An Improved Plan By Paulson

Nov 12, Paulson on TARP priorities going forward: "First, Although the financial system has stabilized, both banks and non-banks may well need more capital given their troubled asset holdings, projections for continued high rates of foreclosures and stagnant U.S. and world economic conditions. Second, the important markets for securitizing credit outside of the banking system also need support. Approximately 40 percent of U.S. consumer credit is provided through securitization of credit card receivables, auto loans and student loans and similar products. This market, which is vital for lending and growth, has for all practical purposes ground to a halt. Third, we continue to explore ways to reduce the risk of foreclosure. " Treasury Secretary Henry Paulson said Wednesday the $700 billion government rescue program will not be used to purchase troubled assets as originally planned. (Finally, some sensibility because buying the troubled assets will not help. If you buy at the market prices, it just means the banks will have to write down the losses with no hope of recouping them. This does not help shore up capital, which is what they need. To shore up capital the Treasury will have to buy them at a premium, which is no good also as it will lock the government into owning toxic assets, or the taxpayers actually owning them at a premium, whereby they could end up with huge losses.)

Paulson said the administration will continue to use $250 billion of the program to purchase stock in banks as a way to bolster their balance sheets and encourage them to resume more normal lending. (That is a more sensible way. By owning stocks and maybe even sit on management committees of banks, they can hasten the lending part.)

He announced a new goal for the program to support financial markets, which supply consumer credit in such areas as credit card debt, auto loans and student loans. Paulson said that 40 percent of U.S. consumer credit is provided through selling securities that are backed by pools of auto loans and other such debt. He said these markets need support. "This market, which is vital for lending and growth, has for all practical purposes ground to a halt," Paulson said.

The administration decided that using billions of dollars to buy troubled assets of financial institutions at the current time was "not the most effective way" to use the $700 billion bailout package, he said.

The announcement marked a major shift for the administration which had talked only about purchasing troubled assets as it lobbied Congress to pass the massive bailout bill.

Paulson said the administration is exploring other options, including injecting more capital into banks on a matching basis, in which government funds would be supplied to banks that were able to raise capital on their own. (This is smart. By voicing this out, it would theorectically DOUBLE the amount of capital injection, putting some onus on the banks to look for funding elsewhere as well. Instead of just $500bn of capital, suddenly it becomes $1 trillion. If banks are desperate, they will act fast. The source of capital will have to be largely from sovereign wealth funds. The fact that its on a matching basis should be an easier pill to swallow with the Treasury riding alongside them.)

p/s photos: Nozomi Sasaki

Critical, The New Treasury Secretary

The most important appointment Obama will make over the next few days will be the Treasury Secretary. The person to replace Henry Paulson. As economics is the most difficult and pressing matter facing Obama, it is imperative that he make the right choice. Markets will rise and fall depending on who he selects.

The contenders:

a) Lawrence Summers - A renowned Harvard economist who won the John Bates Clark medal for economists under 40 in 1993, and was the Treasury Secretary under Clinton's administration. Has done it before, but under Clinton, no big financial or economic turmoil. Still an OK selection, but better than Robert Rubin definitely. His strong grasp of economics comes in handy. Summers could provide an economic lift, such as improving health care, reducing dependence on foreign energy sources and changing the tax code. He says focusing on those areas will help the economy by creating jobs and preventing families from cutting spending. Summers was among the first economists to call for a second round of economic stimulus based on infrastructure investment, which he says would help create jobs, bolster the construction industry and provide a cash infusion to municipalities. Markets to move up if he is appointed.

b) Timothy Geithner - President of New York Federal Reserve Bank. Though not well know, he should be viewed as a good selection as he was one of the early and more aggressive proponents of action to stem the crisis. Geithner would come in with an even more interventionist approach, which is what the market seems to be looking for, to solve the mess. He pushed for quicker action on Fannie & Freddie, and help strategise the bailouts of Bear Stearns and AIG. Market savvy and well regarded by Wall Street. Markets will go up slightly if he is selected.

