Back in the old days of derivatives (the mid-1980s), there was an international commercial bank that was famous for declaring how much good derivatives had done for it.

It was famous because it was common knowledge in the marketplace that the bank would have its swap counterparties "buy out" the positions where it was due money, while those on which it had a debit debit were kept on its books.

So I wasn't exactly either surprised or believing when the NYT announced, to much fanfare, that there was a "profit" being made on the bailout funds. As Bruce Webb noted here at the time:

These early returns are by no means a full accounting of the huge financial rescue undertaken by the federal government last year to stabilize teetering banks and other companies.

The government still faces potentially huge long-term losses from its bailouts of the insurance giant American International Group, the mortgage finance companies Fannie Mae and Freddie Mac, and the automakers General Motors and Chrysler. The Treasury Department could also take a hit from its guarantees on billions of dollars of toxic mortgages.

But it got nice headlines at the end of August, when talk of "green shoots" and "inflation fears"needed to get momentum.

Featured less prominently is a now-week-old LAT article with a more realistic perspective:

The Treasury is unlikely to get back the full amount of money lent under the Troubled Asset Relief Program despite a recent spate of repayments from large banks, warned the program's watchdog.

The program "played a significant role" in rescuing the financial system from a meltdown, Neil Barofsky, special inspector general for TARP, testified before the Senate Banking Committee on Thursday. But it was "extremely unlikely that the taxpayer will see a full return on its TARP investment," according to his prepared testimony.

The official story remains that the large banks will be paying everything back. If that's true, then the answer to Rebecca's question of how to drain liquidity from the financial system is clear: take the paybacks and disappear the monies. It's only if there is an excess shortfall on the securities that excess money will be in the system.

So, if the NYT was correct at the end of August, or the cheerleaders are correct now, there will not be an inflation issue, or an excess bubble, just a little "extra lubricant" making certain that valuable securities attain their full value that will naturally be removed from the system (both as cash and as Lines of Credit) as the value is realized.

Indeed, the only reason to fear inflation from TARP/TAF sources is if you expect a significant shortfall in the actual values, something for which you can only compensate by leaving a large quantity of excess lendings in the market. Which, by definition, will not and cannot happen if all the major players repay their allocations in full (let alone with interest).

Second derivatives don't make inflation. And money loaned by the Fed that is fully repaid doesn't make inflation unless it is loaned out ("multiplier effect"), which hasn't been and still isn't happening.

What there is is "excess" cash sitting on bank balance sheets in lieu of full repayments. But it's not being used for other things—no multiplier effect—and it can be disappeared by the Fed as it is paid back.

So where is the inflation, unless money has been added to the system without there being value behind it?

Somewhere, an old derivatives manager is watching. Maybe he recognizes his strategy in the story unfolding. Maybe, just maybe, he also kept underlying deals that didn't have losses as big as the gains he took.

It's possible. But it was never the way to bet.

by Rebecca
(cross posted at Newsneconomics)

Prof. Jim Hamilton at Econbrowser (thanks Mark Thoma for the link) addresses one of the Fed’s standard methods of draining liquidity from the banking system: reverse repurchase agreements. Basically, the Fed will transfer some of its assets to the banking system via short-term loans taken out with its Primary Dealers, presumably offering standard (Treasuries) and less standard (MBS or agency bonds) assets as collateral.

Reverse repurchase agreements simply slosh around the assets (MBS, agencies, and Treasuries) between the Fed and the Primary Dealers, rather than removing the assets from the Fed’s balance sheet permanently. Eventually, though, the Fed must sell the securities outright onto the open market – we are far, far from that!

This is all hot air for now. How can the Fed soak up the expansionary liquidity, let alone unwind $1 trillion in assets, when the banking system is still shedding pounds?

