WSJ: Clean Up Print

http://online.wsj.com/article/SB122230704116773989.html

In 1992, hedge-fund manager George Soros made $1 billion betting against the British pound. In 2007, John Paulson's Credit Opportunities fund correctly bet against subprime mortgages, clearing $15 billion for the year and $3.7 billion for him. Warren Buffett is now hoping to make big money on Goldman Sachs.

What pikers. These are small-time deals. My analysis suggests that Treasury Secretary Henry Paulson (a former investment banker, no less, not a trader) may pull off the mother of all trades, which could net a trillion dollars and maybe as much as $2.2 trillion -- yes, with a "t" -- for the United States Treasury.

 

Here's what's happened so far. New technology like electronic trading meant that Wall Street's bread-and-butter business of investment banking and trading stocks stopped making much money years ago. So investment banks took their enormous capital and at first packaged yield-enhanced, subprime mortgage loans into complex derivatives such as collateralized debt obligations (CDOs). Eventually and stupidly, these institutions owned them for themselves -- lots of them, often at 30-to-1 leverage. The financial products were made "safe" by insurance products known as credit default swaps, a credit derivative from companies such as AIG. When housing turned down, the mortgages and derivatives were worth a lot less and no one would lend Wall Street money anymore.

Treasury Secretary Henry Paulson (a former investment banker, no less, not a trader) may pull off the mother of all trades, which could net a trillion dollars

Then the piling on started. Hedge funds could short financial stocks and then bid down the prices of CDOs stuck on Wall Street's balance sheets. This was pretty easy to do in an illiquid market. Because of the Federal Accounting Standards Board's mark-to-market 157 rule, Wall Street had to write off the lower value of these securities and raise more capital, diluting shareholders. So the stock prices would drop, which is what the shorts wanted in the first place. It was all legit.

There is a saying on Wall Street that goes, "The market can stay irrational longer than you can stay solvent." Long Term Capital Management learned this lesson 10 years ago when it got its portfolio picked off by Wall Street as its short-term financing dried up. I had thought the opposite -- hedge funds picking off Wall Street -- would happen today. But in a weird twist, it's the government that is set up to win the prize.

Here's how: As short-term financing dried up, Fannie Mae and Freddie Mac's deteriorating financials threatened to trigger some $1.4 trillion in credit default swap payments that no one, including giant insurer AIG, had the capital to make good on. So Treasury Secretary Henry Paulson put Fannie and Freddie into conservatorship. This removed any short-term financing hassle. He also put up $85 billion in loan guarantees to AIG in exchange for 80% of the company.

Taxpayers will get their money back on AIG. My models suggest that Fannie and Freddie, on the other hand, are a gold mine. For $2 billion in cash up front and some $200 billion in loan guarantees so far, the U.S. government now controls $5.4 trillion in mortgages and mortgage guarantees.

Fannie and Freddie each own around $800 million in mortgage loans, some of them already at discounted values. They also guarantee the credit-worthiness of another $2.2 trillion and $1.6 trillion in mortgage-backed securities. Held to maturity, they may be worth a lot more than Mr. Paulson paid for them. They're called distressed securities for a reason.

Now Mr. Paulson is pitching Congress for $700 billion or more to buy distressed loans and CDOs from the rest of Wall Street, injecting needed cash onto balance sheets so that normal loans for economic activity can be restored. The trick is what price he will pay. Better mortgages and CDOs are selling for 70 cents on the dollar. But many are seriously distressed (15-25 cents on the dollar) because they are the last to be paid in foreclosures. These are what Wall Street wants to unload the quickest. Traders call this a "Clean Up Print".

Firms will haggle, but eventually cave -- they need the cash. I am figuring Mr. Paulson could wind up buying more than $2 trillion in notional value loans and home equity and CDOs for his $700 billion.

So the U.S. will be stuck with a portfolio in the trillions of dollars in bad loans and last-to-be-paid derivatives. Where is the trade in that?