c) Robert Rubin - another former Treasury Secretary under Clinton, ex top dog at Goldman Sachs and now a director for Citigroup. Impressive resume but largely seen as ineffective over the last 5 years. Did not forsee the crisis or counselled Citigroup properly. Was not entirely effective as Treasury Secretary. It would be a poor choice for Obama to select him. Markets will fall of Rubin is selected. Rubin is a trader, not a good economics strategist.

d) Paul Volcker - Your favourite and mine as well. Possibly the best Federal Reserve chairman ever. In his 80s, is a towering figure in U.S. monetary policy, famous for vanquishing inflation as former chairman of the Federal Reserve. Age might stop him from taking up the post. I would even just ask him to take up the post for 2 years to help guide the US through the economic landmines ahead for Obama. You can expect a sharp rally if Volcker was selected. His reputation from the 70s was unmatched. He dealth with the OPEC crisis, was brave and committed to tackle issues swiftly. Not prone to do popular stuff but effective measures. Markets will rally the strongest if Volcker is selected.

Others being mentioned include: Jon Corzine, another ex-Goldman Sachs top dog, now the Governor of New Jersey and Jamie Dimon of the unscathed JP Morgan.

p/s photos: Top, Paul Volcker with Obama Baby. Bottom, left to right, Summers, Corzine, Geithner

The Vital Signs Are Good, Even Though Patient Is In ICU

There are signs that the financial regulators and leaders know what is troubling the global capital markets. If they know, then we are on the way to properly restoring calm and sensibility. More importantly, it will ensure a properly functioning capital markets - which is still not evident now as many stocks have dipped below way past what is considered as fair value. Its pointless to point out which stocks are worth buying as there are too many to mention. You would be better off to try and see the road signs that say that the root problems are being addressed. If they are not doing that, then we will be in the doldrums for a while. However, I can see two major signs which say we should be on the right path. Treasury Secretary Henry Paulson’s comments that signaled he wouldn’t let another large bank fail, large institutional traders began doubling down on bets that large banks would skyrocket. At a time when almost everyone is deleveraging, several funds were in essence doubling their leverage on one trade. This is essential as the statement indicates that Paulson now knows what a catastrophe it was to let Lehman Brother fail (please read recent posting on Lehman Brother, The Rosetta Stone). That will be as close you can get to an admission of grave fault by Paulson.

The major hedge fund Citadel had a conference call over the weekend and agreed with my take on Lehman Brothers:

3:55 p.m.: “One effect we’ve all seen is about the diversity of counterparties. Given the diversity of counterparties around the world, clearly the diversity isn’t enough to deal with some of what we’ve seen in the past few weeks.”

3:54 p.m.: Lehman’s bankruptcy caused “the greatest dislocation we’ve seen in money market history”

The second major issue is the flight to safe currencies such as yen and USD. But, this is not a currency crisis. This is a liquidity crisis, a growth crisis, a confidence crisis. As such, probably the first step should not be to intervene to save currencies. People calling for their central bankers to protect their currencies are calling for the wrong antidote. At a time like this, you don't need or rather you don't want a strong currency. Look at the OZ dollar, there is no way the Reserve Bank of Australia can do much to stem the reversal of the massive yen carry trade effects. The RBA can only do one thing to protect the OZ dollar and that is to raise the interest rates, which is already crippling in light of the over speculated property market there. What good is it to bump up rates and protect your currency and then find your economy in tatters with property markets there compounding. You would have a graver, and longer term disaster in the works. Better to allow the currency to find its own footing. At current levels, the OZ should start attracting some FDI into property for sure and should see a strong boost to tourism. I mean the OZ dollar is even cheaper than the Singapore dollar now by nearly 10%.

The source of aggressive capital flows into the dollar and yen is emerging markets, and it is the emerging market central banks, flush with dollar reserves, who could take action to stem the market frenzy. Naturally this cannot be allowed to continue, especially for Japan, which needs a weaker currency to prevent a more severe deflation in its economy. Emerging markets “need to act the same way the U.S. and European Union has acted. That will address the root of the problem. However, those governments’ assertiveness is limited by their experience.

