JPMorgan on Geithner and Bernanke…….Apologies for the Small Font But It Is a Good Read

February 10th, 2009 5:39 pm | by John Jansen |

Treasury Secretary Geithner’s announcement on the next steps for the financial bail-out was a major disappointment.  The new plan discussed some of the ideas that have been floated in the media over recent days, and delivered some cosmetic re-labelling of existing programs, but many of the fundamental questions that former Secretary Paulson encountered last Fall remain unanswered.  In particular, the terms at which troubled assets are purchased from banks are still being “explored.”  There are three major elements in the Geithner plan:

— A comprehensive stress test coupled with further capital injections.  In an effort to prevent a large number of “zombie” banks from clogging up the financial system, regulators will encourage banks to value their assets at more “realistic” levels.  Such aggressive regulatory action could leave significant capital holes in banks that are forced to mark down their assets.  For this reason, the stress tests will be paired with more capital injections, this time in the form of convertible preferreds, the terms of which are yet to be decided.  The next round of capital injections will be available to banks with assets in excess of $100 billion.  Smaller banks will receive capital only after a supervisory review.  In other words, after the stress tests not all banks would remain viable, but only systemically important banks will necessarily receive government support to continue as going concerns.  Banks that receive the next round of capital would be restricted from paying dividends or buying back shares and would have senior executive comp capped at $500k.  These conditions would not apply retroactively to first-round TARP recipients

— Creating a bad bank, named the Public-Private Investment Fund, or P-PIF.  The assets in the P-PIF would not be held by any one institution, instead ownership would be dispersed among private investors, creating a sort of “shadow bad bank.”  While the important details of the P-PIF are yet to be announced, it sounds like it would operate almost exactly like the TALF: the Fed will provide non-recourse loans to private sector investors who purchase assets from the banking system.  The size of the P-PIF will initially be $500 billion but could be increased to $1 trillion.  It should be noted that this plan’s so-called private sector pricing of assets would be directly related to how much leverage the P-PIF extends to private investors.  The greater the share of non-recourse lending extended to investors, the higher will be the new “market” price for assets.  The dilemma that first surfaced last September — the higher the price the greater the support for the banking system, but also the greater the risk for taxpayers — is not resolved by the P-PIF but is instead transformed into a decision about how much leverage the P-PIF will provide to investors.

— An expansion of the TALF.  One of the more substantive announcements today expanded the maximum size of the TALF to “as much as $1 trillion” and “could broaden the eligible collateral” to include CMBS, private-label RMBS, and “other” ABS.  The Fed and Treasury press releases were not completely congruent: the Treasury release said CMBS was a done deal, but that expansion into other assets, private-label RMBS and “assets collateralized by corporate debt,” was “possible.”  Both releases noted that the TALF remains intended for newly-issued securities.

There was nothing in today’s announcement about providing insurance or guarantees to assets on bank balance sheets, a proposal that seemed to be the centerpiece of the reform as late as last Friday.  Any announcement related to foreclosure mitigation was deferred for a few weeks.  Note that it appears the majority of the P-PIF and TALF would be funded by the Fed balance sheet, thus not requiring Treasury issuance and possibly not even requiring Congressional action.

This afternoon, after Geithner’s announcement, Fed Chair Bernanke went before Congress to defend recent Fed actions.  Most of the testimony re-hashed earlier themes.  Interestingly, the rhetorical backing-away from Treasury purchases that was apparent in the recent speeches of FOMC members was also evident in today’s talk from Bernanke.  For example, compare today’s remarks to those from his Jan 13th speech:

Today: “The Federal Reserve‘s third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed’s portfolio.  For example, we recently announced plans to purchase up to $100 billion of the debt of government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, and up to $500 billion in agency-guaranteed mortgage-backed securities (MBS) by midyear.  The objective of these purchases is to lower mortgage rates, thereby supporting housing activity and the broader economy.”

Jan 13th: “The Federal Reserve’s third set of policy tools for supporting the functioning of credit markets involves the purchase of longer-term securities for the Fed’s portfolio.  For example, we recently announced plans to purchase up to $100 billion in government-sponsored enterprise (GSE) debt and up to $500 billion in GSE mortgage-backed securities over the next few quarters.  Notably, mortgage rates dropped significantly on the announcement of this program and have fallen further since it went into operation.  Lower mortgage rates should support the housing sector.  The Committee is also evaluating the possibility of purchasing longer-term Treasury securities.  In determining whether to proceed with such purchases, the Committee will focus on their potential to improve conditions in private credit markets, such as mortgage markets.”

The relevant remarks today were mostly taken verbatim from his speech last month, though he omitted any references to Treasury purchases.  A clue to the Fed’s thinking here may come from the criteria that Bernanke laid out for purchasing any asset class: (1) the market for that asset is severely disrupted (2) the Fed’s tools would improve conditions in that market and would be the most effective means to do so and (3) improvement in that market would improve the overall economy.  Which of these criteria does not now hold is open to debate, and while the committee’s mood could swing back toward purchasing Treasuries, currently the tide seems to be moving away from such action.
Michael Feroli
US Economist, JPMorgan Economics
tel: 212-834-5523

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  1. 6 Responses to “JPMorgan on Geithner and Bernanke…….Apologies for the Small Font But It Is a Good Read”

  2. By Dave in SV on Feb 10, 2009 | Reply

    Geithner wants to stress test the banks and you want to stress test my eyes! 🙂

    Roubini’s discusses the various proposals and recommends the government start to prepare to nationalize the banks:

  3. By John Jansen on Feb 10, 2009 | Reply

    Well I did apologize in advance!

  4. By BL on Feb 10, 2009 | Reply

    If you use Firefox as a browser, CTRL+ will increase font size. CTRL- will reduce it.

    Very handy if you like to sit back from the screen, or you’re bleary eyed in the morning.


  5. By BL on Feb 10, 2009 | Reply

    Maybe the recession is already ending anyway.

    The Age reported that iron ore is recovering from a 3 year low just as Vale, Rio Tinto and BHP Billiton start talks with Asian steelmakers to set prices for annual supply contracts.

    Mr Ric Ronge from Pengana Capital in Melbourne said that “The tone of the iron ore market has definitely changed. The outcome might not be so dire.”

    Mr Michael Rawlinson, head of mining resources & energy at Liberum Capital said that the increase in the spot market may limit the decline in contract prices.

    Mr Andrew Driscoll, head of resources research at CLSA Asia Pacific Markets said that Australian iron ore for immediate delivery is now just 15% less than the 2008 contract price.

    Goldman Sachs analysts wrote in a note earlier that “There are more signs than before that the cycle trough may have been reached. The probability has increased that iron ore negotiations could produce a better outcome than the 30% drop we forecast.”

  6. By GreenAB on Feb 11, 2009 | Reply

    thanks a lot John.

    for the record as far as the expanded TALF goes:

    …Protecting Taxpayer Resources by Limiting Purchases to Newly Packaged AAA Loans: Because these are the highest quality portion of any security — the first ones to be paid — we will be able to best protect against taxpayer losses and efficiently leverage taxpayer money to support a large flow of credit to these sectors…

    ->replaces securitization of new loans but it does nothing for the bad assets.

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