Well, unlike Mr. Buffett or any hedge fund, the Treasury and the Federal Reserve get to cheat. It's not without risk, but the Feds, with lots of levers, can and will pump capital into the U.S. economy to get it moving again. Future heads of Treasury and the Federal Reserve will be growth advocates -- in effect, "talking their book." While normally this creates a threat of inflation and a run on the dollar, and we may see dollar exchange rates turn south near term, don't expect it to last.

First, with Goldman Sachs and Morgan Stanley now operating as low-leverage bank holding companies, a dollar injected into the economy will most likely turn into $10 in capital (instead of $30 when they were investment banks). This is a huge change. Plus, a stronger U.S. economy, with its financial players having clean balance sheets, will become a safe haven for capital.

Europe is threatened by an angry Russian bear. The Far East, especially China, has its own post-Olympic banking house of cards of non-performing loans to deal with. Interest rates will tick up as the economy expands -- a plus for the dollar. Finally, a stronger economy driven by industry instead of financials means more jobs, less foreclosures and higher held-to-maturity payouts on this Fed loan portfolio.

You can slice the numbers a lot of different ways. My calculations, which assume 50% impairment on subprime loans, suggest it is possible, all in, for this portfolio to generate between $1 trillion and $2.2 trillion -- the greatest trade ever. Every hedge-fund manager will be jealous. Perhaps Mr. Buffett is buying a small piece of the trade via his Goldman Sachs investment.

Over 10 years this could change the budget scenario in D.C., which can also strengthen the dollar. The next president gets a heck of a windfall. In the spirit of Secretary of State William Seward's purchase of Alaska for $7 million in 1867, this week may be remembered as Paulson's Folly.

Comments

[David Ulevitch]

Amazing. And so glad you are able to explain what nobody else seems to be able to, no matter how hard they try.

[matt]

Interesting. You take the polar opposite view to Gretchen Morgansen, who on NPR's Fresh Air program this week anticipates that we (the taxpayers) will end up paying more for this junk that FMV. After all, that would be in the best interests of the banks and its the banks that have the lobbying groups, not the taxpayers.

I hope your version plays out.

[kessleisacrook]

dude, you've been preaching the strong dollar and china demise for years now.

your models? are you fucking daft? you, warren buffet and the other rats are just talking your book.

positive carry? yeah if treasuries stay at 4%. what about at 10%? can't happen? just like home prices?

that 30c on the dollar paper? is going to be worth $0 even if they keep it to kingdom come.

unless they pump the inflation to 20% for years to make good. either way you're screwed.

oh, i forgot you got aapl. make sure you ask woz to make an ipod with a semiautomatic attached. might come in handy.

[Robert Dobb]

Good on 'ya, mate.

And yes, Hank Paulson came on the cheap. Forging at the least 200 million to take the job as T Secretary, as you point out, working 24/7.

You know you are right and on the right side of this issue when almost everyone else is spouting some sort of doomsday scenario, (wonder if some are talking THEIR book?) and people are calling representatives by the thousands... and you get comments like the above.

It's usually the other way around, as the public gets the cramdown. But Hank Paulson is a freaking genius. And you can hear the institutions who stuck THEMSELVES with this "distressed' paper, squirm about, calling for bailouts, while Hank full court presses this cramdown on the behalf of the citizens.

Good on Hank Paulson. ... he's SAE thru and thru.

The True Gentleman

The True Gentleman is the man whose conduct proceeds from good will and an acute sense of propriety, and whose self-control is equal to all emergencies; who does not make the poor man conscious of his poverty, the obscure man of his obscurity, or any man of his inferiority or deformity; who is himself humbled if necessity compels him to humble another; who does not flatter wealth, cringe before power, or boast of his own possessions or achievements; who speaks with frankness but always with sincerity and sympathy; whose deed follows his word; who thinks of the rights and feelings of others, rather than his own; and who appears well in any company, a man with whom honor is sacred and virtue safe.
—John Walter Wayland(Virginia Omicron Chapter 1899)

[D]

Where are the [sarcasm] [/sarcasm] tags?