Ahead of the Asia Europe Meeting, which began Friday, Japan and other East Asian leaders agreed to establish an $80-billion joint fund aimed at fighting the global financial crisis. Much of the movement into yen and USD can be said to be coming from emerging markets themselves, and that needed to be reversed. The setting up of the "fund" is a good start. More collaboration will go some way to slowly unwind the weakness in emerging markets' currencies.

p/s photos: Deepika Padukone

Lehman Brothers, The Rosetta Stone

The 'Rosetta Stone' is an Ancient Egyptian artifact (حجر رشيد in Arabic) which was instrumental in advancing modern understanding of hieroglyphic writing.

Lehman Brothers' demise probably caused the "banking crisis of confidence", which brought about the present state of financial markets. The massive deleveraging by funds of all kinds, the downgrading of emerging markets' debts and currencies, the flight to USD and yen, the numerous injection of liquidity into the system by central banks, the guaranteeing of deposits to prevent bank runs, the notion that nothing has real value anymore... may all be traced to Lehman Brothers' bankruptcy, or rather Paulson's refusal to save the company. Lehman Brothers may be the Rosetta Stone which helps us better understand why things are the way they are now.

Though Lehman was the smallest investment bank when it failed — and regulators decided it was not too big to fail — its demise set off tremors throughout the financial system that reverberate to this day. The uncertainty surrounding its billions of dollars of transactions with banks and hedge funds exacerbated a crisis of confidence. That contributed to the freezing of credit markets that has forced governments around the globe to take steps to try to calm panicked markets, including guaranteeing bank deposits.
The list of creditors with material exposure to Lehman Brothers is long. There will be dozens of holders of senior notes, sub debt and junior sub debt, so you can’t make too much of the fact that it looks as though the Japanese banks were laid out. We’d need to see the signatories to the Trust Indentures of the three sets of Notes to see just how many financial institutions and debt funds were exposed to Lehman’s various debt pieces:

• $138 billion of senior notes, which have Citibank and BONY listed as indenture trustees
• $12 billion of subordinated debt, with BONY listed as indenture trustee
• $5 billion of junior subordinated debt, also with BONY as indenture trustee
• $463 million of bank debt provided by Japan’s AOZORA
• $289 billion of bank debt provided by Japan’s Mizuho Corporate Bank
• $275 million of bank debt provided by Citibank N.A.’s Hong Kong Branch
• $250 million of bank debt provided by BNP Paribas
• $231 million of bank debt provided by Japan’s Shinsei Bank
• $185 million of bank debt provided by Japan’s UFJ Bank
• $177 million of bank debt provided by Japan’s Sumitomo Mitsubishi
• $140 million L/C provided by Svenska Handelsbanken
• $93 million of bank debt provided by Japan’s Mizuho
• $93 million of bank debt provided by Canada’s ScotiaBank branch in Singapore via NYC
• $75 million of bank debt provided by Lloyds Bank

Paulson obviously did not appreciate Lehman's involvement. Lehman is a leveraged brokerage shop that was the counterparty to trades sized in billions, including interest rate swaps, commodity futures, corporate bonds, international equities and real estate loans, currency swaps, and private equities. The counterparty risk created fear and triggered domino selling. Banks refused to lend to one another fearing the other end to be infested with Lehman's positions. Insiders claim that it could take over a decade to fully unwind Lehman's positions.The scary bit is that Citigroup and Bank of NY may not be out of the woods yet as things stand.

What's more, Lehman was one of the largest prime brokers to international hedge funds. Lehman's bankruptcy immediately caused wholesale panic within the hedge fund industry as funds tried to close/transfer/pull their money out of their Lehman custodian. Today over $60 billion is still locked up in Lehman's London brokerage unit. Given the leveraging nature of hedge funds, the effect on global equity markets was catastrophic as trillions of dollars were wiped off global equity markets. If you were to leverage the $60 billion twenty times (about right) it comes to $1,200 billion worth of positions that needed to be unwound.