The Fed is considering another route, too: conducting the same repurchase agreements with the money-market mutual fund industry in tandem. An excerpt from the FT:

The Federal Reserve is looking to team up with the money-market mutual fund industry as part of its strategy to ensure that its unconventional policies to stimulate the economy do not produce a bout of post-crisis inflation.



The central bank envisages eventually draining liquidity from the financial system by engaging in trades called “reverse repos” with the deep-pocketed money-market funds. In these, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds.

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets. By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure from regulators and investors to stick to low-risk liquid investments.

The Fed is solely attempting to assuage inflation angst at this time; it’s still very premature to talk about an exit of expansionary policies when credit markets still crimp the stimulus that the Fed so desperately wants to get into the open market (much of the base, roughly $855 billion on September 23, 2009 and up from $2 billion in August 2008, remains on balance with the Fed in the form of “excess reserves). Just look at the crunch in the consumer credit space (chart to left).

As Prof. Hamilton suggests, the mechanisms of the reverse repos should successfully sterilize the base before it starts to become inflationary (with either the Primary Dealers and/or the Mutual Funds industry). However, one of the programs through which the Fed utilized previously to sterilize its liquidity, and to which Prof. Hamilton refers, – the Supplementary Financing Program – is unlikely to be an avenue for removing liquidity.

In fact, it’s quite the opposite. The Treasury already announced its imminent plan to liquidate the bulk of its $200 billion account with the Fed. There’s another $200 billion in excess reserves with which the Fed must contend (see my previous post here).

It’s easy to get the liquidity into the financial system. But getting it out without collapsing the economy or allowing inflation pressures to build? Well, that’s a different story.

by Bruce Webb

Big Banks Repay: 15% interest earned

The profits, collected from eight of the biggest banks that have fully repaid their obligations to the government, come to about $4 billion, or the equivalent of about 15 percent annually, according to calculations compiled for The New York Times.

These early returns are by no means a full accounting of the huge financial rescue undertaken by the federal government last year to stabilize teetering banks and other companies.

The government still faces potentially huge long-term losses from its bailouts of the insurance giant American International Group, the mortgage finance companies Fannie Mae and Freddie Mac, and the automakers General Motors and Chrysler. The Treasury Department could also take a hit from its guarantees on billions of dollars of toxic mortgages.

But the mere hint of bailout profits for the nearly year-old Troubled Asset Relief Program has been received as a welcome surprise. It has also spurred hopes that the government could soon get out of the banking business

People who are wringing their hands at Barovksy's $37 trillion dollar in guarantees outstanding figure need to get a grip. Much of that money has not been extended and at this stage probably won't be, and much that has is backed by assets with real if undeterminable value. (The notion that something has exactly the value of its current price in the market is just a byproduct of EMH magical thinking). More:

American taxpayers could still collect additional profits on their investments in two other big banks that have repaid their preferred stock but not their warrants: JPMorgan Chase and Capital One. They are expected to yield over $3.1 billion in gains for the Treasury in the next month or so, although the full tally will depend on how much they will pay to buy back their warrants.

And the government is owed about $6.2 billion in interest payments from banks that have not yet repaid their federal money.

But all the profits taxpayers have won could still be wiped out by two deeply troubled institutions. Both Citigroup and Bank of America are still holding mortgages and other loans that were once worth billions of dollars but whose revised values are uncertain. If they prove “toxic” because they cannot attract buyers, they could leave large holes in the banks’ balance sheets.

Neither bank is ready to repay its bailout money anytime soon, even though the banks’ stock prices have surged in the last month, leaving the government sitting on paper profits of about $18 billion between them.

Given that just about a third of our record budget deficit is the direct result of outlays from TARP, the fact that we are getting much of that money back with double digit interest should, but probably won't, give some of those bailout/stimulus/Obama haters a little pause.

by divorced one like Bush

Well, well, well, seems our Robert will have some more thinking to do. Via C & L to Radamisto who want's to know if we have ADD or what comes the Bloomberg story that the money from money machine is being restarted.

