C.M.O. 4.7.2009

Credit Market Overview
April 7, 2009

To say that these are unusual times would clearly be classified as a “marvelous grasp of the obvious”, but just as you find the best shells searching the beach after a storm there has been at least one benefit to the tumult the world is struggling through; the number of high profile people contributing their thoughts in the media on various ways to solve the multiple challenges we face.

Advisors, cabinet members, professors, market practitioners, both past and present have supplied a constant stream of ideas on how to overcome various aspects of the obstacles that must be surmounted for a meaningful recovery to begin. It has been a case study as none ever offered by Harvard B-school with a quorum of adjunct faculty no one could afford to pull together (especially not in these times). All there and costing nothing more than the price of the paper and the time it takes to read it.

There are so many submissions in fact, that on occasion, a point: counterpoint situation occurs. That is pretty much what happened recently between a piece published by Martin Feldstein, Chairman of the Council of Economic Advisors under President Reagan and Harvard professor and James Keller, former head of structured products at UBS. Understand that these were not published in the same paper and it was only after reading them both that the idea came to do a little comparative analysis.

Writing in the WSJ this past weekend Mr. Feldstein’s overall impression of Tim Geithner’s Public Private Investment Plan (PIPP) is a positive one. He champions the Treasury’s idea of getting private investment capital to determine the price of the assets and having the taxpayer go along for the ride with the FDIC providing the financing. Making the specific point that one of the key reasons this might work is that no one has to ask congress for the money.

From here, Marty seeks to put his own twist on things and adds a few tweaks. The first of which is that the Treasury must be willing to inject capital into the banks that sell assets as the prices the assets fetch could be a tad different than the price they are currently assigned on the bank’s books. (Imagine that!) The capital, Marty thinks, should be in the form of preferred shares or perpetual debt.

Second, MF raises the point that the banks now own $3TN of residential mortgages, $1.5TN of corporate real-estate loans and $1TN of consumer debt ($5.5TN in total) and he believes getting all of this off the books is going to take a wee bit more than the $0.5TN (9% of total assets) currently planned for the program so he suggests increasing the amount allocated.

Thirdly, Marty reiterates his earlier solution of having the Government issue “mortgage replacement loans”. This is where Uncle Sam offers homeowners with negative equity; low interest recourse financing for 80% of the existing mortgage, wiping out the existing one. The benefits here are lower payments for the home owner and a 20% cushion to keep home equity positive even if prices fall a bit further reducing the likelihood of defaults; emphasizing that participants would be personally liable for the money, a big difference from current mortgages.

Mr. Keller has a few problems with the PPIPlan but since the Keller piece was published in a different paper (Barron’s) and not specifically written to refute the professor Feldstein’s piece it stands on its own as another view point.

I must first say that James is a bit more opinionated and not quite as approving of Mr. Geithner’s plan as Marty’s was but then who knows with Larry Summers already in Washington, Marty might be waiting for the nod and Harvard might become the new Goldman as a source of financial intellect.

In any case one of the key issues James Keller has with the PIPP is the pricing of the assets. I will quote JK here because nothing I could write would sum it up so succinctly.

“One of the principal aims of Geithner's plan is to provide a market where none exists, so that these securities can be valued and traded. But it is not true that nothing is trading because nobody knows what things are worth. Nothing is trading because too many people know what things are really worth.”

As such Mr. Keller believes “Banks don't want to sell to astute investors, who are bidding conservatively for something that may continue to fall in value. Banks want to sell to investors who will overpay for noneconomic reasons.” and he thinks “Geithner proposes to give them that chance.”

The other issue James has is the structure of the deal itself as from his perspective, it looks a lot like a CDO which, he says is “the very structure that supposedly caused all the trouble.” He adds that cheap financing and leverage also added much fuel to the fire and wonders why if, given the combo above, investors would act any differently this time around than they did last time and the specific act he is talking about is the overpaying for financial assets by investors.

Keller closes with a quote from none other than Will Rodgers asking "If stupidity got us into this mess, why can't it get us out?"

I will leave you with that one to ponder for yourself.

Enjoy the week.

Jim Delaney