Maybe now we can get a better grip on why so many injections of liquidity and bailouts still failed to calm the markets. The injection of capital is more than sufficient, its just that those with fresh capital are not really lending, except to very solid names. Maybe Paulson would be better off addressing the root, i.e. unwind those institutions and creditors affected by Lehman's failure. The escalating domino effect from Lehman's failure is already cascading across the globe. I hope its not too late for Paulson and the global financial leaders to stem the tide.

p/s photos: Jiang Yu Chen

Roach's Take On TARP / The Revised Package

Finance Asia: Stephen Roach, chairman of Morgan Stanley Asia, says the US government’s Troubled Asset Recovery Plan (Tarp), aka the Paulson Plan to bail-out the finance sector to the tune of $700 billion, deserves a grade of B-.Roach’s take: a package needs to deliver the Three S’s: speed, scale and simplicity. In terms of speed, he gives the plan an A- or B+, noting it was churned out very quickly by Washington standards. [It had been; the Republican revolt is a stunning turn against President Bush and Congressional GOP leaders - Ed.]

For scale, he gives Tarp a B- or C+, noting that $700 billion is plenty big, but Congress has decided to dole out funds in tranches, with the first pool only $250 billion. Roach doesn’t think this is going to be welcomed by the market. He is also concerned about some of the red tape and procedures involved in prying out further tranches from Congress. Lastly, for simplicity, he says the original three-page Paulson Plan deserved an A+, but the Congressional bill, at 110 pages over 42 sections, gets a C- or a D+. It includes four new government bureaucracies, including oversight panels, an Office of Financial Stability, an inspector and a schemes administrator. Roach calls this evidence of a “significant regulatory backlash”. “The best grade I can give this is a B+,” Roach says. “The plan does deal with the issues, but in a sub-optimal way.”

Thus, with the fiscal strategy now set forth, attention will turn back to the Federal Reserve Bank, where governor Ben Bernanke will be under pressure to augment Tarp if market confidence doesn’t improve. Roach reckons that Tarp means we are more than halfway through the financial stage of the credit crisis. The real economy in the United States is only partway through. “Most adjustments are yet to come,” Roach warns, “particularly in consumption.”

More ominously, he thinks this crisis will extend to the real economies of Asia – a process that has only just begun. “Asian economies have been the beneficiary of the US consumption boom,” he notes. In 2007, the US consumer accounted for 72% of US GDP growth, thanks to bubbles in property markets, which in turn fuelled bubbles in credit (using home equity loans to borrow, for example). As Americans spend less, it will keep the US economy wobbling at very low growth for a prolonged period of time – and it will hurt Asia.

The US consumer spent $9.7 trillion in 2007, versus only $3 trillion among consumers in China and India combined – and much of that Asian wealth was based on exports. Granted, the US only accounted for perhaps 20% of those exports, but Europe and Japan are also experiencing economic declines as a result of the credit crunch, so Asian export markets worldwide are losing steam. This threatens Chinese GDP growth rates, which have already fallen from around 12% in 2007 to an expected 10% for 2008. A further cut in exports threatens to move Chinese GDP growth to 8%. The government can’t afford to see growth fall beyond that, so it is now cutting interest rates, loosening bank credit rules, and may introduce fiscal stimuli or act against further renminbi appreciation, Roach says.

(MarketWatch) -- The U.S. Senate is scheduled to vote Wednesday on its version of the historic $700 billion Wall Street rescue package, two days after the House of Representatives' stunning rejection of the original legislation.

The move capped a day of behind-the-scenes negotiations to try to salvage some version of the package that the House, defying President Bush and its own party leaders, rejected on a 228-205 vote.

The package before the Senate will be similar to the House version, with these additions, the New York Times reported in its online edition:

• The higher limit for insured bank deposits sought by the Federal Deposit Insurance Corp., which asked to raise the cap to $250,000 from $100,000, to quell opposition by individual and small-business depositors.
• Tax breaks for businesses and alternative energy, part of a package that has been caught in a stalemate in the House of Representatives. The Senate version of the gridlocked tax legislation would cost more than $100 billion and extend and expand many individual and business tax breaks, including tax credits for the production and use of renewable energy sources, like solar energy and wind power, the Times said. It would also extend the business tax credit for research and development, expand the child tax credit, protect millions of families from the alternative minimum tax and provide tax relief to victims of recent floods, tornadoes and severe storms, according to the Times.

p/s photo: Fiona Sit Hoi Kei