem by a Treasury Department that, up to this point, has been viewed as inept. Secretary Geithner and his staff have managed to construct a bailout of the banking industry that is politically acceptable because it allows the taxpayer to participate in the profits (if there are any) and it avoids having to ask Congress for more money because the funding is coming from the FDIC and money already committed under the TARP. The balance that Geithner has managed to establish between financial necessity and political reality is quite ingenious.
On April 1st, the FASB announced that they would adjust some key accounting rules to reflect current market conditions. The biggest change FASB approved was a revision to their fair-value mark-to-market rule, which now states that the value of an asset in an inactive market “is the price that would be received to sell the asset in an orderly transition,” and not the forced liquidation price. This is a big help to banks, as they will now be able to use subjective models rather than the currently unfavorable market price in valuing many of their asset-backed securities. This will improve the solvency of the banks as defined by their regulators, but it leaves us asking an uncomfortable question: If these assets are worth more than the current market price, as the banks claim they are, why is no one buying them?
On April 8th, the Securities and Exchange Commission decided to consider the reinstatement of the “uptick rule.” This rule, which was removed in 2007, allows a short sale (a bet that the price of a stock will decline) only when the latest price of the stock is higher than the previous price. The debate comes after harsh public criticism of the SEC for failing to restrain short sellers from allegedly manipulating bank and brokerage stocks in order to profit on sharp price declines. The SEC is also considering a bid test, which would allow short selling only if the best available bid was higher than the previous bid. Other possible measures the SEC is considering are a circuit breaker approach that would trigger the “uptick rule” or an alternative circuit breaker that would ban short selling in a stock for the rest of the day once it has declined by 10%. The SEC will issue these proposals for a 60-day public comment period, after which it is widely expected that some version of these restrictions will be adopted.
Several individuals, mostly from the hedge fund industry, have argued that the proposed changes will have little to no impact on short sellers and that unrestrained short selling is a critical aspect of properly functioning capital markets. However, because hedge funds have the potential to profit tremendously from aggressive short-selling, when we hear hedge fund managers insisting that short sellers are not manipulating markets and the uptick rule will have no positive impact, we are, to put it as politely as possible, highly skeptical of these claims.
We hope this brief summary will add some clarity to what has become a confusing assortment of government bailouts, regulatory changes and special interest maneuvering. The equity markets have responded quite positively to these recent developments, with the global stock markets rising 25%-30% during the past five weeks. However, the uncertainty surrounding the economy and the solvency of the banks remains, and as a result we expect elevated levels of market volatility to persist. As always, we welcome your questions, comments and suggestions for future topics.
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