This is an effort to clear the books of the primary dealers who have soiled the balance sheet of the Federal Reserve. The next leg of the real estate price decline is upon us and the primary dealers have to find a way to offload these securities before the insolvencies can no longer be disguised. I bet we burn through this pile of money and are asking for more before the end of Q1'09. I have profited on both sides of this market and will continue to do so, so I prefer not to be characterized in a binary bear/bull fashion. This is debt deflation my friends and Bernanke's thesis that a lack of liquidity caused the great depression is being proven wrong right in front of your eyes. This market cycles on the quarter, so keep an eye on your positions as we approach each quarter end.

The most laughable comment is from Bob Dobb though, "Hank Paulsen came on the cheap." The man got a tax waiver to dump all of his GS equity.

[D]

Andy there was a time when you supported independent research, you even called Jim Cramer and thestreet.com sell-outs. It's a tragedy that you've been softened by the money you earned while successfully running VelCap. Return to your roots man!

[Bob Dobb]

Most everyone that mattered knew about Paulson's selling of his GS shares. Too bad, didn't he even leave another $100 per in the timing of that sale, summer of 2006?

The problem now is, will a bill pass with out major changes. And that looks like a big zero.
This offered McCain insurance scheme is an even bigger fat zeroth.

[BobinBoston]

Thanks for the most lucid description of how this could work out for the best. I'm not sure why Paulson (and Bush, and Barney Frank, for that matter!) isn't positioning his plan in at least partly this positive a light. It's strange to see them not working the bully pulpit to move public opinion, which is now so insanely one-sided against any deal (200-1? When is that ever the case??)

I hope that Henry begins to understand that HE's the one who has to go to the People and convince us that he is sure that this is the best idea that is out there. Nobody else is credible to sell it for him, since few in Congress (gov't) have even the vaguest notion of how economics works.

[Wisdom Seeker]

I liked Kessler's book about his adventures in the Dot-Com Bull, but this piece is all wrong.

50 cents on the dollar for subprime? He must be joking. Much less. And Alt-A and Pay-Option ARMs and the rest are not far behind. The macro risks - higher interest rates due to credit scarcity, and lower real estate prices due to higher mortgage costs and lower household incomes - are huge. Besides, there is plenty of intelligent capital, now sitting on the sidelines, that knows the banks' current pricing is still too high -- otherwise it'd be buying. Paulson and the others in Washington are only making things worse by changing the rules on a daily basis and preventing anyone from being able to make a comfortable investment decision.

Paulson's TRAP can only overpay for junk; it's not like the banks are going to hand over their best stuff at bargain prices!

Furthermore, Paulson's tax-free sale of the $0.5 Billion he got for spewing toxic bonds out of GS was a heck of a windfall for becoming Treasury Secretary. And his cronies have made enormous fortunes off of his department's malfeasance in eviscerating every regulation that would have stopped this mess. His $0.5B should be put in as the first of the $700B bailout... at least 10% of which could easily come from the "bank robber" CEOs - who robbed the shareholders of their banks and left us with this mess.

[Bob Dobb]

the majority party goes first, and on the record with their opinions in from of all the cameras. foot meet mouth.

the minority party gets to go second. counter offering a plan against the first offer that the far majority of citizens did not dig at all. (even though they did not full understand it).

the majority party thinking GW is a lame duck, did not realize they were being front run by the GW admin.

brilliant.

new highs coming.

in tonite's debate, the Obama uhhhh count will reach new highs.

[Slash]

It boils down to this "Government stay solvent a lot longer then the markets can stay irrational" So the trade is to hold this portfolio til the market recovers and with banks having less of this junk marked to market on today's valuations, could actually lend and restart the economy and Uncle Sam that doesn't need equity/capital injunctions can sit on these loans til the market is higher then what's being marked today.

How about this solution : Tell FASB/SEC/Treasury or whoever runs the show now, to ask for injunction on mark-to-market on these portfolios. Since there wont' be a decrease in value of these "Assets" there won't be a need for banks/thrifts/insurance companies to raise capital to keep the liquidity in balance. No need to raise cash, no need to dump these "assets" on the street and we can have some stability. Since these assets would be treated as off-balance sheet, the banks can about doing what they do best making money out of leveraging their cash. We the taxpayers won't have to foot the $700b and the market won't be innudated with these toxic loans. Yea but the Paulson (who worked for one of the best I-banks Goldman) won't get to make the trade of the century.