Morgan Stanley plans to repackage a downgraded collateralized debt obligation backed by leveraged loans into new securities with AAA ratings in the first transaction of its kind, said two people familiar with the sale.

Morgan Stanley is selling $87.1 million of securities that it expects to receive top AAA ratings and $42.9 million of notes graded Baa2, the second-lowest investment grade by Moody’s Investors Service, according to marketing documents obtained by Bloomberg News. The bonds were created from Greywolf CLO I Ltd., a CDO arranged in January 2007 by Goldman Sachs Group Inc. and managed by Greywolf Capital Management LP, an investment firm based in Purchase, New York.

Gee, Morgan Stanley, Goldman Sachs? Two totally separate companies, just happen to be mentioned together implimenting the same strategic plans.

8/18/08 Morgan Stanley, Goldman link lending to their own creditworthiness

The Financial Times is reporting that Morgan Stanley is implementing systems that tie the prices of credit insurance on their own debt to their commitment to provide financing to their hedge fund clients. The shift would allow the bank to pull out from its funding commitments should it run into a crisis of confidence like that which wiped out Bear Stearns in only a matter of days. Goldman uses a similar arrangement that ties its lending commitments to the firm's own bond prices.

9/21/08
WASHINGTON (Associated Press) -

The Federal Reserve said Sunday it had granted a request by the country's last two major investment banks - Goldman Sachs and Morgan Stanley - to change their status to bank holding companies.
The decision means that the Goldman and Morgan Stanley will be able not only to set up commercial bank subsidiaries to take deposits, giving them a major resource base, but they will also have the same access as other commercial banks to the Fed's emergency loan program.

3/9/09 UPDATE 2-Barclays cuts price targets on Goldman, Morgan Stanley

March 9 (Reuters) - Barclays Capital cut its price targets on Goldman Sachs (GS.N: Quote, Profile, Research) and Morgan Stanley (MS.N: Quote, Profile, Research) and said it expects the former investment-banking giants to post losses for December, mostly due to asset markdowns, investment losses and "very subdued" core earnings.

5/19/09
Goldman Sachs and Morgan Stanley have formally asked the Federal Reserve for permission to repay a combined $20 billion in federal bailout money.

6/17/09 JPMorgan Chase, Morgan Stanley cut ties with government

In separate statements, Morgan Stanley and JPMorgan Chase said they will not issue bonds backed by the Federal Deposit Insurance Corp. The banks are striving to show they can raise funds without help from the government. Goldman Sachs and other financial institutions might follow suit.

Continuing the July 8, 2009 Bloomberg article:

A lot of banks and insurers “cannot buy anything but AAA,” said Sylvain Raynes, a principal at R&R Consulting in New York and co-author of “Elements of Structured Finance,” which is due to be published in November by Oxford University Press. “You’re manufacturing AAA out of not AAA, therefore allowing those people who have AAA written on their forehead to buy.”

While the Morgan Stanley deal is the first to involve CDOs of loans, banks have been doing the same with commercial mortgage-backed securities in recent weeks.

Jennifer Sala, a spokeswoman for Morgan Stanley, and Gregory Mount, a Greywolf partner, declined to comment.

Banks are using re-REMICs to protect against losses on residential-mortgage securities during the worst housing slump since the Great Depression...Re-REMIC stands for “resecuritizations of real estate mortgage investment conduits,” the formal name of mortgage bonds.

Nice to know We the People have their backs huh?

Suppose I told you that there was a crisis with a stock, say, GE. That the price of the stock had dropped around 75% in the past year. And you responded, "But the problem is solved; the prices of long-term Call Options (say, the January 2011 20s) has gone up, as has their Open Interest.

You will (rightly) point out that this won't revitalise the assets themselves and I will (rightly) note that option markets rather saved the equity markets in 1987, for instance. You will note that I am too optimistic, and I will agree, holding up a Brad DeLong mask (since I'd rather have DeLong's [relative to mine] abundant hair than Geithner's abundant forehead).

