Monday, March 23, 2009

A Solution Announced?

Every bank plan that has been presented all the way back to the original TARP program has had one major underlying problem that our leaders have not been able to find a solution for. Here is the problem:

Imagine you are a bank called J.P. Morgan. Your balance sheet is fairly simple. You have ten large bundles of mortgage securities (CDO's) that you paid $10 trillion for back in 2006. So here is your portfolio breakdown:

CDO 1: $1 trillion
CDO 2: $1 trillion
CDO 3: $1 trillion
CDO 4: $1 trillion
CDO 5: $1 trillion
CDO 6: $1 trillion
CDO 7: $1 trillion
CDO 8: $1 trillion
CDO 9: $1 trillion
CDO 10: $1 trillion

Total company worth: $10 trillion

Today these bundles of mortgage securities have lost value because home owners are not paying their mortgages. In order to try and remove some of these assets J.P. Morgan goes out into the open market and tries to sell them. The problem is that new investors are afraid to purchase these securities because they cannot put a value on the CDO based on the large number of mortgages in each bundle.

So the government has repeatedly come in to try and figure out a way that they could purchase the assets to put a price in the open market and get real buyers (private capital) buying as well. The problem is that the government obviously has no idea what they are worth, and if they underpay to try and protect the taxpayers there are huge consequences.

For example, lets say that the government approached J.P. Morgan and told them they would like to buy their CDO 1 for $600 billion. This is a huge discount from the original price purchased and if home prices ever find a bottom the government may be able to one day sell that CDO for a price higher than $600 billion and make a profit.

But here is where the problem comes in:

Because J.P. Morgan sold their first CDO for $600 billion, that means that the other nine CDO's are now worth $600 billion and they have to write down each one to represent that when they report earnings. That means they would have to write down a $400 billion loss for all nine remaining CDO's for a total loss of $3.6 trillion.

Most banks do not have even close to the cash reserves to cover that kind of loss. This means they are now insolvent and would have to declare bankruptcy.

Other banks around the world are now insuring investors against the failure of J.P. Morgan. For example, lets say that Bank of America purchased $200 billion of J.P. Morgan debt(bonds) back in 2006. They then asked Citigroup to insure that debt to protect them in case of a J.P. Morgan failure. So if J.P. Morgan fails, then Citigroup has to come up with $200 billion in capital to pay out to Bank of America.

Citigroup does not have this money and thus they would have to declare bankruptcy as well. Another bank that is insuring Citigroup is facing the same issue and they would have to declare bankruptcy.

This is the concept of systemic risk. One large failure would trigger the payment of insurance (called a credit default swap), taking down every institution.

This brings us to the new plan that is going to be announced today. The government is announcing a plan that involves backing private investors who would like to purchase these mortgage securities. If the assets rise in value, the private capital gets to keep the profits. If the assets fall in value, the government will pay for the losses.

It is a pretty fantastic opportunity for new investors that have the ability to purchase. Of course, they take the risk that the government could change the rules of the game. That assurance will be the most important component of getting private capital to participate.

However, even if they do participate, it does not solve the underlying problem that I was describing before. Who will cover the losses when the banks need to write down the rest of their assets to market prices?

My personal guess is that this is already in place as well. It will involve the Fed covering the difference with those crispy, freshly, printed dollars. The cost to do so will dwarf the size of the money printed so far.

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