My money is on Goldman...oh I mean Paulson

[Shultz]

This is a confidence crisis for sure. Liquidity has frozen. Complex mortgage backed securities can fetch only 25 cents on the dollar. So Paulson and Bernanke come up with solution: use taxpayer money to buy these toxic assets from financial institutions. The argument is systematic market failure justifies government action.

Let me ask a question: if these toxic assets are really such a good deal and would likely make money, why would there be no private investors? Is it because of the size? Or is it because these CDOs are too complex that no smart investor can figure out the "hold to maturity" value? Is it complex to a degree that even Warren Buffet would have a preferred stock deal with Goldman instead of buying these good value assets outright?

Let me also point out a fact: Japanese real estate never returns to the level before bubble burst. In fact they fetch less than 50% of that value today, more than 15 years after the crisis started.

What if the market is right, that these mortgage back securities really is worth 25 cents on the dollar only?

"The central bank gets to cheat" - by reflating the housing price? It's really a scary thought.

[E]

Gov may do well with Fanny and Freddie - but the shareholders got the shaft. They are at the back of the line now.

[Bob Dobb]

From Dot coms to penny stocks galore, shareholders get crammed down with losses all the time. And the economy just keeps on producing.

The Paulson plan ain't no bailout, it's an asset swap.

So, yea, call your Congress doofus and complain.... and show you don't really understand it all. Let them vote it all down, and watch the USD lose it's imbedded goodwill.

[Mark Sigal]

Great analysis, Andy, and I agree with your take fully. Part of the problem here is that if you are staring at an upcoming re-election bid, and being tasked to sell this to your constituency this is a tough sell because:

1) It is too complex for the layman to grok. The interplay between collateralized debt obligations, credit default swaps, massive leverage and the dynamics/dynamite of short selling hedge funds is akin to E=MC2 for most folk (myself included).

2) The message of bailout is incongruent with our pattern recognition about market efficiency and the government having no place to be a player is such an environment. We read about billionaires and their hedge funds, superstar CEOs, etc. and are told that their reward is commensurate with their results (as risk takers), but now in crash times, we are told about the consumer needing to bail out the system. Does not compute.

3) There is such tremendous distrust of Bush administration that has played the ready-fire-aim game more than once that people hear fire, and they tune out.

What is needed, as another commenter suggested, is Paulson as a front man (perhaps surrounded by Buffett and a couple of such luminaries - no one trusts economists), a clearer message that this is not just a bail out but a future nest egg for our economy with an explicit message that government is working on behalf of the consumer, not the financial institutions, and clear articulation of goals and how it will be transparent.

You sell this one once you feel that the House/Senate is lined up (behind closed doors without cameras) so Congress is packaged as having gotten something done, and this is kept as apolitical as possible.

Mark

[D]

I know some of "those" that are in the middle of the transaction flow at FNM/FRE...there is currently a $300-400 "B"illion hole that has been created there in the last 12 months via leveraging to buy/insure complete CRAP!

Let's get this dance over with and move onto the next stage of grieving...anger.

PS - I've got an IT bottom scheduled for tomorrow +/- 2 trading days (we are in the window).

[Greg]

Did your calculations take into account the debts connected with owning security contracts? You mentioned that "$2 billion in cash up front and some $200 billion in loan guarantees" that the government owns approx. $800 billion in Fannie/Freddie loans and guarantees additional loans. Does not taking over $800 billion in mortgages also mean they took over approx. the same in mortgage security debt? In other words, Fannie and Freddie generated money for their mortgage products by selling mortgage securities which they guarantee will be paid back to security investors. Their profit is made between the difference in interest repaid by mortgage borrowers and the rate paid to security investors. The government take over of Fannie/Freddie does not mean all the Fannie/Freddie security holders lost their investment. That's money the government now ensures will be paid back to those investors.

[Tom Smith]

We the taxpayers won't have to foot the $700b and the market won't be innudated with these toxic loans. Yea but the Paulson (who worked for one of the best I-banks Goldman) won't get to make the trade of the century.