Then I will drop the other shoe and say that the toxic ("legacy") assets should be priced as if the Fed-supported trades were options, with the underlying current price worked out by Black-Scholes. (As I've noted before, B-S is specifically INappropriate for this exercise, as it will overvalue the option. And therefore anyone suggesting the toxic ["legacy"] assets should be priced—or carried on their books—at a level higher than that model will clearly be insane.)

Ladies and Gentlemen, welcome to The TARP Solution. Details beneath the fold.


TARP is the Treasury Department's attempt to confront two realities: (1) it isn't a "market" in any reasonable sense of the word if the Fed is putting up 85% of the cash. (People who tell us that this means firms are committing a "large amount" to the process either do not understand the English language,or are hedge fund managers trying to sell something.) So let's put some random numbers together.

Those "legacy" assets are trading in the market around 30. The Big C and others are carrying them on their books around 80. Several people who should know better (Summers, Geithner, DeLong) have conflated "the market is underpricing the assets" with "the true price of the assets will make the banks solvent again."*

So we know three things. (1) People are willing to pay 30% of their own money to buy these assets, (2) the Fed is only requiring them to pay 15%, and (3) the fair value is between 30 (the current market price) and 80, and probably closer to the former than the later.

So again, using back-of-the-envelope principles, let's pretend that we think the recovery will be soon, that the defaults will slow (or at least that resales will be quick and frictionless), and that the market reaches that consensus quickly. And so fair value should be around 50.**

So let's say the Fed offers to buy a MBS for 50. How, as an investor, do I make money off this? Three possible ways:

1. If I own securities for which I paid <50, I sell them to the Fed.
   
2. If I own securities for which I paid >50, and which I cannot sell for 50 without revealing myself to be insolvent, I buy securities at 50 along with the Fed and "average in." (This is the "how to stay solvent longer than the market can be rational" act.)
   
3. If the Fed is buying securities at 50 so that I can no longer buy them at 30—I buy a LONG-dated Call Option on the security.

It is that last that explains TARP. Effectively, the co-investors with the Fed will be buying a Call option at 7.5 on the security at 50.***

Of course, it may not be an at-the-money Call option. More likely, the hedge fund effectively will be buying an out-of-the-money option (say, a 49.5 Call for 8) where some portion of the purchase is put up by the government.

Now you will note that, technically, TARP requires the hedge fund to buy the asset. So you might argue that this is not an option. But let's look at the generic payoff diagram to the hedge fund of the two scenarios.

Amazingly, you can't tell the difference on the payoff diagram as the security gains.**** In both cases, the hedge fund manager has just gone long volatility.

Expect that to have a ripple effect—I'm guessing dampening, cet. par.—on other option volatility trades.

All that is left is to back out what actual value of the security was assumed by the hedge fund when they bought the option. Which I will also leave as an exercise to the reader, while suggesting that a fair indication is min[x, TotalFedContribution] s.t. x a.s. approaches TotalFedContribution.

Will this bring the markets back, or make bank balance sheets more stable? I'm still saying "No," and hoping to be proved wrong.

But what it should do is reduce volatility buying, especially in the other debt markets, for the foreseeable future. So if any of those Bankrupt "legacy asset constrained" institutions has a long volatility position, there will be even more "Unintended Consequences."

*In fairness to Brad DeLong, I don't believe he believes this. As Dr. Black noted, George Voinovich "wants to see a pile of money in flames before he's willing to vote for what's necessary," and DeLong therefore sees this as a necessary evil. Having seen no evidence from the Obama Administration that they Have a Clue, I am naturally suspicious that this particular idiocy will do anything other than waste time and money—both of which are in increasingly short supply—but, since Larry Summers has shown his brilliant foresight before and clear has no skin in the game, I am reassured that there is no Principal-Agent problem at work here, as they was when Christopher "I never saw a regulation I like" Cox was named head of the SEC by the Previous Administration.

**While we're at it, can we pretend that Amber Benson will be my next wife, which is probably very little less likely than those other possibilities (especially since I'm already married to an sf-writing actress/director)? (Amazingly, even without those conditions, we would be using a BotE number of 50: though there is a legitimate argument that 60 would be easier to work with, I'm assuming no one is that stupid.)

***This is why 60 would have been easier; 15% of 60 is 9, so I wouldn't have to pay attention to decimal places. 40 would also have been easier—and both certainly more realistic than 60 and arguably more realistic than 50, but I want to maintain the pretense of the U.S. Treasury that this is a liquidity, not a solvency, crisis. (They're wrong, but it's their game.)

****The reason we can tell the difference on the losses is the possibility that the hedge fund treats the position as if it were an in-the-money Call option for which the Fed paid the in-the-money portion; the real returns to the hedge fund of the position in a TARP security are the same in both cases; there would be differences in the way the rest of the portfolio was managed, though, which are left as an exercise to the reader.

Dr. Black (you know the site) links to AIG Strike Three. And unlike the Citi debacle previously discussed (relatively) positively and rather negatively here, this one makes some form of sense.

The difference comes down to the meaning of an accounting concept: ongoing concern.

More below the break (yes, this might get wonkish. It's me, after all.)

The Big C and AIG are both large entities with several pieces. Some of those pieces are successful; some of them are AIG Financial Products. Some of them—Citibank branches and office space, for instance—fall somewhere in between.

What we do know is that it is currently not possible to slice and dice The Big C so that something would be left that would be an "ongoing concern." Those assets that are part of the company are dwarfed by the liabilities, and run across business lines. It's not as if you could just magically, say, sell Smith Barney, spinoff any remaining insurance business, and ritually execute Vikram Pandit and produce a working company from the remains. At best, it's a Good Start. There's a reason I refer to the company as The Big C: it's in the lymph nodes, the brain, the lungs, and the brain. You probably couldn't even survive with "just" the Retail and Private Banking operations.

Any auditor who releases The Big C's next 10-Q and describes the firm as a(n) "(on)going concern"**—with the attendant implication that there is a functional business model there and that the firm can create the future unencumbered* cash flows to remain viable—should be barred from the accounting profession.

AIG is different. Think Enron: there are pieces of the business that are still viable (now, the insurance and re-insurance pieces; then, the power plants and transmission facilities), but they are dwarfed by the losses at AIGFP. So there is a viable, separable business that is making pennies while the rest of the firm loses Benjamins.

The difference is that there is a possible end in sight. AIG-Prime could go back to doing the things AIG knew how to do, and stay away from the things that made Hank Greenberg rich and pauperized U.S. taxpayers.***

So, if we were to assume that a leaner, less mean AIG will come out of this, can we look at the plan changes and say they point toward a goal?

Unlike The Big C, the answer is clearly "yes."

Under the deal, the interest rate on AIG's credit line from the government would be cut to match the three-month London Interbank Offered Rate (Libor), now about 1.26 percent, a source with direct knowledge of the matter said.

This is perfectly reasonable for the moment: AIG is a financial institution, the reconceived version will be a financial institution of respectable size and strength, and the current version has the strong support of the U.S. government, which can borrow well inside LIBOR. While I suspect the final company will end up looking more like State Farm than Morgan Stanley, it's not out of the question that it could borrow at LIBOR, which is approximately a AA rating level anyway—a perfectly reasonable assumption for the reconstitution of a formerly-AAA company with some carryover liabilities.

The additional equity commitment would give AIG the ability to issue preferred stock to the government later, the sources said.

This would presumably be the reverse of the deal with The Big C: "equity" for debt. Again, a sign that regulators expect there to be a survivor/successor firm of the current mess.

The most interesting quote in the piece is:

[Robert Haines, senior insurance analyst at CreditSights] said. "The counterparties on most of the book are (European) banks that would be hammered if the U.S. walked away."

Note that Mr. Haines does not speak of AIG as an independent entity. Note also that, in supporting the AIGFP fiasco/deals, the U.S. can reduce the overall size of the bailout needed while ensuring that domestic entities retain full access to capital markets. It doesn't make anyone happy, but the option is worth keeping open.

Then we get to the meat of the deal:

AIG will also give the U.S. Federal Reserve a preferred interest in its American Life Insurance Co (Alico), which generates more than half of its revenue from Japan, and Hong Kong-based life insurance group American International Assurance Co (AIA) in return for reducing its debt, they said.

The U.S. doesn't really want to own either of these, but they have a promise to be valuable assets.

The government likely will get a 5 percent cumulative dividend on its ownership stake in Alico and AIA, said one source. AIG had been trying to sell Alico and part of AIA in a bid to raise money to pay back the government.

Sales of these assets are still a possibility, with some bids already received, said one person. [italics mine]

Think very carefully about the italicized part above. Markets clear—but they don't always flow well. Combining the two, it appears that the government is effectively giving AIG a bridge loan on those two entities. In the worst case, it will become a "pier loan" (h/t CR), but that's not the way to bet, especially if others follow the Chinese model of buying international assets while they are cheaper.

The rest of the moves look as if the outlines of the new company are already falling into place:

AIG may also securitize some U.S. life insurance policies and give them to the government to further reduce its debt, the source said.

The company may securitize up to $10 billion under that plan, one of the sources said.

The debt-to-equity swap would help AIG repay much of the roughly $38 billion it has drawn from its government credit line, the source said.

Translation: we know this business, and can do it well and continue it.

Last year, AIG said it planned to sell all assets except its U.S. property and casualty business, foreign general insurance and an ownership interest in some foreign life operations, to pay back the government.

While the company has announced some sales, it has found it difficult to find buyers and get a good price for assets amid the financial crisis.

Translation, again: if the market ever comes back, this is what we plan to look like. And we will again be a "going concern."

In short, unlike The Big C, there is a plan, there are moves afoot to move closer to the end game, and targets by which they plan to keep the viable parts of the business going. For instance,

The company now plans to spin off up to 20 percent of the property-casualty business in an initial public offering, said a person with direct knowledge of the plans.

The business would be renamed to differentiate it from AIG, and have its own board of directors.

So long as that board doesn't include Hank Greenberg, I'll be cautiously optimistic. The other piece of spinoff is more problematic:

To aid the auction of at least one major asset, the government could help potential buyers of aircraft lessor International Lease Finance Corp with financing, the sources said.

ILFC has some debt coming due in 2009 and, if needed, AIG could use its new equity commitment to help potential buyers with that, one of the sources said.

This is a piece that probably still needs to exist for non-business reasons, at which point we might be able to argue that there could be a Public Good in government support of its sale. Under any condition, it doesn't fit into the trimmed-down model of AIG-Prime that appears to be envisioned.

None of this means there won't be another round—asset sales are very dependent on buyers—or that they should be paying non-contractual bonuses this month (which they are). The company still needs to reach its full restructuring, and this is not exactly a prime time to be a seller in the marketplace. But at least this restructuring/new bailout has a clear Endgame in sight.

*I use "unencumbered" in place of the usual "free" for the sake of clarity.
**It appears that "Ongoing concern" is used in the U.K., "going concern" in the U.S. I won't pretend to know which will be the standard as accounting standards are weakened standardized.
***This is, of course, another case where I will point to the results and ask how anyone can take "we'll get 2/3s of the money back" seriously. But that dead horse has been soundly beaten for the moment, so I'll leave the tanning of the hide to Yves (She likes the new deal a lot less than I do) and Paul (who hasn't discussed it yet, since he's still rewriting 2 Henry VI and checking out The Great Solvent North) and the rest.